Investors are enthusiastic about Microsoft (MSFT -0.11%) right now. The tech giant's 42% gains so far in 2023 are trouncing the 30% gain in the Nasdaq Composite and the stock recently exceeded all-time highs set in early 2022.
The wider tech rally is obviously contributing to this performance, but it's also easy to see why Wall Street is excited about the potential for this particular company. Microsoft has many large growth avenues available to it across areas like cloud services, artificial intelligence (AI), video gaming, and productivity software.
But investors should also note that shares aren't cheap following the latest rally. With that valuation challenge in mind, let's look at some reasons to buy the stock, along with a few factors that weigh in favor of caution.
Microsoft is reporting accelerating growth
A few of Microsoft's big sales niches, like personal computing software and tech devices, are shrinking right now. Yet this business is still firmly in growth mode.
A 25% year-over-year spike in the cloud services segment helped overall revenue rise 10% in the selling period that ran through late March, marking a welcome growth acceleration over the prior quarter when revenue rose just 2% year over year.
But one of the best reasons to love this stock is Microsoft's financial strength. The company generated $34 billion of operating cash in just the past six months, after all, and operating income landed at $42 billion, or roughly 40% of sales in that period.
Few companies on the market can approach either that amount of earnings or that level of profitability, which suggests this company maintains some incredible competitive advantages.
There are some reasons for concern with Microsoft
Yet it hasn't all been good news lately. In addition to sales declines in the PC and hardware divisions, Microsoft is seeing less enthusiasm among some large enterprises in their spending. Cost cuts are slowing down order volumes and pressuring the sizes of those contracts. It might also be several more quarters before cyclical downturns reverse in the PC market.
The stock is valued at a pricey 12 times annual sales, which isn't far from the all-time high valuation (a P/S of 15) that investors were paying back in the high growth phases of the pandemic. You can buy other tech giants much more cheaply. Apple is valued at 8 times its annual revenue, for example, and Amazon is going for a P/S ratio of less than 3.
Microsoft can earn that premium, though, especially if subsequent AI improvements unlock a significant portion of the expected software benefits that executives are predicting right now. CEO Satya Nadella said in late April that the industry is on the cusp of "a new era of computing," and enthusiasm about that phase is clearly one factor underpinning his company's stock rally this year.
Risk-averse investors might want to wait for a better price, which could come as volatility strikes the wider market. There will be inevitable bumps in Microsoft's growth trajectory, too, including potentially when the company announces fourth-quarter results in late July.
Patient investors will likely still generate solid profits from holding this stock, even at today's elevated valuation. Microsoft's returns should be bolstered by its growth and ample cash flow over the coming years, even if expectations around AI and cloud software turn out to be a little overblown.
