When it comes to this recent market selloff, I’ve been doing a lot of dip buying. The selloff has been sloppy, but the S&P 500 just bounced dramatically off its 200-day moving average, which was widely viewed as this market’s last line of technical defense. It held, and now we are cautiously moving higher.
In other words, it looks like the worst is over, which means that it may be time to start buying quality names at discounted prices. My shopping list starts with big tech. It includes the likes of Facebook, Inc. (NASDAQ:FB), Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG) and Amazon.com, Inc. (NASDAQ:AMZN).
But one big tech stock I’m still not interested in? Microsoft Corporation (NASDAQ:MSFT). I once loved MSFT stock. But ever since it crossed above the $70/$80 levels, I’ve grown wary on the name.
I’m still wary today. I think Microsoft stock can head higher with the rest of market. But I doubt it will be a winner or an out-performer.
Microsoft continues to feel like a mild growth company being treated like a hyper-growth one. I can’t really wrap my head around why this stock should head that much higher.
Why Microsoft Stock Looks Overextended
The reason MSFT stock has had so much success over the past several years is the company’s burgeoning cloud business. When Satya Nadella took over as Chief Executive Officer in 2014, his focus was on making MSFT a cloud giant.
He’s done that. Now, Microsoft runs not only one of the biggest cloud businesses in the world, but also one of the fastest growing. MSFT’s cloud market share has grown four percentage points over the past year, while market leader Amazon has actually lost market share.
But even with this booming cloud business, revenue growth was only 12% last quarter. It was 12% the quarter before that and 5% last year. Revenue growth is expected to be 10% this quarter, 11% this year, and below 10% next year. In other words, for all the hype surrounding the company’s cloud business, revenue growth at MSFT is stuck in the 10% range.
Meanwhile, gross margins are just flat, and operating margins are up only slightly. In sum, then, what you have is a 10% revenue growth narrative with insignificant margin drivers. That leads to (at most) 15% earnings growth per year over the next five years.
MSFT stock currently trades at 23 times forward earnings for that 15% growth. That is a price-to-earnings/growth (PEG) ratio of 1.5, which looks exceptionally expensive next the market’s 1.2 PEG.
Bulls will make the argument that MSFT has a higher PEG because it’s just a higher-than-average quality company with strong cash flows and a healthy dividend.
But while the company’s trailing free cash flow yield of 4.8% is strong, it’s also right near a five-year low. Same with the dividend yield, which at 1.9%, is also right near a five-year low. Moreover, across essentially every single valuation metric, MSFT stock is trading at a significant premium to its five-year average.
Bottom Line on MSFT Stock
At the end of the day, there was a lot of enthusiasm surrounding the growth narrative of Microsoft’s cloud business. That enthusiasm shot the stock up to all time high levels and extended the valuation out to levels not seen before.
That worked when the bull market was chugging along in a low-rate environment, seemingly unconcerned about valuation. But as rates continue to creep higher and put equity valuations in the spotlight, I think valuation will start to matter a little bit more across the board.
Consequently, I’m not terribly attracted to MSFT stock on this dip. It has a PEG ratio more than 25% larger than the market’s PEG ratio. Its free cash flow and dividend yields are at five-year lows. And the valuation on the stock across every single important metric screams overvalued by historical standards.
I think MSFT stock can and will bounce from here as the market stabilizes and heads higher. But I don’t think it will be a winner. Valuation will limit upside.
As of this writing, Luke Lango was long FB, GOOG and AMZN.
