One of Wall Street's biggest winners of the day is Microsoft, a software company whose shares have climbed 1.1% to a price of $244.36 -- 17.7% below its average analyst target price of $296.91. The average analyst rating for the stock is buy. MSFT may have outstripped the S&P 500 index by -0.5% so far today, but it has lagged behind the index by 8.8% over the last year, returning -27.4%.
Microsoft Corporation develops, licenses, and supports software, services, devices, and solutions worldwide. The company is part of the technology sector, whose combine explosive growth potential with high valuations and high volatility. Investors are often willing to overlook the risks and inflated valuations of the sector because of this promise of future growth potential.
Microsoft's trailing 12 month P/E ratio is 26.3, based on its trailing Eps of $9.29. The company has a forward P/E ratio of 21.9 according to its forward Eps of $11.18 -- which is an estimate of what its earnings will look like in the next quarter.
As of the third quarter of 2022, the average Price to Earnings (P/E) ratio for US technology companies is 26.5, and the S&P 500 has an average of 15.97. The P/E ratio consists in the stock's share price divided by its earnings per share (Eps), representing how much investors are willing to spend for each dollar of the company's earnings. Earnings are the company's revenues minus the cost of goods sold, overhead, and taxes.
We can take the price to earnings analysis one step further by dividing the P/E ratio by the company’s projected five-year growth rate, which gives us its Price to Earnings Growth, or PEG ratio. This ratio is important because it allows us to identify companies that have a low price to earnings ratio because of low growth expectations, or conversely, companies with high P/E ratios because growth is expected to take off.
Microsoft's PEG ratio of 1.95 indicates that its P/E ratio is fair compared to its projected earnings growth. In other words, the company’s valuation accurately reflects its estimated growth potential. The caveat, however, is that these growth estimates could turn out to be inaccurate.
To better understand the strength of Microsoft's business, we can analyse its gross profits, which are its revenues minus its cost of goods sold only. The extent of gross profit margins implies how much freedom the company has in setting the prices of its products. A wider gross profit margin indicates that a company may have a competitive advantage, as it is free to keep its product prices high relative to their cost.
MSFT's average gross profit margins over the last four years are 67.8%, which indicate it has a potential competitive advantage in its market. These margins have slightly increased over the last four years, with an average growth rate of 1.3%. Microsoft's financial viability can also be assessed through a review of its free cash flow trends. Free cash flow refers to the company's operating cash flows minus its capital expenditures, which are expenses related to the maintenance of fixed assets such as land, infrastructure, and equipment. Over the last four years, the trends have been as follows:
| Date Reported | Cash Flow from Operations ($ MM) | Capital expenditures ($ MM) | Free Cash Flow ($ MM) | YoY Growth (%) |
|---|---|---|---|---|
| 2022-06-30 | 89,035 | -23,886 | 65,149 | 16.09 |
| 2021-06-30 | 76,740 | -20,622 | 56,118 | 24.06 |
| 2020-06-30 | 60,675 | -15,441 | 45,234 | 18.23 |
| 2019-06-30 | 52,185 | -13,925 | 38,260 | n/a |
- Average free cash flow: $51,190,250,000.00
- Average free cash flown growth rate: 19.5 %
- Coefficient of variability (lower numbers indicating more stability): 23.2 %
With its positive cash flow, the company can not only re-invest in its business, it can 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 1.1% 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 indicates that the market value of the company exceeds its book value by a factor of 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 by most measures fairly valued 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 it has a an average PEG ratio and consistently strong gross margins with a stable trend.
