Investors have modest expectations for Microsoft (MSFT 1.83%) in 2023. The tech giant is on track to grow sales and earnings just slightly, according to most Wall Street pros, after big gains over the past two years. Yet the stock is valued at a huge premium compared to many of its tech peers.
Does that premium reflect Microsoft's strength as a long-term investment, or does it mean shareholders are likely to see sluggish returns over the next several years? Let's take a closer look at the bullish thesis for the stock.
Pockets of weakness
Microsoft's latest earnings report demonstrated the power of its diverse business while still showing significant growth challenges. Overall, sales rose 7% to $53 billion through late December after accounting for currency exchange-rate shifts. Revenue was up 16% on that basis in the prior quarter .
Zooming in, shareholders can see big disparities between Microsoft's major business lines. Growth is strongest in cloud services, which was up 22% in the fiscal second quarter. The company is dealing with a cyclical pullback in PC products and video games, though. These crosscurrents help explain why Wall Street is expecting sales to rise at a single-digit rate in fiscal 2023.
Financial strength
Its financial strength is moderating, but Microsoft still trounces most of its peers in this arena. Operating profit margin shrank by 2 percentage points last quarter yet remains above a blistering 40% of sales. That figure is higher than most rivals, and it's also holding relatively steady at a time when other software and hardware businesses are struggling.
MSFT Operating Margin (TTM) data by YCharts.
Investors will also find plenty to like about Microsoft's cash position. The software-as-a-service (SaaS) specialist generated over $11 billion of operating cash flow and $5 billion of free cash flow in the latest quarter. While both figures are down compared to pandemic spikes, they reflect a highly efficient business with competitive moats that span industries like enterprise cloud services, cybersecurity, and business productivity.
Cash returns and valuation
Microsoft executives said in a late January conference call that they're seeing more caution from big customers across enterprise spending. Combined with a continued downturn in areas like PC and video games, these trends point to a second half of fiscal 2023 that looks a lot like the Q2 performance.
That weak short-term outlook clashes with Microsoft's stock movements lately. Shares are trouncing the S&P 500 and are valued at over 10 times annual revenue today. That valuation has expanded from 8 times sales in late 2022.
The greatest risk with Microsoft stock, then, is in overpaying for this stellar business. Cautious investors might want to watch for a better chance to buy, potentially when markets turn negative again on worries about a potential recession on the way.
But while the stock's 2023 rally has lowered potential returns from here, Microsoft still looks like a great long-term investment. Holding this business, and the exposure it brings to key growth industries like AI and cloud services, will likely generate strong returns over many years. Investors shouldn't let an elevated stock valuation keep them away from those positive results.
