It has truly been an impressive run for Microsoft (NASDAQ:MSFT). Microsoft stock has almost quadrupled in the past six years, with the price of MSFT stock rising from under $30 to its current level around $114. And for more than two years now, Microsoft stock has done pretty much nothing but go up.
I was admittedly slow to see the bull case for Microsoft stock, although I argued early this year that MSFT stock had a clear path to $100 and beyond. Now that the price of Microsoft stock has cleared those levels – and then some – some of my original skepticism has returned.
Tuesday’s announcement of a 9.5% dividend increase might seem to warrant some optimism toward Microsoft stock. But from here, given the current valuation of the shares, it actually looks like a red flag. Microsoft is definitely a wonderful company. Its adaption to the cloud environment vastly exceeded the view of skeptics (myself included). The travails of companies like Oracle Corporation (NYSE:ORCL) and IBM (NYSE:IBM) show that the shift is much tougher than Microsoft has made it look.
But valuation matters, too. And with the MSFT stock price just off its all-time highs, investors are paying a premium valuation for what still should be relatively limited growth. That’s a concern that investors at least have to keep an eye on.
Microsoft Stock Has Earned Its Gains
There’s no doubt that Microsoft stock has performed exceedingly well – and that there’s some logic to the gains seen so far. The company had posted years of stagnant earnings. The company’s adjusted earnings per share in fiscal year 2012 came in at $2.73; four years later, the figure was $2.79. In the last two fiscal years, however, the company’s adjusted EPS has risen some 39%. Analysts expect it to increase another 10%+ next year.
And the gains really haven’t come from U.S. tax reform; given its worldwide profit base, Microsoft’s effective tax rate hasn’t moved all that much. Rather, the company’s impressive growth has come from its transition to the cloud. Microsoft has moved a number of its products, including Office and even Windows, from “on-premise” to the cloud. Its Azure cloud platform has steadily gained ground against the likes of Alphabet (NASDAQ:GOOGL,NASDAQ:GOOG) unit Google and Amazon.com (NASDAQ:AMZN). Azure’s sales surged 91% in FY18 on top of a 99% increase in revenue the year before.
This isn’t a case in which the market isn’t paying attention to the company’s business. Microsoft has executed an impressive turnaround under its CEO, Satya Nadella. The question at this point is how much of that turnaround is priced into Microsoft stock – and how much growth the company really has left.
Is the Price of MSFT Stock Too High?
Microsoft’s earnings have risen over the past few years. But the multiples underpinning the price of MSFT stock have risen even faster. A stock that only a few years ago traded for price-earnings multiples between 11 and 13 now trades at a whopping 26 times analysts’ FY19 consensus EPS estimate.
At this point, it’s fair to wonder whether that’s simply a bridge too far. Traditionally, a price-earnings multiple of 26 suggested that a company was growing at a rather brisk pace. But Microsoft’s dividend increase of just 9.5% itself suggests that the company is planning for lower, likely high-single-digit percentage, increases in earnings. And that hike actually is a bit disappointing in the context of expectations: at least one analyst had projected a dividend increase of 10%-15%.
As good as the news is in areas like Azure and the Dynamics CRM product, Microsoft still has hefty exposure to the relatively stagnant PC market. And at a certain point in the not-too-distant future, the benefits of moving Office licensees to Office 365 will fade, if not stagnate. Above $110, I’m simply not sure how the price of MSFT stock can move much higher.
After all, the company’s forward price-earnings multiple of 26 seems unlikely to rise significantly. Will the market really award MSFT stock a multiple of 30+ when the company’s earnings are growing 9%-11% per year? And if the multiple stops expanding, as seems likely, Microsoft stock becomes dependent on earnings growth. Earnings growth of 9%-11% plus a nearly 2% dividend yield suggests decent annual returns in the low double-digit percentage levels. But that’s not what Microsoft shareholders have become used to over the past few years. In 2018, for example, MSFT stock has gained some 32%.
Investors Should Be Cautious About Microsoft Stock
As I wrote last month, I am concerned about the valuation of many stocks in this market. Actually, Microsoft stock seems an awful lot like many other names in the market. Investors have shown a willingness to pay premium prices for good businesses. And Microsoft undoubtedly has a good business.
Yet I can’t help but think that at some point the high valuations will pass. And the single-digit dividend increase might highlight the core issue here; Microsoft’s earnings aren’t going to grow all that quickly going forward. But the market is pricing Microsoft stock as if the company’s earnings will rise rapidly. At some point, it seems likely that either Microsoft’s earnings or the price of MSFT stock will have to change.
As of this writing, Vince Martin has no positions in any securities mentioned.