The Rally in Microsoft Stock Will Slow — But Should Continue

The core question with Microsoft (NASDAQ:MSFT) stock at this point seems to be: how much further can it go? There are some minor questions, admittedly, in terms of competition in cloud and the integration of acquisitions like LinkedIn and GitHub.

The Rally in Microsoft Stock Will Slow -- But Should Continue

Source: Peteri /

But from a broad standpoint, the story here is clear — and compelling. Microsoft has dominant market share in its core products. The transition to delivering software over the cloud instead of via disk has helped revenue and margins, and should continue to provide benefits going forward. Demand should only rise, with international sales still less than 50% of total revenue.

Simply put, this is a wonderful business. But, again, the question with Microsoft stock comes down to valuation. The worry is whether even this wonderful business can support a market capitalization that now sits well above $1.2 trillion.

It’s a legitimate worry. In fact, it’s a concern I’ve expressed in the past, even when Microsoft stock was cheaper. However, the lesson of the past decade for both MSFT stock and the market as a whole has been simple. If valuation is the only real worry, there probably isn’t all that much to worry about.

That’s still the case, even if investors can’t expect the next 13 months to look like the last 13.

The Enormous Rally in MSFT Stock

In November, I highlighted the unprecedented rally in shares of Apple (NASDAQ:AAPL). Apple had added an amazing $420 billion in market capitalization in barely five months. Even now, there are only eight U.S.-listed companies worth that much.

The rally in AAPL has continued, and now looks even more impressive. That company’s market capitalization has increased over $750 billion in little over a year, a figure roughly equal to the total value of Facebook (NASDAQ:FB) with an Anheuser-Busch InBev (NYSE:BUD) thrown in. $620 billion of the gains have come just since June 3 of last year.

But if it weren’t for Apple, investors would be talking about the historic gains in Microsoft stock instead. Since June 3, the rising MSFT stock price has created about $325 billion in market value. That’s just shy of Walmart’s (NYSE:WMT) market capitalization. Go back to Christmas Eve 2018, and Microsoft’s value has risen a stunning $525 billion in less than 13 months.

Obviously, the record-setting values of both Apple and Microsoft affect these figures. Few companies in history had the opportunity to even consider adding $300 billion or more in value in a year; few companies ever even reached that level. Furthermore, even in a market at all-time highs, currently only 14 U.S.-listed companies have market caps over $300 billion. And the market’s largest companies historically have not been the types to double in a reasonably short amount of time.

However, Apple actually has done so. At its close on Jan. 3 of this year, it had risen 90% from levels reached following its early 2019 guidance cut. Here, too, MSFT stock hasn’t been quite as impressive, but it has a chance to post 100% gains in two years. Shares closed at $94.13 on Dec. 24, 2018, meaning Microsoft stock needs to rise about 16% to double from those levels.

What the Rally Means

The question, as is it is for so many stocks in the market, is whether those enormous gains mean the easy money has been made — or the rally has gone too far.

Certainly, Microsoft’s performance is responsible for a good chunk of its rally. A steady stream of big earnings beats has raised growth expectations — and thus, theoretical fair value. Indeed, even fiscal 2021 (ending June) consensus estimates for earnings per share (EPS) have come up by 12 cents just in the past 90 days, moving to around $6.07.

However, investor reaction also has played a key part. The MSFT stock price has gained about 17% over the past three months, during which time earnings expectations for next year have come up a little over 2%. The bigger factor has been that investors are willing to pay much more for Microsoft profits: the forward price-to-earnings multiple has risen from 23.5x to the current 26.9x.

It’s that latter multiple that looks like the biggest risk at the moment. It’s likely not a risk in the sense that investors will suddenly decide Microsoft is worth 18 times earnings, leading shares to plunge. But it’s reasonable to wonder if 27x earnings is something close to a ceiling on the multiple-assigned MSFT stock.

How High Does the Multiple Go?

Because for those of us who have been in and around the market for years, 27x on its face is a big multiple for a mature company. It’s a multiple usually assigned younger, faster-growing names. In fact, it’s worth remembering that earlier this decade, MSFT stock itself often received a multiple in the mid-teens.

Obviously, this is a much better company than it was then, and growth expectations have increased tremendously after Microsoft’s adjusted profits were basically stagnant for the first half of the 2010s. Still, an investor might balk at such a multiple for a company whose EPS is expected to grow about 13% next year — with growth potentially decelerating from that point.

In that context, it’s interesting to look at other S&P 500 stocks with similar forward valuations. Visa (NYSE:V) and Starbucks (NASDAQ:SBUX) have almost the exact same multiple to next year’s earnings. Nike (NYSE:NKE) actually garners a premium to MSFT, trading at nearly 29x forward EPS.

Those relative valuations are in the eye of the beholder — but there is a case that they suggest Microsoft’s gains at least have to moderate. Those peers aren’t necessarily better companies, but they do have potentially larger, long-term opportunities. Visa and Nike in fact should deliver greater near-term earnings growth, at least based on analyst estimates.

To be sure, if U.S. stocks keep reaching new all-time highs, all four stocks can gain nicely. That’s indeed how it’s worked out over the past year. But simply looking at that cohort, it does get a bit more difficult to see Microsoft outperforming the market, as it has over the past 12 months.

Expectations Should Be Lowered

Again, that doesn’t mean MSFT stock is going to fade, or that it should be sold. It just means that Microsoft stock probably acts more like the second-most valuable company in the world; Matching or even underperforming the market on the way up, while posting manageable drawdowns in the event U.S. stocks finally stumble.

That’s not a bad outcome, particularly given that Microsoft’s history suggests it can once again outperform relative to current expectations. But, that profile does suggest that the rally from December lows is going to moderate.

That, too, isn’t a bad thing. Microsofts just posted what is likely the second-greatest rally of all time. Failing by that standard still leaves a lot of room for success, and plenty of reason to stick with MSFT stock.

As of this writing, Vince Martin has no positions in any securities mentioned.

Article printed from InvestorPlace Media,

©2022 InvestorPlace Media, LLC