microsoft vs fang stocks

Is Microsoft Stock Price Too Much of a Good Thing?

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Should you invest in shares of Microsoft and at what price?

Shares of Microsoft have surged over 200% in the last five years but are shares about to go a little soft? What are the major factors driving the stock price and should you invest now or wait for a better opportunity?

In this video, I’ll break down that massive return and give you a full analysis including the Microsoft stock news that could move the market.

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Microsoft Stock Price Returns

The stars have aligned for Microsoft lately and shares have produced a 27% annualized return in the last five years. That’s almost triple the 9.3% annual return on the broader market.

In fact, even against some of these big growth names, Microsoft has outperformed. It’s beaten the big FANG stocks like Facebook and Apple over that five-year period. In fact, only Netflix has produced a higher return and I’ll be doing a full analysis of that stock in our next video so don’t miss that one.

microsoft vs fang stocks
Microsoft vs FANG Stocks

But is it too much of a good thing? Can Microsoft keep up that pace? One analyst has a $163 price target for 17% upside over the next year while another has the shares at just $93 each or a potentially devastating 33% downside…so which is right?

Let’s look at what those analysts are watching, what matters most in Microsoft’s stock price and develop a stock price target of our own. First though, if there’s a company you want to see analyzed, let me know in the comments below and I’ll put something together.

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Is Microsoft a Dividend Stock?

Shares of Microsoft have been on fire with growth in its cloud business. That 27% annual return over the last five years would be impressive for any company but it’s absolutely amazing considering the sheer size of Microsoft.

This is a trillion-dollar company growing revenue and earnings at 10% a year!

Now one casualty of this huge growth has been the dividend yield. I’ll get into the cash return numbers but even on solid dividend growth, the payout hasn’t been able to keep up with the stock price.

Remember that the dividend yield is just the dividend divided by the stock price so even if the dividend is increased, you can still be getting a lower return if the shares increase faster. Microsoft has increased its dividend but the share price has grown so much faster that the company is only paying a 1.3% dividend yield versus a 2.5% yield in 2014.

So Microsoft doesn’t qualify for our 2019 Dividend Portfolio because it fails that 3% yield requirement but a total return of almost 30% a year would put the company on anyone’s radar.

Microsoft Earnings and Outlook

Right now, shares are trading at 29-times the company’s earnings. That’s pretty lofty considering competitors like Cisco trade and the industry itself trades around 20-times last year’s earnings. Looking at this graphic on Microsoft’s price-to-earnings history, the valuation on shares has contributed to about half the overall stock price increase.

Microsoft PE History
Microsoft PE History

We’ll look at the company’s earnings growth but think about what I just said. The price-to-earnings ratio represents investor enthusiasm, how much investors are willing to pay for a company’s earnings, and that increase in sentiment has contributed to half of Microsoft’s stock price increase.

As we’re looking through the company’s business growth, you’ll see that a lot of that positive sentiment is deserved. Microsoft has really been firing on all cylinders in a lot of its business segments but whenever you have a big chunk of a stock’s return depending on that investor sentiment, the PE ratio, it gets very hard to keep that up.

Earnings are expected higher by 9.9% over the next year to $5.22 per share and you can see that management has done a good job of beating expectations. That 13% earnings surprise last quarter was just over the average with Microsoft beating earnings estimates by about 11% on average over the last two years.

Microsoft Earnings
Microsoft Earnings

Sales are expected 9.8% higher to $138.2 billion over the next year and this is really where I think we could see the company continue that strong earnings performance.

Not only is Microsoft growing sales at a very strong clip but it’s improving profitability as well and spinning off a huge amount of cash flow. So current expectations are for sales and earnings to grow at that same 10% rate but if Microsoft is becoming more profitable, it should be able to grow earnings faster than sales.

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Microsoft Fundamental Analysis

We’re here in the company’s income statement, the financial statement showing its sales and earnings and remember you want to look at the company’s operating income. I pointed this out a few weeks ago as one of the most important measures to compare stocks, taking that operating income against the revenue to find the company’s profitability compared to peers.

We see that Microsoft made just over $35 billion last year in operating profits against $110 billion in sales. That’s an operating margin of 32% which is a huge improvement over the 25% margin it reported in 2017.

By comparison, Cisco is reporting a 26% operating margin so not only is Microsoft above its peers in this business profitability measure but its improving on that profitability as well.

