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Wed, September 30 at 4:00PM ET

Valuation is High, But Microsoft Stock Could Head Higher

MSFT stock is overvalued, but don't try to fight the trend

After a 55% gain in 2019, do Microsoft (NASDAQ:MSFT) shares have runway? Despite a sky-high valuation, analysts remain bullish on MSFT stock.

MSFT stock
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Wedbush’s Daniel Ives recently raised his price target to $195 from $185. This implies around 20.9% upside from the stock’s $161.34 Jan. 10 close. The analyst also believes shares could trade as high as $210, which would indicate 30.1% upside from today’s prices.

Microsoft’s Azure cloud computing business continues to drive growth. Analyst consensus calls for revenue to climb 11.3% between this fiscal year (ending June 2020) and FY21. Earnings projections see 12.2% growth during the same period. This justifies a premium valuation. But the company’s forward price-to-earnings (P/E) ratio of 29.9 may be overdoing it.

To be sure, a runaway bull market could help sustain this high valuation. Call FOMO, momentum trading, or speculation. But until the bull market sees a correction, Microsoft shares could head higher.

With these dynamics at play, what’s the call? Let’s dive in, and see whether it’s worth joining the wave, or going contrarian, with Microsoft stock.

Azure Success Could Send MSFT Stock Even Higher

How can MSFT stock move higher in 2020? Two factors are at play. The first is continued economic growth. With less uncertainty around geopolitical events (Middle East tensions, U.S.-China trade war), the boom times could continue this year. But as we are just two weeks into the new year, it may be too early to tell.

The second factor is Azure’s continued success. As the economy remains strong, expect Azure’s growth to continue. According to a Goldman Sachs survey, Microsoft’s Azure has an edge over Amazon’s (NASDAQ:AMZN) AWS in terms of popularity. This is despite AWS continuing to hold the leading market share. This could be an early indicator of where corporate IT dollars will flow in coming years.

Microsoft’s cloud innovations may be a key factor in this growing popularity. Tech analyst Beth Kindig recently discussed how Azure has the edge in “hybrid” cloud computing. Hybrid cloud computing protects sensitive data with an on-premises “private cloud” and using a “public cloud” for non-sensitive data. In other words, the best of both worlds (security and flexibility).

This factor (not politics) could be behind Microsoft’s recent JEDI contract win. This $1 billion a year contract won’t move the needle. But looking at the big picture, Azure’s edge could help them close the revenue gap with AWS. Microsoft is scheduled to begin its work on the contract on Feb. 11, but AMZN yesterday asked a federal court to block the start date.

Growth in the company’s other business could also help push shares higher. Microsoft’s suite of enterprise products (Office 365, Dynamics 365) could continue to perform well. Cross selling Office 365 and other products to Azure clients (and vice versa) could also help Microsoft sustain growth.

Hard to Call a Top, but We Might be Getting Close

Microsoft stock’s strong fundamentals make it a solid long-term investment. But does this mean now’s the time to buy? Everybody and their mother is bullish on MSFT stock. According to FactSet, 91% of analysts have a “Buy” rating or equivalent. It’s tough to go against the crowd. Yet, I’m concerned how bullish the analyst community remains on the name, no matter the price.

At current price levels, Microsoft trades at a high valuation. As mentioned above, shares trade for nearly 30 times forward earnings. The company’s enterprise value/EBITDA (EV/EBITDA) ratio is 20.6, which is staggering compared to prior year EBITDA multiples. Microsoft’s earnings-per-share (EPS) have more than doubled doubled since 2016. But multiple expansion is what’s driving the stock’s multi-year outperformance.

Microsoft now trades at a premium to FAANG stocks like Alphabet (NASDAQ:GOOGL) and Facebook (NASDAQ:FB). But both these stocks have a lower price-to-earnings growth (PEG) ratio. Alphabet has a forward non-GAAP PEG of 1.95. Facebook’s non-GAAP PEG is 1.22. Microsoft’s non-GAAP PEG? A staggering 2.4.

Microsoft is overvalued relative to growth. Yet, shares could head higher. As the bull market continues, investors who missed out at lower price levels could jump into Microsoft, without concern over valuation. This sounds like the makings of a bubble. But it may be too early to bet against it. Going short now could be painful. With momentum on its side, Microsoft could easily climb up to Wedbush’s price target.

Don’t Use FOMO as a Reason to Buy Microsoft Stock Today

Microsoft has strong underlying fundamentals. But shares have gotten ahead of themselves. Valuation has reached near-frothy levels. Yet, I won’t try to be a hero and call a top in MSFT stock. The trend won’t likely reverse anytime soon. Shorting the stock in today’s market is equally as risky.

Does this mean buy Microsoft stock today? It depends. Are you confident in the bull market continuing? Then yes, shares could move higher. But buying MSFT due to FOMO rather than fundamentals is speculation at best. Wait for more reasonable valuation levels before entering a position.

As of this writing, Thomas Niel did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2020/01/valuation-high-but-msft-stock-could-head-higher/.

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