How Microsoft's diverse growth justifies its valuation

Microsoft Corp. (MSFT, Financial) is still the second most valuable company in the world, narrowly beaten by Apple Inc (AAPL, Financial).

Among the 10 largest companies in the United States, some stand out for trading at above-market multiples, such as the two mentioned above, but also Nvidia Corp. (NVDA, Financial), Amazon.com Inc. (AMZN, Financial) , Eli Lilly and Co. (LLY, Financial) and Tesla Inc (TSLA, Financial).

Of all these, some require very aggressive forecasts or accept a small margin of safety to justify the valuation, such as Tesla, where significant increases in fundamentals through the FSD must be taken into account, or Apple, where the high P/E ratio does fit not good for growth prospects, but that's not really the case with Microsoft.

Even if the expected price-earnings ratio is very similar to that of Apple, Microsoft is expected to grow faster and have very solid competitive advantages that guarantee good sustainability, and it is also possible to benefit from various opportunities as its sales are higher is very varied.

Microsoft divides its revenue streams into three main sources: Productivity and Business Processes, i.e. the part that includes the Office Commercial, Office Consumer, LinkedIn and Dynamics business solutions, accounted for 31% of revenue in the fiscal fourth quarter; Intelligent Cloud, which includes server products and cloud services such as Azure, Visual Studio, GitHub and others, accounted for 44% of revenue last quarter; and finally, More Personal Computing, which represents revenue from Windows, gaming (Xbox and the like), search, and news, accounted for 25% of revenue last quarter.

Note that even if we divide sales into three segments, there are infinite sub-segments within each segment, and although they have different perspectives, the vast majority are good companies that manage to make significant sales progress and continue to do so steadily, supported by each individual's competitive advantages.

Windows, for example, is present on more than 70% of desktops, and from this data alone it would be possible to compile a list of competitive advantages such as economies of scale, cross-selling power, lock-in effect, compatibility, etc. Not to mention Office 365 and its applications, used by thousands of large companies that need to use Microsoft products every day not only on Windows but also on Macs and mobile phones, and although there are alternatives that could threaten market share – such as Alphabet Inc.'s tools . (GOOG, Financial) – loyalty is very high.

These characteristics are directly reflected in Microsoft's fundamentals: with the ability to improve its recurring revenues, pass on inflation to the prices of its services, and grow on other fronts, the company was able to increase its revenue per share by an average of 12.2% increase The company recorded an EPS growth of 20.9% in the last 20 years, while in the same period the EPS growth was 20.9%, which also shows the improvement in the net profit margin.

Source: GuruFocus

From these trenches and the stability it can already be deduced that Microsoft earns many times over for different quality, at least compared to the average in its market.

In the most recent quarter (fiscal quarter 4), this positive trend continued, with Microsoft growing all three key revenue lines by double digits, resulting in consolidated growth of 15%. Looking a little deeper, the highlights were server products and cloud services, up 21%, and Xbox content and services, up 61% but impacted by the Activision acquisition, while office consumer products were up just 3 % increased.

Source: Microsoft presentation

These good numbers will continue for the next few years (depending on the year and the analyst, it could be even more optimistic). The forecast is for average revenue growth for the next three fiscal years to be ~14.3%, and EPS is even better, with growth of just over 15% and EPS of $17.98 in fiscal 2026 .

It makes sense to construct a scenario in which Microsoft maintains growth close to 15%. I would even say: easy. Its more “traditional” part, Productivity and Business Processes, has the ability to maintain price adjustments, continue to attract new customers and also benefit from long-term trends in productivity, cybersecurity and AI, as the trend is for Office 365 to always be becomes more complete and integrated.

More personal computing should be driven by trends like the new Copilot PCs, which can help increase sales, improve the operating system update cycle, and the like. Copilot subscriptions alone could also see significant growth in the next few years, especially in terms of broader adoption.

The cloud division, which already accounts for the majority of sales, also shows long-term trends and continues to be one of the pillars for the progress of artificial intelligence. In the last earnings call, it was mentioned that Azure AI's customer base reached 60,000 customers, representing 60% year-over-year growth.

Some other macroeconomic trends, such as acquiring customers in emerging markets and small and medium-sized businesses that do not yet have access to these products and services, could also further drive the growth of Microsoft's financials.

What bothers me is that while it's easy to understand that the company is growing at almost 15% in the next few years, it's difficult to sustain that over a few decades. For a company that already has nearly $250 billion in revenue and nearly $90 billion in net income, it's possible to continue growing at an accelerated rate, but that could become increasingly difficult. For example, new ventures must become more mature if they are to contribute to annual growth, and at some point it may become more difficult to acquire new customers around the world.

Given the growth mentioned in the previous section, this premium would already be somewhat closer to the index average in a few years. Using the average of 2026 EPS estimates, the price-to-earnings ratio would be just over 24x, an apparent value quite reasonable given that it is one of the most consolidated companies in the world , which still has a lot of growth potential. If you did the same with Apple, its FY2026 price-to-earnings ratio would be ~27.2x, a higher level even if driven by large buybacks.

Historically, Microsoft has traded at a higher valuation multiple than Apple, but in recent years that gap has narrowed. In the latest data, Microsoft shares traded at 31.8 times earnings, while Apple traded at 30.5 times earnings, and while both are excellent companies with good prospects and competitive advantages, Microsoft's growth is a little more reliable (and will probably be at least higher). short and medium term). It is also worth noting that Apple trades at a higher premium compared to its own history, as the mean of its indicator is ~21.3x, while Microsoft's is 26.8x.

Source: GuruFocus

Since the scenario for Microsoft's growth is clearer and the company continues to be one of the main players that will benefit from the AI ​​trend, this premium seems to me reasonable in relation to both the market and its own history. Another factor supporting the bullish thesis is that there may be positive surprises along the way, especially given the company's good track record in terms of management, capital allocation, etc.

This level of evaluation is even more justified given the quality. Microsoft is a unique company and, in the end, hardly comparable to the market average and even to the US Treasury. Many investors may prefer to invest in the 10-year Treasury note, which yields about 3.7%, rather than buying Microsoft, which has an earnings-to-market cap ratio of about 2.7%. However, it must be taken into account that these gains will be achieved by the 2026 financial year. The return should exceed 4%.

Traditionally, a DCF should take into account a more robust equity risk premium. For Microsoft's current price to work in a DCF model, it must either take into account that the company will be able to sustain growth of around 15% over two decades, or disregard its cash flow at a very low rate Rate (e.g. 5% or 6%).

In short, there's not much asymmetry or a bargain here, but you can still justify Microsoft's price without too much trouble.

Given the above information, although Microsoft is by no means undervalued, its valuation can certainly be justified without overly optimistic assumptions or abandoning the entire margin of safety. Of course, the investor is trading upside potential for quality and stability, but is still investing in a growth company that could surprise positively in various segments over the next decade, which could then become an interesting option to make the portfolio more predictable.