• Microsoft will report earnings on Thursday, April 25 after the bell

• Analysts expect solid growth, driven by artificial intelligence

• But share valuation is already stretched, so upside may be limited

Leading the AI arms race

Microsoft has been at the forefront of the ‘artificial intelligence wars’ over the past year, following its acquisition of OpenAI and several other startups. Just last week, the company announced it will invest $1.5bn in Abu Dhabi’s G42 group, its latest bet on this emerging technology.

The market has rewarded Microsoft shares handsomely, with the stock rising more than 40% over the last year to make it the world's most valuable company by market capitalization. It’s still unclear how much AI initiatives have boosted Microsoft’s earnings, but investors are hopeful that the enormous investments will pay dividends down the road.

Of course, Microsoft has several revenue streams beyond artificial intelligence such as Azure, its rapidly-growing cloud computing business and its video gaming arm, Activision Blizzard. Its Office 365 services have also been a major growth driver in recent years.

Solid quarter expected

For the quarter that ended in March, analysts expect Microsoft to report earnings growth of 15.3% compared to the same quarter last year. Revenue is also expected to have risen by 15% over the same period.

The market reaction will depend on whether the actual results are stronger or weaker than these projections, as well as the guidance by management about the next quarters.

It’s useful to note that Microsoft has a strong history of surpassing analyst earnings forecasts, having done so in all four of the preceding quarters.

Looking at the charts, Microsoft shares are trading near the 397.00 region, which successfully halted multiple declines this year, raising its importance as support. The earnings report will probably be a catalyst either for a downside violation or another rebound.

Strong results could propel the price back higher towards 417.00, an area that also encapsulates the 50-day simple moving average near 415.00. On the downside, a disappointing report could see sellers slice below 397.00, turning the spotlight towards 385.00 next.

Share valuation seems stretched 

From a valuation perspective, however, Microsoft shares don’t appear very attractive. The stock is currently trading at 30.7 times what analysts expect earnings to be over the next year, under the assumption that earnings will rise another 15% in this period.

This is a historically stretched valuation, especially for a mature company. Outside of the early pandemic years in 2020-2021, the last time Microsoft shares were trading for over 30x forward earnings was back in 2002 as the ‘dot com’ bubble was imploding.

In other words, even though the company has a bright future ahead considering its leading role in the artificial intelligence revolution, a lot of this optimism is already baked into the cake. For Microsoft shares to keep rising, earnings growth would need to be even more impressive than the market’s already-rosy assumptions. 

Otherwise, the valuation multiple would need to expand even further, but that seems unlikely in an environment of rising bond yields, which act as a dampener on valuations.

Ultimately, the real question is whether Microsoft can beat the 15% growth threshold the market expects in the coming year. If not, some ‘air’ might come out of the shares, but probably nothing that would threaten the longer term positive trend.