Is Microsoft an Undervalued Growth Stock to Buy?

Tech giant Microsoft (NASDAQ:MSFT) has been one of the biggest beneficiaries of the stock boom that has taken the market by storm over the last two years. MSFT shares finished 2022 at about $236 and have since risen to nearly $440.

Even with these massive gains, there’s still a strong argument that Microsoft could have plenty of room left to run given its margins are even better than those of Apple. Is MSFT an undervalued growth stock, and what kind of returns can investors expect to see from the tech titan going forward?

Where Is Microsoft’s Performance Right Now?

Microsoft is currently turning in extremely strong performance, a fact that has helped to propel its shares gradually higher. In fiscal Q1 2025’s earnings report, the company reported revenue growth of 16% to $65.6 billion and net income growth of 11 percent to $24.7 billion. Operating income rose even faster than net income, rising 14% to $30.6 billion.

One of the company’s fastest-growing revenue lines was its Intelligent Cloud business, which saw a revenue increase of 20 percent to $24.1 billion. This is the segment through which Microsoft is currently capitalizing on its large AI investments, though the technology will likely have large impacts across the company’s product and service offerings. This is an area in which Microsoft has a significant lead on other companies due to its early investment in OpenAI, the company that created ChatGPT.

One of the particularly appealing aspects of Microsoft is its sky high level of profitability. For the 12 months ending in fiscal Q1, the company reported a net margin of over 35 percent. Just as encouraging is the fact that return on equity came in at a very similar level over the same period. On the whole, Microsoft has shown its ability to generate very large returns on its invested capital and capitalize fully on its revenue growth over time.

Microsoft’s Valuation and Expected Growth

Right now, Microsoft trades at about 34x forward earnings, nearly 13x sales and over twice its expected earnings growth. These metrics may present some problems for traditional value investors, as MSFT trades at a fairly premium price. Though Microsoft has shown that it can support high multiples for long periods of time, the trailing 12-month P/E ratio is currently at about its highest level since 2018.

The story around Microsoft’s valuation changes a bit, however, when long-term growth is taken into account. Over the next half-decade, the company’s earnings per share are expected to keep rising at a little over 13% annually. If Microsoft can deliver this kind of result, it’s very possible that its seemingly high valuation could be justified and that the stock today could be priced more or less fairly.

On an even longer time horizon, Microsoft’s earnings could keep growing for many years to come if its investments in AI technology keep producing. A recent study commissioned by Microsoft itself suggests that businesses see about $3.70 in returns for every $1 spent on AI. If these numbers hold true, Microsoft could see enormous demand for its AI services in the coming years. The company is also in a unique position to deploy new AI products, as its existing suite of business software is a go-to among both businesses and consumers.

How High Could Microsoft Go?

In the short term, MSFT shares appear likely to appreciate a bit faster than the overall stock market over the coming year.

The 12-month median price forecast for Microsoft is $500, about 13.8% above the latest closing price.

The S&P 500, meanwhile, is expected to fall back into its historical return range of about 10 percent in 2025.

Is Microsoft Stock In a Bubble?

While there’s little doubt that Microsoft is an excellent company that’s performing extremely well, there is a risk that its share prices have become inflated too much by the AI stock boom.

As recently as late November, the European Central Bank’s semi-annual Financial Stability Review called out the strong possibility of a price bubble around AI stocks. If generative AI fails to keep up with extremely optimistic expectations from investors, Microsoft and other large tech firms could see their share prices deflate.

Closely related to that risk of the AI bubble bursting is the financial risk that Microsoft could be taking on if AI doesn’t generate the returns it’s expected to. Microsoft has invested tens of billions of dollars into building out its AI capabilities.

By 2027, the company is expected to be spending $23 billion a year on AI data centers alone. If these investments don’t pan out, Microsoft could end up deploying a huge amount of cash that could otherwise be reinvested elsewhere in its business, used to acquire other companies or returned to shareholders through buybacks and dividends.

So, Is Microsoft an Undervalued Growth Stock?

Microsoft is growing rapidly for its size in the mid-teens range while also 13.8% below its fair value according to analysts consensus.

At the moment, it’s difficult to make a case that Microsoft is a real bargain. The stock is still trading at a premium for both its current and expected future performance. That said, a stock doesn’t necessarily need to be undervalued to be a good investment.

Microsoft is also in a good position to boost its total return to shareholders through continued dividend growth. Although MSFT has paid a dividend for over 20 years, its payout ratio is still only 27.4% due to its historically high rate of earnings growth.

Today’s yield is 0.8%, and each share pays $3.32 annually. Management has prioritized dividend increases quite a lot in recent years, with the payout having increased at a compounded rate of more than 10% annually for the last decade.

MSFT shares currently appear to be a fair value, even though there are risks associated with the company’s AI-inflated pricing in the short term. If Microsoft can continue its trend of building earnings by staying at the cutting edge of in-demand technologies, the stock could be a good long-term compounding investment. MSFT may also appeal to dividend growth investors with long time horizons, as it’s likely that the company can keep building its dividend at a fairly rapid rate for many more years to come.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.