Ask Matt: Is Microsoft a good stock to buy?
— -- Q: Is Microsoft a good stock to buy?
A: Quick. Name a company that's releasing a new operating system for tablet computers. It's a leader in software and services that work on the cloud, or remote servers. It has software for smartphones that's widely acclaimed.
While investors typically think of Microsoft for its dominant position in desktop computing systems, the company has been working to reinvent itself in an age of mobility and cloud-based services.
The company's upcoming Windows 8 operating system, for the first time, promises to bring the power of a desktop to a mobile tablet computer. Microsoft Windows Phone operating system continues to garner kudos from early adopters, especially thanks to the partnership with Nokia. And Microsoft already has a deep expertise in cloud-based systems both for productivity software such as spreadsheets, but also for consumer products, including its free cloud-based storage system called SkyDrive.
But Microsoft's stock has been far from the clouds, until this year. The stock, which has hardly budged over the past few years, has been starting to rise, gaining 26% this year. But should you bet on this former leader that's trying to regain its luster?
To find out, we'll put the stock through the four tests considered at Ask Matt, including:
Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Microsoft's trading history back to 1986, we see the company generated an average annual compound return of 26%. That's a solid performance if you consider the S&P 500 returned an annualized 9.5% return over the same period, says IFA.com.
But to get that better-than-average return, you had to take greater risk. You accepted risk — standard deviation — of 54 percentage points. So, by investing in Microsoft, you took on 242% more risk to get a 173% greater return. Taking on more risk than you get in return isn't a good trade-off, so Microsoft doesn't pass this test.
Step 2: Measure the stock's discounted cash flow. Some investors decide whether a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs.
When we run Microsoft's stock, we find it's rated "very attractive." In other words, the current stock price is well below the value of what the company is expected to generate in cash over its lifetime. Microsoft passes this test, and it indicates the stock is deeply undervalued.
Step 3: Compare the stock's current valuation to its historical range. BetterInvesting's Stock Selection Guide can help. If the company can increase earnings 8.8% a year the next five years, that would put the stock in the "buy" range. This indicates Microsoft's stock is a bargain relative to the earnings the company is expected to generate.
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