This “MSFT Stock Forecast: Are Investors High on Hopium?” article was written by Rafi Rees – Financial Analyst at I Know First.

Highlights

• MSFT has found itself in the news a lot in recent weeks with a large investment of $10bn in OpenAI – the company behind ChatGPT.
• MSFT reported decent results last week however, a slowdown in the growth of their cloud segment has pulled into question the current valuation.
•  A reverse DCF suggests the market is currently pricing in a 13.5% annual growth rate in free cash flow for the next 10 years.

Company Overview

Microsoft is a company everyone is familiar with. Founded by Bill Gates in 1975, the company is now headed by Satya Nadella at CEO.

For those that don’t know, MSFT is a multinational technology company that develops, licenses, and sells computer software, consumer electronics, and personal computers. Figure 1 displays MSFT’s revenues by segments over the last 5 years.  The company’s primary source of revenue comes from its personal computer business and licensing of its proprietary software products such as Windows operating system and Office Suite. Another significant source of revenue is its cloud computing services under the Azure brand. In recent years, MSFT’s intelligent cloud segment, which includes Azure, has been growing rapidly and is expected to continue to do so in the future. The company also generates revenue from its gaming division through the Xbox gaming console and related services. Overall, Azure and the intelligent cloud segment are expected to be the fastest growing revenue sources for MSFT.

Microsoft’s Investment in OpenAI:

On January 10^th it was announced that Microsoft were considering a $10bn investment in OpenAI – the creator of ChatGPT. The stock has risen over 10% since then (see figure 2). Investors believe that the investment into OpenAI will provide Microsoft exclusive access to integrate ChatGPT features into their current software solutions. There has been talk of a resurgence in the use of Bing as a competitor to Google search as investors believe the incorporation of ChatGPT into search will encourage users to make the switch. Furthermore, Microsoft will be able to add a ChatGPT functionality in their suite of office products, from Teams to Outlook to Word. It is clear to see the value proposition being proposed to users as ChatGPT has gone viral, being one of the fastest applications to reach a million users in just 5 days. The popularity of the product speaks to the popularity and whether for better or worse, it is here to stay.

The expectation is that this investment will also push Microsoft’s cloud segment ‘Azure’ to a new level of competitiveness as they have recently announced the launch of an Azure OpenAI service with ChatGPT. This could sway businesses who are choosing between the main cloud providers – AWS, Google Cloud and Azure to go with Microsoft’s offering. This is what CEO Satya Nadella had to say about it in the most recent earnings call. “We are excited about the Chat GPT being built on Azure and having the traction it has. So, we look to both, there is an investment part to it and there is a commercial partnership. But fundamentally, it’s going to be something that’s going to drive, I think innovation and competitive differentiation in every one of the Microsoft solutions by leading in AI.”

These expectations are all well and good, however, it is important to see the thesis backed up by real-life data. Microsoft recently announced that they will not address revenue recognition related to OpenAI’s use of Azure, and that if it was a significant factor in Azure’s growth, they would have mentioned it. This suggests that OpenAI’s Azure consumption is not a significant contributor to Azure’s growth right now. This is however only one data point in which the period of growth was limited. It will be interesting to see how this plays out over the coming quarters and years. There is always the possibility that their competitors come out with competitive solutions, for example, Google owns the company DeepMind who have recently announced that they are considering releasing its own rival to ChatGPT called Sparrow in the coming year. This could materially affect the growth proposition Microsoft is selling us right now.

Trimming the Fat

Microsoft announced earlier this month that they would be laying off 10,000 employees, which equates to roughly 5% of the workforce. The recent earnings call may have shed some light onto the reason as MSFT reported Q2 2023 Revenues of $52.7bn which missed consensus estimates of $52.9bn. Their EPS however managed to beat consensus, reporting an adjusted EPS of $2.32 compared with consensus of $2.30. This represented growth of 7% YOY in constant currency terms largely driven by a 38% YoY growth in Azure, compensating for the decline in Office Consumer (-2% YoY), Windows OEM (-39% YoY) and devices (-39% YoY). Windows OEM – the faction of MSFT that sells windows licenses to PC makers is a hugely profitable segment, so in order to maintain this level of profitability, MSFT is looking to reduce costs. This is a difficult task to rise to as MSFT’s problems are being compounded by two factors. The first of which is that demand is being normalized after some of it was pulled forward by the pandemic as the world moved to a work-from-home model and everyone wanted to update their equipment. The second pertains to the macro factors as overall liquidity is falling and companies as well as consumers are becoming wearier of budgeting factors. The excess of the past 10 years is no longer guaranteed over the coming 10 years, and this is where I fear the market may be getting it wrong regarding the current pricing of MSFT.

MSFT Valuation Analysis

I have used GuruFocus.com for their DCF valuation functionality in order to get a better understanding of what the market is currently pricing into the stock price.

According to the DCF, the market is forecasting a free cash flow growth rate of 13.5% per annum over the next 10 years. I have used a terminal stage of 50 years with a growth rate of 2.5%, in line with the annual global economic growth. I used 50 years as MSFT is a tech giant with a deep moat and is a business that is very difficult to disrupt. Given that the FCF growth rate per annum over the last 10 years has been 11%, this suggests that the market expects MSFT to continue growing at a rate above the historical 10-year growth rate. Bearing in mind that we had covid during that period which pulled demand forward as well as the excess liquidity mentioned previously, it is difficult to see MSFT outperforming and growing faster than in the last 10 years. Especially given the macro headwinds and the law of large numbers which means the bigger MSFT gets, the harder it is to grow. If we use a more conservative 11% growth rate which is consistent with the last 10 years as growth rate over the next 10 years, we arrive at a fair value for the stock at $212.87. This suggests that the current share price is almost 20% overvalued and we would expect it to come down from here. I wouldn’t be shocked if the growth rate ended up being even lower than 11% over the next ten years as there are significantly more headwinds today than there were 10 years ago.

MSFT Stock Forecast: Conclusion:

The margin of safety is one of the key tenets of investing espoused by the father of value investing himself, Benjamin Graham. When investing in a company, it is important to consider the impact of what would happen if you were wrong. The law of compounding can only take place if you can stay in the game, so it is important to remain a player. This is how the likes of Warren Buffett has managed to accumulate such a large fortune. 95% of his wealth was made after the age of 65. This demonstrates the importance of not losing too much money as that can set you back significantly. Since Microsoft at these levels has no built-in margin of safety, I would recommend not investing at this point in time. Should the share price fall 20%, then the value proposition may turn interesting. Until then, I will be sitting on the side-line.

It is worth paying attention that the stock-picking AI of I Know First has a high signal on the one-year market trend forecasts. The light green for the short-term forecasts is mildly bullish, while the darker green is a strong bullish signal for the one-year forecast.

Past Success with MSFT Stock Forecast

I Know First has been bullish on the MSFT stock forecast in the past. On November 7^th, 2022 the I Know First algorithm issued a forecast for MSFT stock price and recommended MSFT as one of the best stocks to buy. The AI-driven MSFT stock prediction was successful on a 1-month time horizon resulting in more than 10.38%.

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Please note-for trading decisions use the most recent forecast.