Microsoft (MSFT 1.08%) is one of the "Magnificent Seven" -- a small set of massive tech companies that were key drivers of the S&P 500's impressive 20%-plus returns so far this year. The company's role in artificial intelligence (AI) -- including its investment in and partnership with ChatGPT-maker OpenAI -- made it a popular stock for growth-oriented investors. But that attraction could face a big test next year when some investors will be looking for rapid signs that AI truly is having a game-changing effect on the business.
Given how well the stock performed this year, they will likely expect a lot from the business in 2024. It won't be easy for Microsoft to meet those expectations.
Microsoft is on track for another huge year
Share prices of Microsoft are up by more than 50% this year. And in four of the past five years (2022 being the only exception), the tech stock's price has gained at least 40%. Since 2019, the stock has climbed by an incredible 260%. The S&P 500, by comparison, has risen by a more modest 84%.
The challenge with such a fast-growing stock can be, however, that its profits aren't able to keep pace. And while Microsoft has generated strong revenue and earnings growth in recent years, they haven't grown at nearly the rate that the stock price has. Microsoft finished its fiscal 2019 with $39.2 billion in profit. In its fiscal 2023 (which ended in June), profits were $72.4 billion -- only 84% higher.
That means new investors are now paying a big premium for a piece of the business, which also means they are effectively paying for a lot of expected future growth.
The tech stock's valuation is much higher than normal
While there have been periods when investors have paid higher multiples for Microsoft than they're paying today, the stock's average price-to-earnings ratio over the past decade is close to 31.
MSFT PE Ratio data by YCharts.
There's a lot of excitement surrounding the company's growth prospects related to AI and gaming, with its acquisition of Activision Blizzard now complete. The danger, however, is that the company might not deliver the kind of growth that investors expect.
Why Microsoft might disappoint investors
Over the past year, Microsoft generated some decent revenue growth, but not as much as you might expect for a stock that's trading at 35 times earnings.
MSFT Revenue (Quarterly YoY Growth) data by YCharts.
Investors are eager to believe that Microsoft's AI-powered products will be a huge catalyst for the business. One way Microsoft is using AI is to enhance its existing Office software suite. For $30 a month per seat, businesses can gain access to Microsoft 365 Copilot, which uses AI to make Word, Excel, Outlook, and PowerPoint more powerful.
However, I'm skeptical about how much interest there will be in this service, especially as businesses remain cautious about their spending in an uncertain economy. The possibility of a recession is still a concern heading into 2024. And with many other chatbots out there, as well as other rivals offering similar services, I'm not convinced that the widening use of AI will lead to the huge revenue growth investors expect from Microsoft.
I do believe AI can help improve Microsoft's products, but I'm a bit more of a skeptic on the question of whether there will be enough value added there for it to lead to huge sales growth. While management predicts that AI will add $10 billion in annual revenue, that's still a relatively small chunk (less than 5%) of the more than $210 billion in revenue that Microsoft generated last year. AI can help grow the business, but investors may be expecting too much of it as a catalyst, especially in the near term.
Should you buy Microsoft's stock?
If you're investing for the long term (i.e., with a planned holding period of 10 years or more), then Microsoft could still be a solid stock to buy at its current level. But investors should temper their expectations for how it will perform over the next year, as the stock could start to run out of steam given its inflated valuation.
