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Evolution of the Business

Microsoft Azure, which was still in its infancy a decade ago, has undergone a complete transformation. Significant growth has been propelled by the company’s foray into the cloud and artificial intelligence (AI). This surge is reminiscent of Microsoft’s history, characterized by pivotal moments when the company was on the verge of becoming a stalwart and then changed course, demonstrating adaptability and resilience in a dynamic market.

In the second quarter of fiscal 2024, the Intelligent Cloud segment garnered $25.88 billion in revenue with an impressive 48.2% operating margin. Meanwhile, the Productivity and Business Processes segment generated $19.25 billion in revenue at a superior 53.4% margin, and More Personal Computing yielded $16.89 billion in revenue with a respectable 25.4% margin, particularly notable for a hardware-intensive business.

The impact of AI is pervasive across Microsoft, with strong adoption of AI solutions such as Microsoft Copilots in Office products, Microsoft Edge, and GitHub. Subsequently, GitHub Copilot paid subscribers increased by 30% compared to Q1 fiscal 2024, spurring a 40% year-over-year rise in GitHub revenue.

In the realm of cloud services, Microsoft boasts 53,000 clients for Azure AI, and over half of the Fortune 500 companies utilize Azure OpenAI. While AI has become a buzzword in numerous sectors, Microsoft’s tangible results and measurable impact set it apart, reinforcing the company’s credibility.

An Exceptional Quarter

Reflecting on Microsoft’s Q2 results over the past decade sheds light on the substantial transformation of its business model. Despite a near-doubling of revenue over the last five years, the company has nearly tripled its operating income and diluted earnings per share (EPS) through margin expansion and strategic stock buybacks. Going further back, Microsoft now generates more diluted EPS in a single quarter than it did in an entire fiscal year seven to ten years ago.

Metric	Q2 FY15	Q2 FY16	Q2 FY17	Q2 FY18	Q2 FY19	Q2 FY20	Q2 FY21	Q2 FY22	Q2 FY23	Q2 FY24
Revenue	$26.47 billion	$23.8 billion	$25.83 billion	$28.92 billion	$32.47 billion	$36.91 billion	$43.08 billion	$51.73 billion	$52.75 billion	$62.02 billion
Operating Income	$8.02 billion	$6.03 billion	$7.91 billion	$8.68 billion	$10.26 billion	$13.89 billion	$17.90 billion	$22.25 billion	$20.4 billion	$27.03 billion
Operating Margin	30.3%	25.3%	30.6%	30%	31.6%	37.6%	41.6%	43%	38.7%	43.6%
Net Income	$5.86 billion	$6.03 billion	$6.27 billion	($6.3 billion)	$10.26 billion	$11.65 billion	$15.46 billion	$18.77 billion	$16.43 billion	$21.87 billion
Diluted EPS	$0.71	$0.62	$0.80	($0.82)	$1.08	$1.51	$2.03	$2.48	$2.20	$2.93

Data sources: Microsoft, YCharts.

The most striking aspect of Microsoft’s results is its robust revenue growth alongside expanding margins, spearheaded by AI initiatives. Notably, 72.8% of the company’s revenue in the quarter stemmed from its ultrahigh margin Productivity and Business Processes and Intelligent Cloud segments. This fundamental shift towards high-margin segments has propelled Microsoft to deliver a remarkable 43.6% operating margin, significantly higher than the approximately 30% margin achieved in pre-fiscal 2020.

Microsoft’s Predominant Challenge

The foremost concern surrounding an investment in Microsoft is its valuation.

The Distorted Path to Microsoft’s $4 Trillion Valuation

Price-to-Earnings Expansion: A False Mirage?

Viewing the chart depicting Microsoft’s price-to-earnings (P/E) ratio, one cannot overlook its glaring deviation from historical valuations. Yet, this isn’t the crux of the matter. What truly captivates lies in the market’s proclivity to assign the software giant loftier multiples as time ticks by.

Over the last five years, Microsoft’s median P/E ratio has eclipsed both the preceding seven-year and three-year spans. Such progression mirrors the market’s inclination to bestow a higher premium on the tech behemoth’s earnings. The abiding rationale, of course, predicates upon Microsoft’s burgeoning stature and enhanced business quality. This is a sensible trajectory given Microsoft’s sustained blistering growth rate, a facet substantiated by its most recent fiscal quarter.

Amid stark demands, scrutiny becomes inevitable: Microsoft’s current 36 P/E ratio is merited, yes. However, fostering any further valuation expansion demands an uphill acclivity in margins or revenue growth, a feat approaching the bounds of impossibility. Yet, one heartening revelation endures—Microsoft, hovering around its historic zenith, need not court valuation expansion to engender substantial investor interest.

Earnings Growth: The Precarious Principal

Presuming Microsoft trades at fair valuation, its stock should shadow earnings growth commensurately. A 25% earnings uptick should ideally translate to a corresponding surge in Microsoft stock to maintain a consistent P/E ratio. Should it resist the shift, the resultant P/E nudges downwards, gravitating to approximately 27 based on the prevailing P/E of 36. The underlying theorem remains undemanding—an earnings uptick is synonymous with an escalating stock price, or conversely, a glaring valuation discount. In either vein, long-term investors emerge triumphant.

Multiple Paths to $4 Trillion

Microsoft’s sojourn to a $4 trillion valuation, whilst seemingly effortless through a market-anointed 50 P/E, is in reality anything but. True ascendancy lies in robust fundamentals, not ephemeral market impressions. Should Microsoft perpetuate its extant P/E ratio and amplify earnings by 33%, it potentially eclipses the $4 trillion benchmark. Even with a recession to, say, 30, more in tune with its 10-year median, a 65% earnings augmentation unshackles the same destiny. Given extant growth patterns, an exponential earnings surge within three years remains a plausible conjecture.

Irrespective of the path solemnized—a pliant or onerous odyssey—Microsoft resonates as an indefatigable investment. Even amidst a valuation squeeze and slackening earnings growth, the monarch could effortlessly eclipse the $4 trillion metre in the interim.

Skeptical of an impetus toward the $4 trillion echelon this year, I ardently speculate a 2026 or 2027 ascent presents a likelier scenario.