Stack Ranking and Value Traps
Eric is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Several older technology firms look cheap right now. Microsoft (NASDAQ: MSFT) currently has a trailing P/E of 11.3 and a forward P/E of 10, which is lower than companies in many sectors, let alone the tech industry. Investors may be wondering if these tech firms are value traps. Tech companies that aren't innovating aren't good investments, even if the firms' stock isn't selling for a premium. Vanity Fair plans an August article that could explain a few of the reasons behind Microsoft's current valuation, including Microsoft's employee stack ranking system.
Stack ranking is simple to explain and has several obvious advantages for a manager, so many companies have implemented their own stack ranking systems. For example, a manager might have 10 employees who produce an average of 50 widgets each day, which gives a total of 500 widgets. If the least efficient employee makes 30 widgets on average, and the manager lays off this employee, the manager now has 9 employees who produce 470 widgets. Now the manager has a team that produces an average of 52 widgets per employee each day, which means that the team is now 4 percent more productive. The manager may need to hire another employee to get back to making 500 widgets a day, which adds training and hiring costs that reduce the financial benefits of stack ranking.
Although the company may gain a short-term performance improvement with stack ranking, it can reduce the firm's long-term potential. John C. Dvorak at PC World explains that stack ranking rewards an employee if his coworkers perform badly, as the employee who has a higher performance rating will look better and have a more secure job. An employee may not tell her manager if a coworker has an innovative idea, and the employee may switch her focus to gaming the stack ranking metric instead of thinking up new products.
Stack ranking seems like an ideal way to create a value trap. The stack ranking company's short-term earnings may rise because of its increased productivity, which could help the company beat earnings forecasts. This could make the company look very good under various value metrics, but investors may wonder why a company that was once a tech innovator seems more focused on making minor upgrades to its original product lines now.
Microsoft did take a major step toward becoming more innovative in 2011 with its Garage initiative. Like the original Hewlett-Packard (NYSE: HPQ) founders, Microsoft employees tinker with new projects in the Garage, and Microsoft can afford lots of high-end tech tools to help its employees test out their new ideas. Microsoft's Garage has 60,000 square feet of space and frequently hosts science fairs where Microsoft employees show off their inventions, reports Jay Greene at CNET. The Mouse Without Borders program, which allows a user to drag a cursor across separate computer screens, is one of the Garage's public achievements.
Although Hewlett-Packard has served as a model for many tech companies, it's now in the middle of a major turnaround, led by Meg Whitman of eBay fame. With a P/E of 7.9 and a forward P/E of 4.6, Hewlett-Packard is even cheaper than Microsoft, although Hewlett-Packard and Microsoft both have some of the same problems right now. They both rely on the personal computer market heavily, but many consumers have switched to smartphones and tablets.
Many projects in Microsoft's Garage involve the Web, as the Google (NASDAQ: GOOG) Chrome browser continues to attract Internet Explorer users, and Microsoft's Bing search engine remains a distant competitor to Google. The Bing blog mentions a Garage project that translates instant language messages, which could help Microsoft compete with Google and Facebook's (NASDAQ: FB) language translation capabilities.
Microsoft has also been increasing its focus on business customers, which its Yammer acquisition illustrates. Mary Jo Foley at CNET reports that Yammer cost Microsoft $1.2 billion and Microsoft plans to add Yammer to upcoming editions of Microsoft Office, although it might be too late to add it to Office 2013. Adding social features to business products seems like a better strategy for Microsoft than setting up a Microsoft social network for the general public to compete with Facebook directly, as even Google has struggled to convince Facebook users to switch to Google+.
Even though stack ranking might have prevented some innovative products from coming out, Microsoft's Garage initiative shows that the company isn't out of ideas just yet. Microsoft has one of the strongest balance sheets in the tech industry, with $58 billion in cash right now, so it can afford to buy companies like Yammer when Garage projects like OfficeTalk don't look as promising. Microsoft's management methods and dependence on a few product lines could be potential sources of trouble, but the Garage stops Microsoft from being a true value trap.
enovinson has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook, Google, and Microsoft. Motley Fool newsletter services recommend Google and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.