Right Now It Looks as If Microsoft Stock Is Getting Too Hot

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There’s a huge difference between a great company and a great stock. To be both, an excellent company also has to be selling at a halfway reasonable price. Unfortunately, Microsoft (NASDAQ:MSFT) is no longer a great stock. I’ve been a proponent of Microsoft stock on numerous occasions here at InvestorPlace but today I have to make the opposite recommendation. MSFT has simply run up so far, and so fast, that it is looking like a sell here, at least for shorter-term investors.

Microsoft Stock

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This time last year, MSFT was trading around $95 per share. Last summer, it ramped up to around $110 and then dropped back to $95 with the correction. All in all, a pretty normal performance given market conditions. Since December, however, things have gotten weird, with Microsoft ramping all the way to $130. That’s a 35% move in five months.

Now, for a smaller tech company, a 35% move is nothing out of the ordinary. But we’re talking about a company with a $990 billion market cap. As of this writing, Microsoft is the largest company in the world, in fact.

Though this could change when the runner-up, Apple (NASDAQ:AAPL) reports earnings this week. In any case, the market is suggesting that the value of Microsoft’s business has increased more than $300 billion in a few months. That’s pretty crazy.

Impressive Revenue Growth

Of course, Microsoft’s earnings are causing the excitement. The company has put up a string of solid quarters with the most recent one being no exception. Azure, as usual, led the way with 75% growth. That impressed, as it was only a point slower than Q2’s 76% growth rate. As the business grows, it will be harder and harder to maintain outlandish growth rates, but so far Microsoft is managing the trick.

Don’t let Azure’s stratospheric growth rates overstate Microsoft’s total growth in your mind, however. Despite Azure’s growth, Intelligent Cloud grew by a still impressive but more down-to-earth 24% rate.

Productivity and Business chipped in with 14% year over year growth. Meanwhile, even Personal Computing was good for a 9% growth rate. This led to the overall company growing revenues at a 14% rate. That’s great and beat expectations, but you have to ask how much upside it justifies for the stock. Normally 14% annual revenue growth isn’t enough to power a 40% return on a stock.

Pricey Valuation

For a company as large as Microsoft, even huge earnings results such as they just posted don’t add that much value to the company. The world’s most valuable enterprise simply doesn’t become 40% more valuable in a year, let alone a few months. All else equal, if Microsoft keeps managing to grow revenues at 14%/year, which is no small feat, the stock should rally something like 15%-17%/year.

Over time, Microsoft’s stock price may be able to rally faster than revenues as it adds more and more high margin and highly desirable recurring revenues.

Still, there are limits to how high the valuation can realistically go. Microsoft is already trading at more than 8x Price/Sales. For a smaller-cap tech company growing rapidly, 10x Price/Sales is a fair price. But for a huge tech firm, 8x is pretty aggressive.

Even Amazon (NASDAQ:AMZN), which has long sported a high P/S ratio due to its own booming web services business, is currently only at 4x Price/Sales. Microsoft should trade higher than Amazon as it doesn’t have a low valuation retail business like Whole Foods diluting things.

Even so, in a normal market, I’d expect Microsoft to settle closer to 6x Price/Sales. Figuring another year of 14% revenue growth, that’d give you a 12-month price target of around $115/share. Similarly, looking at earnings, Microsoft is at 29x trailing, 26x forward. Even with its standout earnings results, the company is simply so big that EPS growth isn’t fast enough to bring that forward P/E ratio down that quickly.

With any signs of slowdown in cloud growth, Microsoft stock could slide 10 or 20 percent to get back to a more defensible valuation. Remember that a huge chunk of the revenues here are still basic Windows and Office sales. That’s a great cash cow, but it’s not worth anything close to 29x earnings on its own. Microsoft will grow into its current valuation, no doubt, but upside for 2019 is extremely limited with the stock already up so much.

Microsoft Stock Verdict

It’s worth making the comparison to another huge tech name, Alphabet (NASDAQ:GOOGL). GOOGL stock had been running like it stole something throughout the month of April. In just three weeks, GOOGL stock had soared $100 per share. Then, on Monday, it got hit with a soft earnings report. EPS beat, but revenues came in light. Traders walloped the stock hitting it with as much as 10% losses in the after hours following its report. The faster you go up, the quicker you can drop.

Obviously Microsoft has already reported earnings this cycle, but it’s still exposed to a string of potential misses from other big tech names. Furthermore, any negative developments in Microsoft could cause it to take an outsized drop. Not because the business is showing much weakness, but simply because the stock has moved up so far so fast. Feel free to try your luck riding the momentum even farther, but there’s a good case for taking profits here.

At the time of this writing, Ian Bezek had no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.


Article printed from InvestorPlace Media, https://investorplace.com/2019/05/right-now-microsoft-stock-too-hot/.

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