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Microsoft Is Trading Near Its Record High. It’s Still Undervalued.

Microsoft Is Trading Near Its Record High. It’s Still Undervalued.

Posted November 27, 2023 at 10:45 am
Steven M. Sears
Barron's

Investors should think of Microsoft as a red-hot stock that trades at a stodgy multiple.

The assertion seems insane when Microsoft’s stock (ticker: MSFT) is near a record high. Not only that: So many people are long Microsoft that it is technically overbought, in the argot of traders, and could soon experience a sharp decline. But that likely fails to reflect the impact that artificial intelligence could have on Microsoft.

This call to bullishly rerate one of the world’s top stocks was prompted by Satya Nadella, Microsoft’s CEO, and his move in response to the shake-up at OpenAI, which might be leading every other company in the world in harnessing the power of AI.

After OpenAI CEO Sam Altman was ousted by his board, reportedly over an internal battle over profits and how the company would utilize AI’s power, Nadella offered Altman a job—and then offered to hire everyone else at OpenAI.

Altman’s surprise return to OpenAI doesn’t change the thesis: Nadella’s response to Altman’s initial termination should be viewed as a rare insight into a CEO’s strategic thinking.

The move should lead investors to disregard Microsoft stock’s current valuation and instead employ a thematic analysis, placing a greater emphasis on the ultimate impact of a significant trend. Investors who followed a thematic approach in Amazon.com’s (AMZN) early trading days benefited greatly, to cite one example.

The market is usually slow to recognize anything that can’t be expressed in a financial model. Amazon was thought to be a loser stock for a long time—until everyone woke up to its long game.

Unlike high-risk thematic trades predicated on a company solving a complex challenge, such as a major disease, Microsoft’s risks are relatively muted. It is a financial powerhouse that generates so much free cash flow that owning the stock—even bought around record-high prices—arguably adds exposure to AI for free, or at a de minimus price. Microsoft owns 49% of OpenAI.

At about 36 times trailing earnings, Microsoft is valued at about double the S&P 500 index—which means the stock is expensive by traditional analysis. But that premium valuation is arguably warranted by the company’s fundamental strengths. Consider: Nvidia (NVDA), another AI play, trades at around 120 times earnings.

We recently suggested using Microsoft options to profit from a year-end stock market rally. The stock has since surged, and those trades produced dramatic returns in less than a month.

Until the OpenAI drama, we intended to let the trades profitably expire. But Nadella’s move suggests we have failed to fully appreciate AI because of our distaste for hype and celebratory media coverage.

Many pundits aver that AI could fundamentally reshape human existence. But we have rarely seen the somber leader of a major corporation move so quickly and decisively in reaction to the news as Nadella did when Altman was fired.

Investors who followed our early-November suggestion to sell Microsoft’s January $325 put option for about $9.50 and buy its January $350 call option for about $11.10 should take profits. The put was recently worth $1.30 and the call $30. Use the profits to establish a bigger Microsoft position—provided you can hold the stock for three to five years, and ideally longer.

With Microsoft’s stock at $373.07, investors could sell the March $350 put for about $9.50 and buy the March $385 call for about $16.50. The risk-reversal strategy—that is, selling a put and buying a call with a higher strike price and same expiration—positions investors to buy the stock lower and to participate in gains above $385.

The March expiration provides time for investors to bullishly rerate Microsoft’s stock and ponder the ultimate message of Nadella’s bold move.

Originally Posted November 23, 2023 – Microsoft Is Trading Near Its Record High. It’s Still Undervalued.

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One thought on “Microsoft Is Trading Near Its Record High. It’s Still Undervalued.”

  • Berunda

    So MSFT is under-valued at 36x because NVDA is trading at a 120x multiple?
    You say – “Nadella’s move suggests we have failed to fully appreciate AI because of our distaste for hype and celebratory media coverage” Really? That is why these stocks have returned 40+% YTD with multiples exceeding 30x so far? Not to mention that google searches on AI have grown exponentially and C-level executives scrambling to fit the word AI somewhere in their earnings calls.

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