Standing out among the Street's losers so far today is Microsoft, a software company whose shares slumped -0.8% to a price of $242.84, 18.21% below its average analyst target price of $296.91. The average analyst rating for the stock is buy. MSFT lagged the S&P 500 index by -0.6% so far today and by -7.8% over the last year, returning -23.5%.
Microsoft Corporation develops, licenses, and supports software, services, devices, and solutions worldwide. The company is a technology company. Valuations in the technology sector are often very high, as investors are willing to overlook gaps in the fundamentals if they believe a company’s innovations can dominate or create new markets.
Microsoft's trailing 12 month P/E ratio is 26.1, based on its trailing Eps of $9.29. The company has a forward P/E ratio of 21.7 according to its forward Eps of $11.18 -- which is an estimate of what its earnings will look like in the next quarter. The P/E ratio is the company's share price divided by its earnings per share. In other words, it represents how much investors are willing to spend for each dollar of the company's earnings (revenues minus the cost of goods sold, taxes, and overhead). As of the third quarter of 2022, the technology sector has an average P/E ratio of 26.5, and the average for the S&P 500 is 15.97.
It’s important to put the P/E ratio into context by dividing it by the company’s projected five-year growth rate. This results in the Price to Earnings Growth, or PEG ratio. Companies with comparatively high P/E ratios may still have a reasonable PEG ratio if their expected growth is strong. On the other hand, a company with low P/E ratios may not be of value to investors if it has low projected growth.
Microsoft's PEG ratio of 1.97 indicates that its P/E ratio is fair compared to its projected earnings growth. Insofar as its projected earnings growth rate turns out to be true, the company is probably fairly valued by this metric.
An analysis of the company's gross profit margins can help us understand its long term profitability and market position. Gross profits are the company's revenue minus the cost of goods only, and unlike earnings, don't take into account taxes and overhead. Here's an overview of Microsoft's gross profit margin trends:
| Date Reported | Revenue ($) | Cost of Revenue ($) | Gross Margins (%) | YoY Growth (%) |
|---|---|---|---|---|
| 2022-06-30 | 198,270,000,000 | 62,650,000,000 | 68.4 | -0.77 |
| 2021-06-30 | 168,088,000,000 | 52,232,000,000 | 68.93 | 1.7 |
| 2020-06-30 | 143,015,000,000 | 46,078,000,000 | 67.78 | 2.85 |
| 2019-06-30 | 125,843,000,000 | 42,910,000,000 | 65.9 | n/a |
- Average gross margin: 67.8 %
- Average gross margin growth rate: 1.3 %
- Coefficient of variability (lower numbers indicating more stability): 2.0 %
We can see from the above that Microsoft's gross margins are very strong. Potential investors in the stock will want to determine what factors, if any, could derail this attractive growth story.
To deepen our understanding of the company's finances, we should study the effect of its depreciation and capital expenditures on the company's bottom line. We can see the effect of these additional factors in Microsoft's free cash flow, which was $65,149,000,000.00 as of its most recent annual report. Over the last 4 years, the company's average free cash flow has been $51,190,250,000.00 and they've been growing at an average rate of 19.5%. With such strong cash flows, the company can not only re-invest in its business, it can afford to offer regular returns to its equity investors in the form of dividends. Over the last 12 months, investors in MSFT have received an annualized dividend yield of 1.0% on their capital.
Another valuation metric for analyzing a stock is its Price to Book (P/B) Ratio, which consists in its share price divided by its book value per share. The book value refers to the present liquidation value of the company, as if it sold all of its assets and paid off all debts). Microsoft's P/B ratio is 10.4 -- in other words, the market value of the company exceeds its book value by a factor of more than 10, so the company's assets may be overvalued compared to the average P/B ratio of the Technology sector, which stands at 5.57 as of the third quarter of 2022.
Microsoft is likely fairly valued at today's prices because it has a lower P/E ratio than the sector average, an elevated P/B ratio, and a steady stream of strong cash flows with an upwards trend. The stock has strong growth indicators because of its consistently strong gross margins with a stable trend, and an average PEG ratio. We hope this preliminary analysis will encourage you to do your own research into MSFT's fundamental values -- especially their trends over the last few years, which provide the clearest picture of the company's valuation.
