Microsoft: How to balance between competitive advantage and valuation?

Zhitong App has learned that in the ever-evolving technology industry, tech giant Microsoft (MSFT.US) has found a way to maintain relevance year after year. Microsoft is undoubtedly one of the best companies in the world, and its financial indicators prove this. However, this does not necessarily mean that one should buy the company's stock. It is understood that Microsoft's valuation is close to its historical high, which is unreasonable. Therefore, a "neutral" attitude should be maintained towards the stock.

The competitive advantage of Microsoft can be quantified.

There are several ways to analyze Microsoft's stock and demonstrate the rationale for buying it. First, those who are bullish on Microsoft can talk about the growth potential of Microsoft's artificial intelligence and cloud computing. This is indeed very promising, as Microsoft owns 49% of OpenAI (the owner of ChatGPT) and operates Microsoft Azure, a rapidly growing cloud computing platform.

Second, a good way to determine whether a company has a competitive advantage is to look at its gross profit margin. This is because the company represents the premium that consumers are willing to pay for the cost of its products or services, and an expanding gross profit margin indicates a sustainable competitive advantage. If an existing company does not have an advantage, new entrants will gradually take away market share, leading to a decline in its gross profit margin.

For Microsoft, its gross profit margin has been on an upward trend since the 2016 fiscal year, rising from 64% in 2016 to 69.4% in the past 12 months. Therefore, its continuously rising gross profit margin indicates the existence of a competitive advantage.

Microsoft's competitive advantage has allowed it to earn abundant profits.

Microsoft's competitive advantage has allowed the company to operate very efficiently and earn abundant profits over the past decade. To measure its efficiency, let's look at Microsoft's Cash Return on Invested Capital (CROIC), which is calculated by dividing free cash flow by invested capital.

Essentially, this metric measures how much free cash flow a company generates for every dollar of capital invested. In the past 12 months, Microsoft's CROIC was 21.9%, far higher than the IT industry's average of 3.2%. Therefore, the company generated 21.9 cents of free cash flow for every dollar invested in the past year. Its 5-year average CROIC of 24.2% is also impressive. Based on this data, Microsoft has generated a staggering $63.2 billion in free cash flow in the past 12 months.

This excess cash can be returned to shareholders through buybacks and dividends, and Microsoft has been doing so, although the amounts are not significant.

Risk Warning: Microsoft's valuation is not attractive.

As mentioned above, Microsoft is a great company, but that does not mean that its current stock price is not overvalued. There are several reasons why Microsoft's valuation lacks attractiveness. First, its forward P/E ratio of 32.9 is high. In fact, this is even higher than the company's 29.2 times the five-year average forward P/E ratio, which is the problem.

In addition, the current market is in a higher interest rate environment than usual, which means that investors should expect higher returns from stocks because they can get relatively higher interest rates from risk-free government bonds. Therefore, in a high interest rate environment, Microsoft's current valuation is much higher than its valuation when interest rates were low, which is not reasonable.

In addition, Microsoft's average annual compound growth rate over 5 years is 35.4%, and the compound annual growth rate over 3 years is 18.9%. At the same time, the company's earnings per share are expected to grow by 14% and 15% in 2024 and 2025, respectively. So, while future growth is expected to slow down, the valuation is higher than usual, making it not a good asset allocation. Please note that these earnings per share forecasts take into account Microsoft's potential in artificial intelligence and cloud computing.

Is Microsoft stock worth buying?

On the TipRanks website, Microsoft is listed as a "strong buy" among the 30 "buy" stocks in the past three months, with only one "hold" stock. Microsoft is a top-notch technology company, and looking at some of its financial reports can prove that. However, the company's valuation is too high, so there may be better opportunities elsewhere.

In conclusion, it is not to say that Microsoft's stock will collapse, but at the current level, investors should not expect the kind of returns they are accustomed to from Microsoft's stock. Therefore, it is recommended that investors be cautious and wait until the stock falls to a more reasonable level.