Shares of Microsoft (MSFT 0.37%) shot higher after the company reported fiscal third-quarter results following the market close on Wednesday. That, combined with the stock's strong year-to-date performance, lifted the software giant's market capitalization to around $1 trillion.
Such a significant milestone makes this a good time to reflect on the company's valuation. Is Microsoft really worth $1 trillion, even if its fiscal Q3 results were better than expected?
Image source: Microsoft.
Cloud-driven strength
Microsoft's net income in fiscal Q3 was $8.8 billion, up 19% year over year. This translated to earnings per share of $1.14, up 20%. Revenue increased 14% year over year to $30.6 billion. Analysts, on average, had expected earnings per share of $1.00 on revenue of $29.84 billion.
The impressive quarterly performance was helped by a 41% year-over-year increase in commercial cloud revenue -- primarily from three of the company's most important offerings: Office 365 commercial, Azure, and Dynamics 365. At $9.6 billion, commercial cloud revenue accounted for 31% of the software giant's total Q3 revenue.
"Leading organizations of every size in every industry trust the Microsoft cloud," said CEO Satya Nadella in the earnings release. "We are accelerating our innovation across the cloud and edge so our customers can build the digital capability increasingly required to compete and grow."
Azure saw particularly strong growth: The cloud-computing platform's revenue rose 73% year over year (75% in constant currency).
Valuation
But does Microsoft really deserve a $1 trillion market capitalization?
When its fast-growing cloud business, improving free cash flow, and the recurring nature of its offerings are viewed together, a good case can be made for buying the software giant's shares today.
First, consider Microsoft's heady trailing-12-month free cash flow of nearly $34 billion. Sure, this is well behind Apple's (AAPL 1.27%) $62 billion, even though Apple's market capitalization is currently about $980 billion. But Microsoft's annual free cash flow has been steadily rising, while Apple's peaked in its fiscal 2015 at $69 billion. Microsoft's was about $23 billion in its fiscal 2015.
In addition, investors should give significant consideration to Microsoft's fast-growing commercial cloud business. It now produces nearly a third of the company's total revenue, and could drive meaningful growth for years to come.
Finally, the recurring nature of Microsoft's business model is worth a premium. Unlike Apple, which generates the bulk of its revenue and profits from a single product (the iPhone), Microsoft's business is driven primarily by more predictable cloud-based software-as-a-service revenue. In addition, these revenue sources are diversified across a range of "sticky" platforms and applications, such as Microsoft Office, Windows, Xbox software and services revenue, LinkedIn subscription and ad revenue, Azure, Dynamics products and cloud services, and more.
While Microsoft certainly isn't a bargain at these levels, the stock's valuation relative to the company's underlying momentum does suggest shares remain a buy for investors who intend to hold onto them for the long haul.
