While some stocks rise and fall sharply during earnings season, others stand pat. That's pretty much what Microsoft (MSFT 1.12%) did, as the stock only rose slightly more than the broader market (measured by the S&P 500) the day following earnings.
However, when you dig into the quarter, it may make some wonder why the stock wasn't up more because it was truly incredible. If it should be up more, this could potentially be an opportunity to get in before other investors realize what they've missed.
Microsoft crushed it during the third quarter
Microsoft has become a behemoth during its long rise to become the largest company in the world. Although it used to claim the title (alongside Apple) of a $3 trillion company, it no longer sits above that threshold. But with these results in mind, it may return there.
The law of large numbers states that the larger a figure is, the closer it will be to the average population. When applied to companies and their growth rates, this means that giants like Microsoft shouldn't be growing any faster than the average of all other companies in the market. But Microsoft flies in the face of this assumption.
In the third quarter (ended March 31), Microsoft's revenue rose 17%, and earnings per share (EPS) increased by 20% year over year. That's much faster than most companies, making these results all the more impressive. Furthermore, all of its business segments exceeded the expectations given in Q2.
| Business Segment | Q3 YOY Growth Projection | Q3 YOY Actual Growth |
|---|---|---|
| Productivity and Business Processes | 9% to 10% | 12% |
| Intelligent Cloud | 19% to 20% | 21% |
| More Personal Computing | 10% to 13% | 17% |
Data source: The Motley Fool and Microsoft. YOY = year over year.
But there is one business segment that's doing the heavy lifting. Of Microsoft's three business groups, Intelligent Cloud was the outlier, with its revenue rising 21% year over year to $26.7 billion (35% of its total revenue). This was powered by Microsoft Azure's incredible growth of 31% -- the best of the three major cloud-computing competitors. Why is cloud computing doing so well? It's likely related to artificial intelligence (AI).
AI requires massive data storage and computing power to create the best models. Most companies can't justify purchasing their own server to store and process this data, so they rent computing power from Microsoft. This is convenient for the customer, as they can scale their usage up or down as needed or rent more computing power when they have a large model to run.
As everyone rushes to implement AI into their business, Microsoft is seeing a huge demand surge that's boosting Azure and other cloud services Microsoft provides. Given how well Microsoft is doing, you'd think its stock would be up, but that's not the case.
Microsoft's stock was priced for perfection
There's a great reason why Microsoft stock is still fairly flat after earnings. Leading into the quarter, Microsoft needed to post a perfect quarter to avoid a drop from its lofty levels.
MSFT PE Ratio data by YCharts.
Microsoft's stock was trading at nearly 39 times earnings less than a month ago but still trades for an expensive 35 times earnings after results. That's a premium price reserved only for a few companies growing quickly or executing at a high level. For reference, AI powerhouse Nvidia currently trades at 34 times forward earnings.
So, for Microsoft to avoid a valuation drop, it needed to post a perfect quarter, which it essentially did. Microsoft still has a premium valuation, so its Q4 execution must be similarly flawless.
As a result, I don't think now is a great time to buy Microsoft stock, as there isn't much room for upside. Instead, investors should shift their focus to other companies that are delivering similar execution levels but trade for much lower premiums.
