Will Weakness in Microsoft Corporation's (NASDAQ:MSFT) Stock Prove Temporary Given Strong Fundamentals?

Microsoft (NASDAQ:MSFT) has had a rough three months with its share price down 5.2%. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Specifically, we decided to study Microsoft's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Microsoft

How Is ROE Calculated?

ROE can be calculated by using the formula:

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

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

35% = US$72b ÷ US$206b (Based on the trailing twelve months to June 2023).

The 'return' refers to a company's earnings over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.35 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Microsoft's Earnings Growth And 35% ROE

First thing first, we like that Microsoft has an impressive ROE. Secondly, even when compared to the industry average of 9.8% the company's ROE is quite impressive. Under the circumstances, Microsoft's considerable five year net income growth of 21% was to be expected.

Next, on comparing Microsoft's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 19% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for MSFT? You can find out in our latest intrinsic value infographic research report.

Is Microsoft Using Its Retained Earnings Effectively?

The three-year median payout ratio for Microsoft is 28%, which is moderately low. The company is retaining the remaining 72%. By the looks of it, the dividend is well covered and Microsoft is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.

Additionally, Microsoft has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 22% over the next three years. However, the company's ROE is not expected to change by much despite the lower expected payout ratio.

Conclusion

In total, we are pretty happy with Microsoft's performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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.