Is Microsoft a good stock to buy at a market capitalization of $3.5 billion?

Looking for artificial intelligence plays, many investors ask is Microsoft a good stock to buy. There’s no doubt, the company’s prospects are bright. However, valuation indicators have started flashing red. In this article, we evaluate whether Microsoft’s bright future is worth paying up.

Which factors have driven up Microsoft’s share price to a $3.5T marketcap?

Microsoft’s stock price has appreciated significantly over the past one to five years. It’s up by 40% over the past year and by 238% over the past five years. Understanding the drivers behind this surge requires a closer look at the company’s financial and strategic decisions as well as the market context. This analysis is a crucial element to answering the question is Microsoft a good stock to buy.

The Boom in artificial intelligence

The appreciation in Microsoft’s valuation is closely linked to the boom in artificial intelligence, not the least its investment in OpenAI. Microsoft has heavily invested in AI research and development, integrating AI capabilities into its products and services. This strategic focus not only enhances Microsoft’s product offerings, it positions the company as a leader in the AI space. For many investors, Microsoft is one of the most obvious stocks to ride the AI trend.

Cloud services

Over the past decade, Microsoft’s revenue from cloud services has experienced substantial growth, becoming a major contributor to the company’s overall revenue. Initially, in 2010, cloud services accounted for a mere 3% of Microsoft’s revenue. By 2023, cloud services represented approximately 38% of Microsoft’s $198 billion total revenue, surpassing traditional software and hardware sales. The most recent growth in Microsoft’s cloud services revenue has been impressive. For the second quarter of fiscal year 2024, Microsoft reported that its cloud revenue increased by 24% year-over-year,

Gaming

In addition to its booming artificial intelligence and cloud services division, Microsoft’s revenue is also significantly driven by its strong performance in the gaming sector, including Xbox and related services. LinkedIn, its professional networking platform, has been steadily increasing its revenue through advertising and premium subscriptions.

Microsoft’s attractive growth prospects

Both Microsoft revenue and earnings prospects are stellar. Revenue is projected to grow in the mid teens over the next two years with earnings growth slightly higher at an average of 16% per annum.

Strong but stagnating profitability

Although the company is massively profitable, it has been struggling to improve its profitability. EBITDA margin have barely improved over the past five years. And return on assets is hitting a ceiling at around 20%. Consequently, growth in margins is not a contributing factor to earnings growth.

Still, Microsoft is an absolute cash machine. Having generated $81.5B in operating cashflow during the first three quarters of its current fiscal year, it is highly likely that Microsoft will surpass the $100B mark in net operating cashflow. Considering that R&D expenses are no more than a third of net free cashflow, that leaves a lot of spare cash.

A very rich valuation

Microsoft’s valuation stands at all-time by several measures. It’s long-term trailing PE ratio – a measure dear to famous value investor Benjamin Graham – stands at 45x. The 2024 forward PE ratio is at 39.5x. By a different measure, Price-to-Sales, Microsoft’s valuation is also at an all-time high at 15x.

Our assessment of the question is Microsoft a good stock to buy

It’s a hold at best. When carrying out a data-centric, fundamental analysis of Microsoft, the verdict is clear. The stock is very expensive. Though the company grows fast given its size, revenue and earnings growth in the mid-teens cannot justify such a rich valuation.

Buying Microsoft stock at a PE ratio of 40x is equivalent to an earnings yield of just 2.5%. That’s not a particularly attractive return for a stock, even if its name is Microsoft. You can earn 3x this yield by investing in stable and safe fixed income ETFs.

Does Microsoft’s stock price have room to run? Bull markets – both in general and in specific stocks – can continue for much longer than most investors would expect. So, it’s certainly possible that Microsoft’s stock price can go higher still. We can’t just find a good way to justify it through the numbers.

Important notice

Nothing in article is to be understood as advice or a recommendation to buy or sell. Please conduct your own research before making investment decisions. To this end, we aim to provide you with the best portfolio management tool and investment research data possible. However, note that we cannot guarantee the accuracy of this information in spite of our extensive efforts to ensure that the data is complete and 100% accurate.

Disclosure

Ziggma team members may at times hold shares in one or several of the stocks mentioned in this article.