Microsoft: Time To Take A Break

| About: Microsoft Corporation (MSFT)

The share price of Microsoft (NASDAQ:MSFT) has risen by 16% in the past month primarily driven by the company's Q3 results and pending release of the next-generation Xbox. At $33.11, the stock is trading at its 52-week high and offers a 2.8% dividend yield. Although Microsoft represents a solid long-term investment, for margin of safety reason, I believe potential buyers should wait for a pullback. My view is supported by the following 4 reasons:

1. After the recent price appreciation, Microsoft's forward P/E multiple has recovered and is currently trading in line with its historical level of a year ago (see chart below).

Nevertheless, the company's consensus revenue, EBITDA, and EPS estimates for the current and next fiscal years have experienced multiple downward revisions over the period and are all below their historical figures of a year ago. In addition, analysts' estimated 5-year earnings growth rate has also been lowered slightly from 9.9% to 9.0% since 12 months ago, suggesting the recent expansion of the P/E multiple is somewhat exaggerated (see charts below).

2. From a historical standpoint, Microsoft's valuation has likely reached its fair value level. The stock's trailing EV/EBITDA multiple of 7.1x is currently trading at 8% above its 3-year historical average at 6.6x (see chart below).

However, over the past 3 years, Microsoft's capital return metrics have been riding a downtrend. The firm's various profitability margins have also experienced a flat performance. Further, the company's current revenue, EBITDA, and EPS growth rates are considerably below their levels in mid-2010, and the consensus growth estimates only show a modest recovery (see charts below). As such, based on Microsoft's profitability performance and growth trajectory, the current stock valuation appears somewhat frothy relative to its historical level.

3. The current share price has exceeded analysts' average 1-year price target of $32.67 by 1.3%. Based on capital asset pricing model, Microsoft's cost of equity should be above 9% (see chart below). Hence, the sell-side's average price target actually implies that the shares are likely overvalued by approximately 10%.

4. Microsoft continues to derive a significant portion of the revenues from the PC market. Given the secular declining trend in PC spending, the valuation upside appears to be limited until the company is able to achieve a solid market position in the mobile market.

Despite the above negativity, there are still some positive facts:

1) According to a research note of McAdams Wright Ragen dated April 25, Sid Parakh commented on the outlook for Microsoft's enterprise business, which I tend to agree with (sourced from Thomson One, Equity Research):

"We believe that Microsoft has a significant long-term opportunity on the Enterprise front given its legacy footprint. The company is uniquely positioned to deliver hybrid cloud services (infrastructure, platforms and applications) and we expect to see continued traction on this front."

2) The stock's dividend has experienced a notable growth. The company has raised its dividend per share 3 times since 2010 by 23%, 25%, and 15%, consecutively. Under the current low-interest market environment, the stock's 2.8% dividend yield should continue attracting demand from institutional income investors, thus offering downside support.

3) Microsoft's forward P/E multiple is still trading at a 25% discount to the same multiple of S&P 500 Index despite the fact that the company's 5-year estimated earnings growth rate at 9.0% is slightly above the average estimate of 8.2% for the S&P 500 companies and that the stock's dividend yield is also above the market average.

Given the above, buyers should consider pulling the trigger below $30 for a better margin of safety, assuming everything else being equal.

All charts are created by the author except for the consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the charts and the article is sourced from S&P Capital IQ unless otherwise specified.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MSFT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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