That boost to earnings from profitability plus a share buyback program should make it easy to beat these earnings numbers and I’m expecting profits closer to $5.70 a share over the next year.

Now let’s look at where those sales and earnings are coming from and how Microsoft has been able to grow that stock price by 27% annually.

Last quarter’s Azure sales, that’s the company’s cloud services, surprised to the upside with a 64% year-over-year growth and this is really the driver over the last few years. Microsoft announced its largest cloud services deal ever with a $2 billion contract with AT&T and CEO Nadella said there is a line of sight to many more such deals.

Server products continue to do well and the key is that margins, or that profitability is improving so even as the company books solid growth, it’s doing it more efficiently as well.

Microsoft has successfully transitioned from that point-in-time sales model to a subscription service and is positioned for the cloud-based software-as-a-service future. Office and other software products have all transitioned to the cloud and it’s a virtual monopoly on office software so customer adoption is all but guaranteed. That’s going to mean a steady stream of revenue but at higher margins over the next few years.

I’m forecasting a $1.87 dividend this year and that’s estimating an increase to $0.49 a share in the November payment. That would mean this year’s dividend increase is around 8.7% which is higher than the last couple of years but smaller than what we saw in 2015 and 2016.

Microsoft Dividend Growth
Microsoft Dividend Growth

Microsoft Stock Price Risks

Overall the company has done a great job at increasing its cash payout. It returned $7.7 billion to shareholders last quarter alone with $4.2 billion in share repurchases and $3.5 billion in dividends. With $134 billion in cash on the balance sheet and generating $30 billion a year in cash flow, that dividend is about as safe as it gets.

What’s a little harder to explain is the company’s increase in debt over the last five years. Ultra-low interest rates have allowed Microsoft to tack on $60 billion in long-term debt which isn’t necessarily a problem. Interest expense is manageable and the company has increased its balance sheet cash by almost exactly the same amount.

Microsoft has always been an acquisitive company, making some big purchases, but I’m a little worried it’s about to use a chunk of that cash for a big expensive acquisition and I’m not sure it really needs it right now.

The company’s strength is that it already has so much of that traditional hardware on-site at companies so it’s got a foot in the door and can convince customers to transition to its new cloud services seamlessly. 

You really get the sense that cloud is a two-horse race between Microsoft and Amazon. AWS bolted out of the gate and really surprised everyone but Microsoft has used its legacy on-premise strength to catch up and come out a length ahead.

In fact, gaming is really the only soft point for the business, last quarter and into the foreseeable future. Fading interest in Fortnite and weak console sales contributed to disappointing revenue last quarter and the this is one segment where Microsoft really hasn’t proven its long-term dominance. Gaming is about 9% of total revenue and still growing double-digits year-over-year so not bad but trailing the strength in other segments.

Microsoft Stock Price Predictions

Taking all this together, we can get a sense for a Microsoft stock price target and where shares go from here.

Microsoft is heavily covered with 27 analysts providing estimates. Michael Turits at Raymond James has the high target of $163 a share for about an 18% upside. John Difucci at Jefferies has the low target at $93 a share and 33% downside.

MIcrosoft Price Predictions
MIcrosoft Price Predictions

Most of the analysts are expecting right around that $150 to $160 price range. That would put the shares at 27-times my $5.70 earnings estimate. It’s a little lower than the current PE but still really high on a historical basis.

There’s a lot of positivity around continued growth in Azure and stronger profitability. Investors are no longer really worried about that sales cliff for legacy products like Office or some of the hardware.

I get the sense that things are almost too good at Microsoft and the market knows it. The last few quarters have been really good and it feels like this best-case scenario is priced into the shares. Cloud and Azure will surely continue to grow but at a slower rate and any headline risk outside that perfect scenario is going to test investor sentiment.

I think the $150 to $160 price target among analysts is probably on the high side but still represents a solid 11% gain on the shares. I’m doubtful the PE ratio can go beyond that 30-times level so shares hit a ceiling at $170 and could potentially be stuck around $142 on any kind of bad news and maybe a 25-times PE multiple. I don’t see the shares as hugely overvalued which is actually saying something considering most of the market is pretty expensive.

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Microsoft really does have something with its cloud growth and that’s going to propel sales for a while. I definitely don’t think you should expect 27% annual returns over the next five years but I’d feel comfortable buying shares now for a good long-term investment.

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