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$MSFT Microsoft Stock Analysis: Is the Risk/Reward attractive?
Thoughtful Investing
May 03, 2023
Business Model
Microsoft’s (MSFT) business model is centered around three core segments:
Productivity and Business Processes
Intelligent Cloud
More Personal Computing
Productivity and Business Processes segment includes products and services such as Office 365, LinkedIn, Dynamics, and Office products. This segment is focused on helping businesses and individuals increase their productivity through cloud-based software and services.
Intelligent Cloud segment includes products and services such as Azure, Windows Server, SQL Server, GitHub, and Enterprise Services. This segment focuses on providing businesses with cloud-based infrastructure and platforms that enable digital transformation and accelerate innovation.
More Personal Computing segment includes products and services such as Windows, Xbox, Surface, and Bing. This segment is focused on providing consumers with computing devices and software that enhance their personal and entertainment experiences.
In addition to these core segments, Microsoft also generates revenue through advertising, gaming, and hardware sales. Microsoft's business model is driven by a combination of product sales, subscription-based services, and licensing agreements
Track Record
Successfully grew Revenue, Net Income and Free Cash Flow for the last 10 years:
And on a per share basis, successfully grew Revenue Per Share, Earnings Per Share and Free Cash Flow Per Share for the last 10 years:
High return on capital:
Balance Sheet
Microsoft has a fortress balance sheet:
Competitive Advantages
Brand recognition: Microsoft is one of the world's most recognizable brands. Its products, including Windows, Office, and Xbox, are household names that have become synonymous with personal computing.
Diversified product portfolio: Microsoft has a wide range of products and services, including personal computers, gaming consoles, software, cloud services, and more. This diversification helps the company stay resilient during economic downturns and helps to offset any declines in one particular product line.
Strong financial position: Microsoft is one of the largest and most profitable companies in the world. Its strong financial position allows it to invest in research and development, make strategic acquisitions, and weather any economic uncertainties.
Network effects: Microsoft's products, such as Windows and Office, have network effects, meaning that their value increases as more people use them. This creates a barrier to entry for competitors and helps Microsoft maintain its market dominance.
Cloud computing: Microsoft has invested heavily in cloud computing, which is a rapidly growing market. Its cloud platform, Azure, is one of the leading cloud services providers, and the company has also been expanding its presence in the software-as-a-service (SaaS) market.
Strong partnerships: Microsoft has formed strong partnerships with other companies, such as hardware manufacturers and software developers, which helps to increase its reach and expand its offerings.
OpenAI Exposure
In July 2019, Microsoft backed OpenAI with $1 billion, and the investment made Microsoft the “exclusive” provider of cloud computing services to OpenAI.
In 2021, The New York Times notes $MSFT "quietly" invested an extra $2 billion since that initial round.
In January 2023, Microsoft said that it’s extending its partnership with OpenAI with a "multi-year, multi-billion-dollar" investment:
“This agreement follows our previous investments in 2019 and 2021. It extends our ongoing collaboration across AI supercomputing and research and enables each of us to independently commercialize the resulting advanced AI technologies.”
Microsoft also became a key backer of OpenAI’s Startup Fund, OpenAI’s AI-focused venture and tech incubator program.
Valuation
In the past 10 years, $MSFT stock has traded at an average of 28x P/E. 5-year average is 35x. It currently trades at 29x P/E:
Current P/E of $MSFT is higher compared to the P/E of NASDAQ 100:
The P/E of $MSFT is higher than some of its peers ( $AAPL, $NFLX, $GOOG, $META ):
Forecast
Analysts are expecting EPS growth rate to be around 12% for the next 5 years:
Free Cash Flow growth forecast:
Risks
Intense competition: The technology industry is highly competitive, and Microsoft faces competition from a variety of companies, including Apple, Google, Amazon, and more. This competition could impact Microsoft's market share and pricing power.
Tailwinds
The global artificial intelligence market is predicted to have a CAGR of 38.1% until 2030.
Cloud computing market size is projected to surpass around USD 2,321.1 billion by 2032, and it is poised to reach a registered CAGR of 16% from 2023 to 2032.
DCF
Using 12% EPS growth rate, 10% discount rate and 2% terminal growth rate:
Using a conservative 8% EPS growth rate, 10% discount rate and 2% terminal growth rate:
Reverse DCF
Using EPS:
Using Free Cash Flow:
Free Cash Flow Yield vs US 10-Year Treasury Yield
Conclusion
Current P/E is lower than the 5-year average and in line with the 10-year average.
Higher P/E compared to the NASDAQ-100 and compared to peers like $AAPL, $NFLX, $GOOG and $META.
Overvalued in the DCF calculations.
The expected growth rates based on the Reverse DCF calculations is difficult to be met.
Free cash flow yield (~2.6%) is lower than the US 10-year treasury yield (3.4%).
In my opinion, the Risk/Reward of $MSFT isn’t attractive. There’s not a lot of margin of safety. The growth rates doesn’t justify the valuation and the potential upside is mainly multiple expansion (e.g, it trades closer to the 5-year average).
I’ll be interested to potentially accumulate $MSFT at around $250 or lower. At $250, it becomes a potentially reasonable buy in my opinion. If I’ll accumulate shares of Microsoft, I’ll accumulate at different price levels like buy at $250 as a starter position and if it keeps on going lower, buy at $230, $200, $180, etc… until I reach the maximum position size (percentage of the whole portfolio) I’m willing to allocate in a single stock.
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