Is Microsoft’s Stock Overvalued or Undervalued?

A view of Microsoft's headquarters in Luxembourg on Nov. 10, 2014. Emmanuel Dunand/AFP via Getty Images

Microsoft Corporation shares have outperformed the S&P 500 in the past year, generating a total return of 42 percent.

Microsoft is still putting up impressive growth numbers. But with a $2.31 trillion market cap, some investors are wondering if there’s any value left in Microsoft stock.

Earnings

A price-to-earnings ratio (PE) is one of the most basic fundamental metrics for gauging a stock’s value. The lower the PE, the higher the value. For comparison, the S&P 500’s PE is currently at about 29.5, nearly double its long-term average of 15.6.

Microsoft’s PE is currently 34.0, slightly higher than the S&P 500 average as a whole. Microsoft’s PE is also up 30.3 percent over the past five years, suggesting its earnings multiple is on the high end of its historical range.

Growth

Looking ahead to the next four quarters, the S&P 500’s forward PE ratio looks much more reasonable at just 20.9. Unfortunately, Microsoft’s forward earnings ratio of 28.8 doesn’t make the stock undervalued at its current price. In fact, it appears to be slightly overvalued compared to technology sector peers that are currently averaging a 27.9 forward earnings multiple.

However, when it comes to evaluating a stock, earnings aren’t everything.

Growth rate is also critical for companies that are rapidly building their bottom lines. The price-to-earnings-to-growth ratio (PEG) is a good way to incorporate growth rates into the evaluation process. The S&P 500’s overall PEG is currently about 1; Microsoft’s PEG is 2.0, a potential red flag that the stock has become overheated.

Price-to-sales ratio is another important valuation metric, particularly for unprofitable companies and growth stocks. The S&P 500’s PS ratio is currently 3.21, nearly twice its long-term average of 1.63. Microsoft’s PS ratio is 12.98, definitely not what a value investor is looking for.

Finally, Wall Street analysts see decent gains for Microsoft shares over the next 12 months. The average analyst price target among the 36 analysts covering Microsoft is $370, suggesting about 20.4 percent upside from current levels.

Verdict

At its current valuation, Microsoft stock is showing a couple of warning signs of being overvalued, so investors should proceed with caution.

By Wayne Duggan

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