Can Microsoft (MSFT) Sustain Its Momentum?

After blowing past analyst expectations for its first quarter 2022 earnings, Microsoft Corporation (MSFT) became the world's most valuable company last week. Its stock price vaulted to a fresh high of $332 per share, and the company's market capitalization surged to $2.48 trillion, slightly more than that of rival Apple, Inc. (AAPL). 

The key question for Microsoft investors now is whether the tech behemoth can sustain the pace and book profits based on sky-high investor expectations. Microsoft's previous reign atop company valuation rankings, back in 2020, was brief. Rival Apple soon overtook it and coasted past the $2 trillion mark soon after. As of this writing, the stocks for Apple and Microsoft are locked in a dead heat of sorts with roughly the same valuation of $2.46 trillion.

Key Takeaways

  • Microsoft became the world's most valuable company on Friday Oct. 29, surpassing Apple in market capitalization.
  • To continue on its current growth trajectory, the tech giant will have to ensure growth for its cloud services division.
  • However, critics say that Microsoft may be overvalued as compared to its peers.

The Cloud Growth Engine 

While other units in the company have also contributed to the increase in profits, Microsoft's recent growth spurt has occurred largely on the back of bumper sales for its cloud division. The company has benefitted from the dual tailwinds of enterprise transformation at companies and a pandemic shutdown that accelerated enterprise shift toward the cloud.

Even though it was late to the game, Microsoft's cloud division Azure has clawed market share from rival Amazon.com, Inc. (AMZN). In the third quarter of 2021, Microsoft had a 21% share of the cloud market and ranked second behind Amazon's 32% share. The Azure division has booked successive quarters of revenue growth, culminating in a 48% year-over-year quarterly increase in the latest earnings report

Research firm Gartner predicts that the market for cloud computing will grow 21.7% to reach $482 billion in 2022. Analysts have reposed faith in Microsoft's ability to garner a substantial portion of that capital spend by enterprises.

"We continue to see Microsoft as well positioned to capitalize on durable secular growth in digital transformation budgets, and we remain convicted in our thesis that Microsoft Cloud is on track to generate $120-$140bn in annual revenue, likely 1-2 years ahead of our initial expectations at the time of our January initiation," wrote Goldman Sachs analyst Kash Rangan.

Bank of America analyst Brad Sills pointed to the steady profits from Microsoft's legacy Server & Windows businesses and the Azure divisions' hefty margins, writing that the "estimated Azure margin in the 59% - 60% range … demonstrates Microsoft’s ability to capture incremental growth in cloud, though not at the expense of these large, profitable legacy businesses."

In the near term, however, Microsoft's cloud division might report results that are below expectations. "We see a slowdown in remaining performance obligation or RPO growth and commercial bookings, two forward-looking metrics, as driven by large Azure deals in the prior year period and not a reflection of deteriorating demand," wrote Morningstar analyst Dan Romanoff. He has assigned a wide moat to Microsoft and bumped up the target value of its shares to $345 from $325.

The Valuation Problem 

While the future of its business is far from cloudy, Microsoft's valuation is being questioned by critics. The company trades at a relatively high price-to-earnings (P/E) ratio as compared to its peers. As of this writing, Microsoft's stock has a P/E ratio of 36.85 times its previous year's earnings. Meanwhile, Apple and Google parent Alphabet Inc. (GOOGL) are trading at P/E ratios of 26.55 and 27.70, respectively, based on their 2020 earnings.

According to some, those valuations are "a bit frothy" considering analyst expectations of 9% growth in earnings for 2021. But others point to Microsoft's competitive advantage and "well-established business model" in its three business units as proof that the company still has ample runway for growth.

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