Valuation Sun Microsystems Style
The high hurdle of payback in ten years is achievable.
Scott McNealy, the CEO of Sun Microsystems in 2002, made an address to investors, lambasting them for the price (10x Sales) they were prepared to pay for his company:
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero costs of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realise how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
McNealy has been seen as an oracle (pun-intended1), a wiser head, in the current market environment where paying 10x Sales for global technology companies has been seen as cheap. But was he really right? Can these valuations make sense? The answer is probably yes.
The Critique
There are three obvious problems with McNealy’s analysis. First, what revenue growth should be expected over the next ten years? Sun had a CAGR of 12.2% between 2002 and 2008. An investor buying Sun in 2002 was paying 5x Sales in 2008 (Is that better?). Second, what is the terminal value at year-10, or alternatively, why a ten-year payback? As an extreme example, the 10-year yield on government bonds (risk-free rate) pays back capital, in coupons, over 33 years. Third, what is a sustainable gross margin for a tech company.
The Exercise
If consideration is made of the critique, it’s possible to use this payback framework to consider current valuations in global equities by comparing cumulative payback over ten years for a number of companies. By using current net income margin, and actual five-year revenue growth, it’s possible to see what the market is buying.
Microsoft: The company has grown 15% per annum for the last five years, it has a net income margin of 37% and a current price to sales of 10.5x.
Apple: The company has grown 11% per annum for the last five years, it has a net income margin of 26% and a current price to sales of 6.1x.
Louis Vuitton: The company has grown 9% per annum for the last five years, it has a net income margin of 20% and a current price to sales of 4.8x.
Nestle: The company has grown 0% per annum for the last five years, but expects 5.1% this year, it has a net income margin of 10% and a current price to sales of 3.6x.
Adobe: The company has grown 18% per annum for the last five years, it has a net income margin of 30% and a current price to sales of 12.6x.
Does Adobe’s faster growth justify its high valuation? Is Microsoft’s profitability underestimated by the market?
The chart below shows the cumulative net income made by each company relative to the current price to sales valuation. In year one, Microsoft makes net income equivalent to 3.6% of its current valuation (market capitalisation). In year 10, it has accumulated 72% of its net income relative to its current valuation.
The analysis shows that none of these companies will payback their initial investment to shareholders within ten years based on current data. But for Microsoft, Apple, and Adobe, further expansion of the net income margin could lead to them achieving payback. Similarly, Louis Vuitton could see sales accelerate out of the pandemic period. This would support them achieving payback.
It also shows that two of the largest companies in the world, Apple and Microsoft, are not particularly expensive relative to the market and their future income production.
Conclusion
This relatively simple analysis shows that McNealy’s concerns over valuations can be over-done. Rapid growth and high profitability enable companies to carry high valuations and still offer good future returns to investors.
Sun Microsystems was bought by Oracle in 2009.