MSFT downgraded to hold; overvalued on DCF basis despite undervaluation on forward P/E; no new buys until fundamentals improve.

When Microsoft's stock fell below $400 a share earlier this year, I upgraded the stock to a high rating and placed it on my list of best stocks to buy with great conviction.

As the share price continued to fall from $400 to $350, I repeated this classification several times, and I bought Microsoft shares for my own portfolio during those moments. Now, I am grateful for those decisions.

Microsoft's stock price has risen from just over $350 per share to over $525 today. It was one of my best moves this year.

But is it too late? Is it time to sell? I wanted to take a look at Microsoft now that its valuation and price have increased so much in a short time. Does it still look attractive?

Is there still a chance to buy? What am I going to do with my Microsoft shares at these levels?

One of the things I'm watching at Microsoft is the developments in its investments in artificial intelligence, and how it's using it internally to improve its products and services, reduce its operating costs, and for its third-party leasing business where it builds data centers and leases computing capabilities to companies like OpenAI.

Recently, they demonstrated success in Copilot, reaching over 30 million paid subscriptions in Microsoft 365 Copilot, with net added subscriptions more than doubling quarterly.

This is a significant acceleration and evidence that they are reaping the benefits of their investments in artificial intelligence.

During this quarter, Microsoft is working to integrate Copilot experiences, including code, into a single, superior application that encompasses both consumer and business experiences.

I left the Microsoft productivity suite a few years ago. So, I'm eager to hear from you users of "Copilot", have they shown a significant improvement in user experience? Was the gradual increase in the price of the 365 subscription with the benefits of integrating artificial intelligence worth it?

They say they are constantly working to improve the quality and performance of "Copilot". And of course, that's what they do. Otherwise, they would not have witnessed this significant quarterly growth in their customer base.

Another aspect I'm watching at Microsoft is the return on invested capital, which is trending downwards in a rather curious way, isn't it? In 2022, the return on invested capital peaked at around 33%, and has now fallen to around 26%.

However, a return on invested capital exceeding 26% is almost double Microsoft's weighted average cost of capital, meaning that every dollar Microsoft invests in the company generates a profitable return on capital that is far higher than the cost of that money to the company.

So, at this level, the more Microsoft invests, the better for shareholders, but the overall trend is worrying. Microsoft investors, myself included as I still own shares in the company, would like to see this trend stabilize and not fall any further.

Another factor that worries me is that Microsoft's revenue growth is the slowest among major cloud computing companies when compared to Amazon, Alphabet, and MetaPlatforms; Microsoft's revenue growth in the recently concluded quarter was only 18%, among the lowest of those companies.

Its operating income growth of 21% was also among the lowest of these major companies.

Microsoft is not reaping the rewards of its investments in artificial intelligence with the same strength as some of its peers in their financial performance. This does not mean that it does not experience any benefits, but to a lesser degree.

Microsoft's operating profit margins have risen to 45%, and here's what I find truly impressive. The company's total number of employees decreased by 2% year-on-year. Thus, Microsoft generated 18% more revenue with 2% fewer employees.

This really impresses me because they were able to increase their revenue and grow their business with fewer employees, which means that every individual is now more productive.

Each individual, when we look at the revenue per employee, we find that each individual contributes a larger amount. This is impressive to me. These are the kinds of signs I like to see when a company makes a large capital investment in its organization.

By “large,” I mean $41 billion in capital expenditures, including the high memory prices that Microsoft indicated to investors. About two-thirds of this spending went to short-term assets, such as graphics processing units and central processing units, as customers increasingly build solutions that take advantage of AI infrastructure and other technologies.

The remaining spending was allocated to long-term assets. In other words, when Microsoft spends on artificial intelligence, one-third of that spending goes towards buildings, structures, land, etc., while two-thirds of the spending goes towards components, graphics processing units, central processing units, and memory.

I mentioned some areas where Microsoft lags behind its peers among major technology companies, but one area where it excels is cash flow, isn't that right? while I estimate that Microsoft will generate significantly positive cash flow.

In fact, in its most recent quarter, its cash flow from operations rose by 30% to $55.4 billion. It has generated a free cash flow of 19.6 billion. Overall, I estimate that Microsoft will generate $65 billion in free cash flow in 2026. 2027 will be lower due to its intensified investments in artificial intelligence, and its cash flow from operations will not increase as much.

Then 2028 will be another year of significantly positive cash flow, reaching 45.7 billion.

Taking all of that into account, I calculated the fair value of Microsoft's stock at $406. Compared to the current market price of 525, it appears to be overvalued now when measured on a discounted cash flow basis.

When measured on a forward price-to-earnings ratio basis, Microsoft is at 22, which still seems to me to be undervalued. I would say that Microsoft stock will appear undervalued until its forward price-to-earnings ratio reaches close to 30.

Therefore, at these levels on a forward price-to-earnings basis, Microsoft stock appears to be undervalued, while when measured on a discounted cash flow basis, Microsoft stock appears to be overvalued.

I mentioned that I have been optimistic since Microsoft's stock price fell below $400 per share. My last update was on August 21, when I rated it as a highly convincing buying opportunity.

However, today I am downgrading my rating on Microsoft stock to hold. I no longer think it's a great buying opportunity at these levels.

Right now, I still own Microsoft shares and I am not interested in selling my stake in it. I would like to be optimistic here and recommend buying Microsoft stock. That would be great for me.

The value of my shares will also increase. I just don't think that's the case. The data does not support that recommendation.

I believe that if you own Microsoft stock and hold onto it for the next five, ten, or twenty years, you will achieve a great return on that investment. That's what I plan to do.

I will probably hold this stock for a long time, unless the market price continues to rise without a similar improvement in business fundamentals. So, I will hold onto my shares for now, but I am not interested in adding more Microsoft shares to my portfolio at these levels close to $500 or more, until the company’s performance shows a tangible improvement, at which point I will reassess my position to see if it is a better opportunity.