Microsoft Stock: Almost Perfect But Overvalued (NASDAQ:MSFT)

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Microsoft company (NASDAQ:MSFT) is basically a strong company and still growing rapidly despite its huge size. While the tech industry has suffered huge losses lately and supply chain issues continue to be a problem, Microsoft It is still innovating and plans to release new products and additions to Edge. However, the company’s stock could be overvalued and ready for a steep pullback.

Microsoft Has Extraordinary Foundations and Continues to Grow

Microsoft has few flaws with its fundamentals, and despite being currently worth nearly $2 trillion, it’s still growing fast. The company can generate income and profits effectively, manage its assets well and manage cash efficiently.

Income and Earnings Continue to Increase

In the last 5 years, Microsoft managed to increase its revenue from $ 96.57 billion to approximately $ 168.09 billion and calculated an average annual growth rate of 14.87 percent. Its gross margin is even more impressive, standing at around 66.48%. The profit margin drops from here, but still an impressive 28%. This decrease is due to higher SG&A and R&D costs of approximately $20 billion each.

It is important to mention the 3 main segments of the company. The first includes More Personal Computing and Windows, Xbox, and more. This segment accounts for about 32.2% of revenue. The next section is Productivity and Business Processes and is mainly made of Office. This segment accounts for 32.1% of revenue. The final segment is Smart Cloud and includes server products and Azure. This segment is growing rapidly and accounts for approximately 35.7% of revenue.

In the company’s latest earnings report, Intelligent Cloud impressed investors. This segment was able to increase revenues substantially, with Azure and other cloud services leading up 46%. Overall, the company’s income statement is very healthy.

A Strong Balance Makes a Great Pillow

Microsoft’s balance sheet tells the same story as its income statement. The company has a current ratio of 2.0 and current assets mainly consist of cash with approximately $104.69 billion. It is also important to mention the $32.61 billion receivables.

As for debt, it may seem high at first, at $64.47 billion. But net debt is great at -26.68 billion dollars. This gives Microsoft a Net Debt/EBITDA ratio of -0.3, which indicates healthy debt management.

With many investors predicting a recession imminent, Microsoft’s strong balance sheet can help protect itself from economic problems and continue to innovate and create new products.

Impressive Cash Flows and Share Buybacks

Over the past 5 years, Microsoft has nearly doubled its operating cash flows from $39.51 billion to $76.74 billion. The main reason for this is the high net income of the starting line coupled with the consistently high depreciation added. The company’s capital expenditures are also increasing, but are still low compared to operating cash flows. Over the past 5 years, the company’s capital expense has increased from $ 8.13 billion to $20.62 billion.

Microsoft is also retiring both stock and debt but focusing much more on stock. In the company’s latest report, $8.35 billion in stock and $4.2 billion in debt are retired. This allows investors to see the increased value in their investments and serves as a good way to tap into the company’s huge stock of cash.

The Technology Sector is in Trouble and Not Healing

The tech sector has been experiencing huge losses lately and shows no signs of getting better. The Nasdaq YTD is down about 25% and the major players are down even more. Companies like Zoom (ZM) and Spotify (SPOT) have dropped over 60% in the last 6 months, and even Netflix (NFLX) by over 70%.

A major problem culminating in the industry is the problem of overstaffing. Recently, Meta (FB) said the company will cut hiring due to lower revenue caused by Apple’s (AAPL) privacy changes. Amazon (AMZN) continued with this theme, saying the company was overstaffed. Also, companies that were successful during the pandemic like Zoom and Robinhood (HOOD) will likely have to cut back on their hiring as demand for their products dwindles as the pandemic wanes. In fact, Robinhood has already laid off about 9% of its workforce.

Even more corrections could occur, as many tech companies are massively overvalued. A great example is Tesla (TSLA), which is worth more than 6 times the combined value of Ford (F) and General Motors (GM). If things don’t start to improve for the industry, tech companies (including Microsoft) could see losses worse than they currently are.

Additions to Xbox TV and Edge Could Drive Higher Revenue

Microsoft does a great job of innovating and creating new products. It was recently revealed that the company plans to launch a new product, the Xbox TV, in 2023. This product will rival the Amazon Fire Stick and Roku Streaming Stick (ROKU). But this product has a unique advantage over its competitors. One can not only watch TV shows and movies with apps on the device, but also play games using Xbox Game Pass Ultimate. To further strengthen the product, Microsoft is partnering with Samsung (OTC:SSNLF) to help develop on-device streaming apps, allowing Samsung Smart TV owners to use the app without having to purchase the device.

Another product expansion is the addition of a free built-in VPN for Edge. Recently, Edge surpassed Safari to become the second most used Desktop browser worldwide, behind only Google Chrome (GOOG).

Graph showing the worldwide market share of each browser.

Worldwide Desktop Browser Market Share (GlobalStats, chart by author)

This free VPN is an effort to make Edge more popular with users and devour Google’s huge market share. Opera is the only other browser with a similar free VPN. While Firefox and Chrome have VPNs, they have to be paid for.

Supply Chain Issues Still Roar

Supply chain issues remain an ongoing theme in the market. China’s zero-tolerance policy could lead to factory closures and exacerbate chip shortages. This chip shortage is causing problems in PC and Xbox production and hurting the company’s More PC segment. However, it is important to note that not all segments of Microsoft are based on chips. The Productivity and Business Process and Intelligent Cloud segments do not rely heavily on chip manufacturing, meaning they are highly resilient to supply chain issues. With these two segments accounting for about 67.8% of revenue, combined with the fact that the Smart Cloud segment mentioned earlier is growing rapidly and worse supply chain issues may not hurt Microsoft.

Valuation

The valuation of Microsoft’s stock is one of the company’s only downsides. When calculating the DCF of a company with a WACC of approximately 9.37% as the discount rate, a fair value of approximately $172.93 per share can be found. This means that Microsoft’s stock may be overvalued by about 34.64%.

A relative valuation does not point to better signs. When using FY23 estimates for revenue, EBITDA and earnings and combining them with industry median ratios, a fair value of $147.41 can be calculated. This means that the stock is overvalued by approximately 44.29%. No matter how you look at it, it’s clear that Microsoft (and the entire tech industry) is extremely valuable right now.

Relative valuation of Microsoft shares.

Relative Valuation of Microsoft (Created By Author)

What Should Investors Do?

While Microsoft is a fundamentally excellent company and can fairly defend itself against current tech industry problems and supply chain disruptions, the value of the company’s stock may be too overvalued for some to handle. If there is a recession coming from the banks and stocks pull back even further, Microsoft could see big drops in its share price, but this may have little impact on the underlying business. This leads me to believe that it might be best to wait for Microsoft’s share price to drop before buying and apply a Retention rating for now.

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