It’s been an impressive run for Microsoft (NASDAQ:MSFT) over the past few years. It was barely five years ago that MSFT stock was trading under $30 — with an earnings multiple in the low double digits. Microsoft was a low-growth former titan that seemed at risk of being passed by newer, younger, and more nimble competitors.
But MSFT stock now has quadrupled from its price at the beginning of 2013. The story has changed markedly. The shift from on-premise to cloud has boosted revenue and profits. The Azure cloud platform continues to grow at impressive rates; Microsoft is now a solid number two to Amazon.com (NASDAQ:AMZN) in that business.
This no longer is a low-growth, fading giant. Rather, Microsoft looks like a re-energized behemoth, capable of taking on anyone in tech — and winning. And that change in perception has been a driver — though not the only driver — of the big gains in MSFT stock in the past five-plus years.
The question now, even after an impressive fourth-quarter report, is how much room is left in the rally. And that’s a question that not only applies to Microsoft stock, but to many of its tech peers — and even the market as a whole.
How We Got Here
Admittedly, I took a while to catch up to the MSFT story. As recently as last year, I worried about Microsoft’s “second-place problem” and its valuation. But like so many skeptics, I’ve been converted over the past few quarters.
The biggest change from a fundamental standpoint is in terms of earnings. Indeed, the beginning of the big rally in MSFT stock that started in 2013 came pretty much from multiple expansion — not earnings growth. In fact, for four years, Microsoft’s non-GAAP earnings-per-share basically didn’t grow at all:
- Fiscal Year 2012: $2.73
- FY13: $2.65
- FY14: $2.63
- FY15: $2.46
- FY16: $2.79
That’s changed in the past two years. Microsoft’s adjusted EPS has risen 39% combined over that period. Fourth-quarter earnings last month were particularly impressive — given that Microsoft was comparing against a year-prior quarter with a significant tax benefit. EPS still grew 7%, capping off an 18% rise for the full year.
And so the rise of about 300% in MSFT stock has had two drivers — at least of late. The earnings multiple assigned MSFT stock has doubled, from low-teens back in 2012-2013 to a trailing 27.7x at the moment. And earnings have grown nicely as well in the last two years, with the Street looking for a 10% increase in FY19 and a 15% rise in FY20. Somewhat incredibly, Street consensus for the latter year of $4.91 suggests a 76% increase over four years — after barely 2% growth over the previous four.
Can MSFT Stock Run Out of Steam?
Certainly, Microsoft and CEO Satya Nadella have earned the gains in MSFT stock. And I don’t think MSFT necessarily is overvalued at these levels. I argued back in February that there was a clear path to $100+
, and strength in both Q3 and Q4 earnings suggests some upside to that target.
That said, it does seem like the rally in MSFT has to at least slow down, after 25% gains year to date and 46% over the past year. MSFT stock now is valued in line with Alphabet Inc (NASDAQ:GOOGL)(NASDAQ:GOOG) and well above Facebook (NASDAQ:FB) — backing out net cash for all three stocks. And at nearly 28x trailing EPS, and about 25x FY19 consensus, it does seem like the multiple expansion part of the MSFT story has to be nearing an end.
If that’s the case, that’s not the end of the world for MSFT stock, obviously. Current earnings estimates suggest something like 14% annual returns over the next two years if multiples hold — including the Microsoft dividend.
Still, there’s an awful lot of stocks in this market with similar fears. In fact, the question surrounding MSFT’s multiples echoes that of the market as a whole. How much further can stocks really run? The S&P 500 now is up over 400% from financial crisis lows. The NASDAQ 100 has performed even better — it’s risen by more than 6x. MSFT stock hasn’t performed quite that well. Still, it’s had a torrid run. And like the market as a whole, there’s an obvious concern as to if, and when, that run has to end.
Ratchet Expectations Down
And that’s where MSFT gets a bit tricky at this point. It’s a great company, admittedly. Fiscal 2018 results were hugely impressive, with revenue growth accelerating from 5% to 14%. The core cloud growth driver here seems reasonably intact.
All that said, investors are still paying 28x earnings for 10-15% earnings growth in the near term. And that growth figure will come down as cloud growth inevitably slows and the shift to licensing for products like Office and Windows moderates.
It’s a big multiple, historically speaking. And it’s a multiple that probably doesn’t have much more room for expansion. If that’s the case, then MSFT can continue to rise — but not quite at the pace it has the last five-plus years. If that sounds familiar, it’s probably because many analysts and investors have said something similar about many stocks, and the market as a whole, over the past few years. It’s up to the individual investor to determine if this time, they — and I — might actually be right.
As of this writing, Vince Martin has no positions in any securities mentioned.
