Microsoft Edges Out Tech Giants in Value Investor’s Analysis
In a practical evaluation of popular tech stocks, Microsoft has emerged as the preferred investment over Apple and Tesla, according to a value investor’s framework. The analysis, which focuses on growth, distributable cash flows, and multiple changes, aims to identify stocks with the highest probability of exceeding a 10% annual return with a low risk profile.
The Value Investing Framework
The methodology employed in this analysis is built upon a decade of market experience and extensive reading in investing. It comprises three core components:
- Growth: This involves projecting a company’s revenue growth rate over the next few years by examining historical performance, management guidance, analyst expectations, industry trends, and macroeconomic mega-trends.
- Distributable Cash Flows: Similar to Warren Buffett’s concept of “owner earnings,” this metric assesses the surplus cash a company generates that could be distributed to shareholders through dividends or share buybacks, accounting for cash efficiency and reinvestment needs.
- Multiple Change (Valuation): This component utilizes key ratios like Enterprise Value to Earnings Before Interest and Taxes (EV/EBIT) and Price-to-Earnings (P/E) to compare a company’s current valuation against its historical averages and peers. It also factors in potential changes in profit margins.
These three components are summed to estimate the yearly return. A crucial addition is a risk profile assessment to ensure comparable risk-adjusted returns.
Apple: A Behemoth Facing Valuation Headwinds
Apple, the world’s most valuable company, presents a compelling case study. Historically, Apple has achieved a Compound Annual Growth Rate (CAGR) of 8.5% over the last decade. However, analysts project a more modest 6% annual growth for the next two years, aligning with the global smartphone industry’s estimated 4% growth. While Apple’s services and ecosystem offer strong customer loyalty, its reliance on the iPhone and the maturing smartphone market pose challenges.
Distributable cash flows are estimated at around 5% annually, primarily through share repurchases and a small dividend. Valuation-wise, Apple currently trades at a higher EV/EBIT of 24 and P/E of 30 compared to its 5-year and 10-year historical averages. The analysis suggests that much of the current valuation is driven by expectations around AI and new product launches like the Vision Pro. However, with projected growth rates not significantly exceeding historical averages, the current multiples are deemed too high.
The analysis forecasts a multiple contraction, expecting Apple to revert to its 5-year historical average EV/EBIT of 20.5 and P/E of 26. This leads to an estimated 3-year CAGR of 4% (6% growth + 5% distributable cash flow – 7% multiple contraction), with a low risk profile.
Microsoft: Strong Growth and Resilience
Microsoft demonstrates robust historical growth, with a 10-year average CAGR of 10.5%, and has shown recent acceleration. Analysts anticipate a 13% annual growth for the next three years, largely fueled by AI adoption in its cloud services (Azure) and Office suite. The cloud services segment, a significant revenue driver, is expected to grow at a 15% CAGR.
Distributable cash flows are estimated at 2.5% annually, derived from share repurchases and dividends, with a slight reduction in net debt. Current valuations stand at EV/EBIT of 26.5 and P/E of 33, closely mirroring its 5-year averages. Profit margins are at a 20-year high, with no expectation of further increases.
The analysis projects a modest multiple contraction to EV/EBIT of 25 over the next three years, reflecting a slightly lower growth rate compared to historical performance. This is justified by Microsoft’s resilience to economic cycles, recurring revenue streams, and a strong competitive moat, potentially wider than Apple’s due to its near-monopolistic positions in operating systems and productivity software.
Microsoft’s estimated 3-year CAGR is 12% (12% growth + 2.5% distributable cash flow – 2.5% multiple contraction). This projection, combined with a slightly higher risk profile than Apple but still considered manageable, positions Microsoft as the current leader.
Tesla: High Growth, High Risk
Tesla’s growth prospects are significant, with analysts projecting a 25% annual growth rate for the next three years, mirroring the expected industry growth for electric vehicles (EVs). However, determining distributable cash flows is complex due to high capital expenditures required for its rapid expansion. Over the last 1.5 years of profitability, shareholder dilution has been approximately 4.5% annually, partially offset by debt reduction.
Tesla’s current valuation is exceptionally high, with EV/EBIT of 61 and P/E of 70, significantly outpacing traditional automakers which trade at EV/EBIT multiples between 9 and 15. The analysis anticipates a substantial multiple contraction, expecting Tesla to trade at EV/EBIT of 40 and P/E of 50 in three years, assuming a growth rate of 20% or lower.
The risk profile for Tesla is deemed the highest among the three. Factors include potential economic downturns, increased competition from established automakers, slower-than-expected EV market growth, reliance on subsidies, and the uncertain timeline and impact of its full self-driving technology. The valuation itself, even with projected multiple contraction, remains aggressive compared to industry peers and even other tech giants.
Despite a projected 3-year CAGR of 13% (25% growth – 4% distributable cash flow – 8% multiple contraction), the numerous uncertainties and the lack of a significant margin of safety lead the analysis to conclude that Tesla is too risky compared to Microsoft.
The Unveiling: Betsson as the Top Pick
While Microsoft emerged as the preferred stock among the tech giants, its projected 12% CAGR is considered only moderately attractive with a limited margin of safety. The analysis then introduces a less conventional, but potentially more rewarding, investment: Betsson, a Swedish online gambling company.
Betsson exhibits a consistent 10% historical revenue CAGR over the past decade and is projected to grow at 9% annually for the next three years, aligning with the online gambling industry’s projected 12% CAGR. Crucially, Betsson generates substantial distributable cash flows of 7% annually, with no significant reinvestment required for its projected growth.
The company’s valuation is notably low, trading at EV/EBIT of 7 and P/E of 8.5, below its historical averages. This undervaluation is partly attributed to ESG concerns and its exposure to the Turkish market, though these factors are expected to diminish over time. The analysis forecasts a multiple expansion to EV/EBIT of 9 over the next three years.
With a 9% growth rate, 7% distributable cash flow, and 6% multiple expansion, Betsson is projected to deliver a 22% yearly return over the next three years with a low risk profile. The primary risks identified are the growth rate and regulatory changes in Turkey, but the company’s diversification and long operational history mitigate these concerns.
Market Impact and Investor Considerations
This comparative analysis highlights the importance of not just identifying great companies, but also assessing their current valuations and risk profiles. While Apple and Microsoft represent strong, established businesses, their current market prices may limit near-term upside potential. Tesla, despite its innovative edge and high growth projections, carries significant valuation and execution risks.
What Investors Should Know:
- Valuation Matters: Even the best companies can be poor investments if bought at too high a price. Apple’s premium valuation, despite its quality, leads to a lower expected return.
- Risk-Adjusted Returns: The focus is on achieving a high probability of returns that exceed market averages, rather than chasing the highest possible return with excessive risk. Microsoft’s balanced profile makes it a safer bet than Tesla.
- Diversification and Unconventional Sectors: Betsson’s case demonstrates that attractive opportunities can exist outside of mainstream tech, often in sectors with less favorable public perception but strong underlying fundamentals and lower valuations.
- Long-Term Perspective: The analysis focuses on a 3-year horizon, but the principles of growth, cash flow, and valuation are applicable for long-term investing.
The analysis concludes that while Microsoft offers a compelling 12% expected return with manageable risk, Betsson’s projected 22% return with a low-risk profile makes it the superior investment choice according to this value-oriented methodology. This underscores the potential for significant returns when combining strong fundamentals with attractive, often overlooked, valuations.
“Price is what you pay; value is what you get.” – Warren Buffett
Source: Which One of These Popular Stocks Would I Buy? (YouTube)
