Declining Stock and Solid Fundamentals: Is The Market Wrong About Microsoft Corporation (NASDAQ:MSFT)?

editorial-team@simplywallst.com (Simply Wall St)

Sat, Nov 23, 2024, 4:00 AM 4 min read

With its stock down 1.8% over the past month, it is easy to disregard Microsoft (NASDAQ:MSFT). But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. In this article, we decided to focus on Microsoft's ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Microsoft

How Is ROE Calculated?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Microsoft is:

31% = US$91b ÷ US$288b (Based on the trailing twelve months to September 2024).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.31 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

Microsoft's Earnings Growth And 31% ROE

To begin with, Microsoft has a pretty high ROE which is interesting. Additionally, the company's ROE is higher compared to the industry average of 12% which is quite remarkable. Probably as a result of this, Microsoft was able to see a decent net income growth of 15% over the last five years.

We then compared Microsoft's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 20% in the same 5-year period, which is a bit concerning.

past-earnings-growth — NasdaqGS:MSFT Past Earnings Growth November 23rd 2024

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is MSFT fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Microsoft Efficiently Re-investing Its Profits?

Microsoft has a three-year median payout ratio of 26%, which implies that it retains the remaining 74% of its profits. This suggests that its dividend is well covered, and given the decent growth seen by the company, it looks like management is reinvesting its earnings efficiently.

Besides, Microsoft has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 22% of its profits over the next three years. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 27%.

Conclusion

In total, we are pretty happy with Microsoft's performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see a good amount of growth in its earnings. The latest industry analyst forecasts show that the company is expected to maintain its current growth rate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.