The U.S. equity market bounced back impressively from the turbulence caused by April's tariff shocks. With strong earnings performance and easing geopolitical tensions, investors are again looking out for the next technology winner.
Nvidia (NVDA -2.20%) had a phenomenal run in the past few years, riding high on GPU demand. However, there is one stock that is also building a bigger moat.
Image source: Getty Images.
Meet Microsoft (MSFT -0.93%), a global technology giant that has embedded artificial intelligence (AI) into every layer of its ecosystem. Although Nvidia and Microsoft are currently challenging each other to become the world's most valuable company, the latter's approach can enable it to surpass Nvidia significantly by next year. Here's why.
An AI-powered ecosystem
Nvidia primarily focuses on developing the hardware and software infrastructure needed to drive the ongoing AI revolution. In contrast, Microsoft has built a strong presence across both the AI infrastructure and AI application markets.
Microsoft is leveraging AI technologies to increase performance and lower costs across the entire technology stack, including data center design, hardware, system software, and model optimization.
Subsequently, the company managed to monetize its AI technologies through several avenues -- from direct use, such as Copilot virtual assistants across applications like Microsoft 365, Dynamics 365, and GitHub, to indirect use through third-party applications built using its Azure AI services.
Microsoft is also scaling up its AI infrastructure rapidly and released the Phi family of small language models (38 million downloads) and BitNet b1.58, which runs on CPUs. This reduced the company's dependency on GPUs, which can help lower costs and broaden AI accessibility.
Microsoft tools and platforms such as GitHub, Visual Studio Code, and Power Platform are increasingly used by developers to build AI applications. This is creating a strong network effect, as the value of these offerings rapidly increases with new insights provided by the existing developer base, attracting even more developers.
Microsoft has also processed over 100 trillion tokens (such as ID tokens, access tokens, or refresh tokens, which are used for user authentication) in the third quarter, a fivefold increase on a year-over-year basis. This massive scale has given the company a strong data advantage in operational and optimization insights, which hardware players cannot replicate.
Third-quarter fiscal 2025 results highlight the success of management's AI strategy. Azure and other cloud services revenue rose 33% year over year, with AI services contributing 16 percentage points to that growth.
The company also reported a threefold increase in Microsoft 365 Copilot use and a fourfold increase in GitHub Copilot use on a year-over-year basis.
A sticky customer base
Enterprise customers extensively used Microsoft's business productivity products over the past decade. Since these products are deeply embedded in the company's infrastructure, clients find it challenging to switch to competitors.
This enterprise software is seeing even better customer retention rates and recurring revenue with AI integration. Furthermore, the company's long-term enterprise relationships also provide cross-selling and distribution opportunities, an advantage that pure-play AI companies are unable to replicate.
Currently, more than 230,000 organizations, including 90% of companies that make up the Fortune 500, use the company's virtual assistant, Copilot. Unlike Nvidia's GPU sales, which are one-time transactions, Microsoft's AI services generate recurring revenue streams.
And companies opt to delay GPU purchases in a tighter economy but are less likely to eliminate mission-critical software that runs their daily operations.
A diversified business
Microsoft generates revenue from a diverse range of sources, including cloud computing infrastructure, a suite of productivity applications, gaming, and advertising. This has significantly reduced the company's business concentration risk stemming from overreliance on a single or a few markets.
All these strategies have led to exceptional revenue visibility. The company ended the third quarter with commercial remaining performance obligations (RPOs) of $315 billion, representing a 34% year-over-year increase. And Microsoft's 98% annuity revenue model offers more predictable cash flows compared to Nvidia's bulk GPU sales, which are highly dependent on semiconductor cycles and ongoing AI infrastructure build-outs.
Nvidia's investment case becomes even riskier when we consider the increasing competition from companies such as Advanced Micro Devices, Intel, and hyperscalers developing in-house chips. As the costs of AI inference workloads rise, more clients will prefer to shift workloads from costlier GPUs to less expensive CPUs or seek software services that can postpone the obsolescence of existing GPUs.
Plus, increased export restrictions on Nvidia's GPU sales to China and other international markets also pose a significant headwind. This can hurt the chipmaker's top line in the coming years.
Is Microsoft stock a buy right now?
Microsoft currently trades at 26.2 times forward earnings, which is lower than its five-year average of 33.2. Despite this, the valuation is at a premium, especially for a company that is not only in AI but is also a major software company. Hence, some investors may be uncomfortable paying premium AI valuations for traditional software businesses.
But AI is gradually transforming every aspect of Microsoft's business. The company's financial results continue to be impressive despite significant investments in AI infrastructure. In the third quarter, Microsoft's operating margins rose 1 percentage point year over year to 46% , while cash flow from operations surged 16% year over year to $37 billion.
The company also maintains a cash and investments balance of $79.6 billion, which ensures strong financial flexibility. Lastly, management remains committed to returning value to shareholders, as evidenced by the $9.7 billion paid in dividends and share repurchases, a 15% increase year over year.
Against this backdrop, it does seem pretty plausible for the company to definitively emerge as the most valuable AI stock in 2026. This may be a smart time to buy at least a small stake in Microsoft.
