Microsoft (MSFT) is expected to deliver strong revenue growth next year, and the market estimates it will be growing exceptionally in the following years. Investing in the company presents a secure risk-reward proposition with optimal downside and considerable upside potential, and as for its price, it is marginally overvalued with modest dividends.
The company is poised to be benefited by AI and productivity tools on the cloud, which could push then to the higher end of the spectrum. Even after reaching a trillion-dollar valuation, it has room to grow, and the slight overvaluation is more than compensated with the degree of safety it has.
Cloud, Teams, and AI
I often point out that three significant changes are coming to the technology world. AI, IoT, and the other half of the population getting Internet. In terms of AI, Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Facebook (FB), Amazon (AMZN), and Microsoft are the most prominent players. Each one has core strengths that will push them forward.
Microsoft has the chance to integrate AI solutions into its cloud services and productivity tools; something only Google is in a position to compete. In other articles, I have pointed out that Google is likely the most influential player in AI, and its Chromebook business could be a threat to Microsoft. While this keeps being a risk, Microsoft is not going to make things easy for Google. The perfect example of how Microsoft is staying ahead of the curve is Teams and Planner.
Microsoft Teams and Planner are comprehensive tools that provide more profound layers of communicating and managing projects. It transforms the conventional Office experience from stand-alone tools to an entire ecosystem.
The product is not new, it launched in 2017, but due to the lifecycle of the Office software, its rollout is gradual. Because Microsoft Teams and Planner are perceived as a service, it will be easier for Microsoft to sell Office packages for a monthly subscription. Entirely switching to a monthly subscription would increase the gross margin of Microsoft and decrease the seasonality of revenue.
Microsoft is the current market leader when it comes to productivity. While Google might take the bottom side of the market, Microsoft is likely to keep its position as the market leader.
A similar situation is happening in gaming. Google’s Stadia might finally make game streaming a reality and gain for itself a share of the gaming market. While Google might lead the race for game streaming, it lacks games that create a loyal following. Sooner rather than later, the remaining console players will want to offer a game streaming platform. Microsoft is the only one that has the capabilities to provide it and the games to back its capabilities. So, it is quite likely that Microsoft, and possibly, Google, will be the top companies leading the gaming industry.
Valuation
For the revenue and earnings prediction, the assessment considers a very pessimistic scenario for the low side and a slightly optimistic scenario for the high side of the valuation. Projecting that revenue growth is in the range of 10.4% and 12.7%, taking the assumption that gross margin is between 69.7% and 72.2%, considering R&D as a percentage of revenue could range between 14.1% and 13%, and G&A as a percentage of revenue could range between 19% and 18.1%, we have the following chart.
Source: Author’s Charts
These approximations are in line with the market expectations for Microsoft in the next couple of years, as the image below shows.
Source: Seeking Alpha
I like to use Peter Lynch’s ratio when valuing a stock. This method uses the ratio between the expected earnings growth plus dividends and the P/E of the stock to determine its fair value. A stock that has a 1:1 ratio is reasonably priced. The higher the number, the more underpriced the stock is.
Source: Author’s Charts
This valuation takes into account the assets and liabilities of the company and the expected change in equity the company will have in the future. The growth considered in the valuation is the average yearly growth of the next years. While the valuation considers the dividend to estimate the fair price, it is not taken into account for the average annual return.
With this valuation, arguably, the stock is at worst overvalued by 27% and at best overvalued by 7%. So, the stock is overvalued.
Source: Author’s Charts
Constructing an adjusted Beta Pert risk profile for the long-term prospects of the stock, we can calculate the risk profile for the company.
Source: Author’s Charts
The risk profile shows there is an 8% probability that Microsoft will ever trade at a lower price than it is today. Considering the potential downside, upside, and the likelihood of each, the statistical value of the opportunity of investing now is of 8.7%
Source: Author’s Charts
The average valuation yearly returned did not consider the dividends received for holding the stock. The chart above shows the average yearly return, considering the dividend that the company issues. An 11.8% average return is a dream come true for conservative investors, especially if the low side of the pessimistic valuation has an expected return of 7.8%.
Conclusions
The core business of Microsoft is remarkably strong. The slight overvaluation of the stock is more than compensated by the firm financials, the unbeatable risk-reward proposition, and the more than acceptable level of debt.
Microsoft’s bet in AI, gaming, and development of its productivity tools will pay off. The company is uniquely positioned to take advantage of the market trends that will hurt its competitors while leaving Microsoft unscathed and stronger than ever.
It might be a good time to get a good and safe position at a reasonable price. It might not be a record-breaking performer, but it has solid chances of overperforming the market for the foreseeable future.
If there is anything in this article, you agree or disagree with or would like me to expand further on; I would sincerely appreciate you leaving a comment. I will address it as soon as possible.
Disclosure: I am/we are long MSFT, GOOG, GOOGL, FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
