Apple And Microsoft: Overvalued Or Undervalued?

Apple and Microsoft stocks had a big run-up in the last five years. As a result, they are overvalued, according to traditional financial metrics like price-to-earnings ratio (PE) and intrinsic value. But they are still undervalued according to one economic metric: economic value added (EVA) or economic profit.

As of Monday's closing, Microsoft and Apple were trading with forward PEs of 32 and 27, respectively, well above the S&P 500 PE of 19. In addition, Gurufocus.com estimates Microsoft's intrinsic value to be $345.60, slightly below its current market price of $352. Gurufocus.com estimates Apple's intrinsic value to be $176.17, very close to its current market price of $179.

However, both companies are undervalued when the EVA growth of the two companies is compared to the growth in their market capitalization.

EVA is a measure of the strength of a company's competitive advantage and the effectiveness of its management in allocating capital in the discovery and exploitation of new business opportunities.

Rising EVA suggests that the company is strengthening its competitive advantage. Its management becomes more effective in allocating capital to business opportunities that deliver superior market returns, meaning the return on invested capital (ROIC) exceeds the weighted average cost of capital (WACC).

By contrast, declining EVA signals that the company's competitive advantage is eroding as management fails to find business opportunities that deliver superior market returns.

Microsoft and Apple belong in the first category. Over the past five years, their EVA grew much faster than their equity, outperforming the rest of the "magnificent" seven stocks.

Microsoft's EVA soared by soared by 640%, while its equity price rose by 200%. Apple's EVA rose by 400%, while its stock rose by 240%. By contrast, Meta's EVA dropped by 55%, while its stock rose by 105%. Alphabet's EVA rose by 60%, while its stock rose by 146%. Nvidia's EVA rose by 450%, while its shares rose by a whopping 737%. Amazon's EVA is still negative, while its shares rose by 66%.

Rising EVA has allowed both companies to keep beating analysts' top and bottom-line expectations, even their guidance. For instance, in the most recent quarter, Microsoft's $2 billion top-line beat resulted in a nearly 13% EPS beat, ahead of company guidance.

There are a couple of good explanations behind the superior EVA performance of Microsoft and Apple among the magnificent seven.

Microsoft has strong moats in its traditional Windows business, which allows it to enter new high-profit margin businesses like the cloud.

"All business segments reported results above street expectations, Office, LinkedIn, Cloud, Gaming," Craig M. Sarembock, a wealth advisor and principal at Bartlett Wealth Management, told International Business Times, commenting on the company's recent financial report. "Even PC results were much better than expected. Both gross and operating margins topped expectations. Cash generation was solid as usual, and the company repurchased $4.8 billion of stock."

"Quite surprising to see strong growth reacceleration in the Azure Cloud segment, which is clearly driven by AI-as-a-service related demand," said Tejas Dessai, research analyst at Global X ETFs. "We think this print should help keep the AI story under focus for the rest of this year and 2024. Microsoft's consumer-facing franchises, including Xbox, are underappreciated and are showing strong growth, which may be a sign of the broader gaming space steadily entering a recovery as well."

Apple's new role as a gatekeeper of the internet and broad ecosystem has allowed the company to create lock-in customer relations. Moreover, the company's services segment, including the App Store, iCloud, Apple Music and Apple TV+, has become a new source of growth and a significant contributor to the company's rising EVA.

Sarembock sees Microsoft's high EVA growth to continue as the company adds on new high-margin businesses. "We are hearing that the Copilot add-on (available Nov. 1) is seeing strong initial demand and usage," he explained. "Also, their recently completed acquisition of Activision and the prospect of a 'Netflix type' subscription service will likely continue to produce upside surprises on Revenue and Earnings."

"As we watch the game board, strategic power plays like acquiring Activision Blizzard and launching the Microsoft 365 Copilot AI add-on are undeniable indicators that Microsoft is 'playing chess while others play checkers' in the tech arena," said Matt Oguz, co-founder of the Venture Science Fund.

Disclosure: The author owns shares of Microsoft and Apple.