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When considering an investment, it can be useful to keep in mind the conditions that lead a company to become either overvalued or undervalued. Generally, a company becomes overvalued when business operations are performing smoothly. If you look at a company like Hershey (NYSE:HSY), Colgate-Palmolive (NYSE:CL), or Brown-Forman (NYSE:BF.B), you will see that each of the companies are experiencing smooth earnings and dividend growth that is expected to continue indefinitely.

Because those businesses are currently functioning as well as can be expected, the valuations happen to reflect the business performance. That is why Colgate is trading at a historically high 24x earnings, Brown-Forman is at a historically high 25-26x earnings, and Hershey is trading well above its dotcom bubble highs by currently trading around 30x earnings (it comes down a bit if you remove some one-time figures). Generally, some trigger event-stagnant volume growth, declining margins, etc.-will trigger each of these companies to experience P/E compression that will bring them more in line with where they have been historically.

When we start to think about Microsoft (NASDAQ:MSFT), we see a company on the other side of this trend. The perception that the company will not be able to create a viable business model that can adjust to the future changes in technology has led the company to a valuation that discounts much of the company's current profits, as well as its future profit potential.

In a few ways, Microsoft seems awfully similar to McDonald's (NYSE:MCD) around the 2001-2004 stretch. At the turn of the millennium, McDonald's suffered from headline risk as the media ran with the narrative that McDonald's could not compete in a world directionally headed towards healthier eating. Although the price of the stock fell from $30 in 2002 to a low of $12.70 in 2003, the actual business performance of McDonald's remained strong.

  • In 2001, McDonald's put up $1.36 in annual profits for each share owned, and returned $0.23 of that to shareholders.
  • In 2002, McDonald's put up $1.32 in annual profits while returning $0.24 to shareholders.
  • In 2003, the company grew profits to $1.43 while raising its payout to $0.40 per share.
  • And in 2004, McDonald's made $1.93 in profits while returning $0.55 per share to their owners.
  • The 2002-2003 period was a great time to invest in McDonald's stock because (1) the share price was unfairly beaten down, and (2) the company was entering harvest mode whereby it was becoming a cash cow that was accelerating its dividend payout ratio while simultaneously growing earnings at a healthy clip. The company grew its dividend by 27% while growing earnings by 14% over the past decade, increasing its payout ratio from 27% in 2003 to 57% in 2013.

In the case of Microsoft, the narrative is that the company will not be able to adjust to the growth of the mobile world, and this will eventually bludgeon the moats of Microsoft's core businesses. But the real story for Microsoft investors has been the declining P/E ratio over the past decade. The core businesses have been operationally sound and growing, but investors have been playing the "how low can you go?" limbo dance with the P/E ratio over the past decade.

Operationally, Microsoft has grown earnings per share by 11% since 2003. It has grown earnings per share by 14.5% since 2008. But why have investors experienced total returns that lag earnings growth? Simply because the valuation has steadily marched downward. In 2003, investors were willing to pay $26 in share price for every dollar of profit that Microsoft generated. In 2008, they were willing to pay $16 in share price for every dollar of profit Microsoft pumped out for shareholders.

The terms of investing in Microsoft are much different today. As of Friday's close, Microsoft traded at $31.40 per share while generating $2.60 in annual profits, $0.92 of which get returned to the owner each year for every share you hold. That's only 12x earnings. If you buy Microsoft today, you are buying a company with a 8.28% starting earnings yield plus whatever the future earnings per share growth rate of the firm happens to be.

And if the company decides to go into "harvest mode" and increase its payout ratio from the current 35% to 60-65% over the long term, shareholders can experience the wealth-building joy that occurs when you get to reinvest dividends into a company growing its dividend rate higher than its earnings rate while giving you the chance to increase your ownership stake at the lower valuation of 12x earnings (this phenomenon is partially responsible for explaining why Altria (NYSE:MO) shareowners have historically made the quickest buck that doesn't require a ski mask or a pistol to achieve).

And plus, there is the fact that Microsoft is sitting on $77 billion in cash, while only having $14 billion in debt (a net of $63 billion). Let me put that $77 billion cash hoard into something tangible for perspective. At current market prices, Microsoft's cash on hand could buy Kraft (NASDAQ:KRFT) and YUM (NYSE:YUM) outright, considering they have a combined market cap of $67 billion (although, in real life, takeovers usually involve paying a premium to market price). That means that Microsoft's current cash hoard would be enough to own every Kentucky Fried Chicken in the world, every Pizza Hut in the world, every Taco Bell in the world, every Kraft cheese product sold in the world, every Oscar Mayer meat sold in the world, every Maxwell House coffee product sold in the world, and the rest of Kraft's extensive product portfolio that would be too numerous to name individually (like A1 steak sauce, Cool-Whip, Jell-O, Planter's Peanuts, etc).

Oh, and Microsoft would still have $10 billion in walking-around money even if it did own Kraft and YUM Brands outright. That $77 billion cash stash does not seem to get much respect in the company's current share price.

One of the easier ways to achieve satisfactory returns is to buy a company that has low expectations baked into the share price that allow you to make money in the event that the company can jump over one-foot hurdles. That $77 billion in cash gives the company great flexibility. That 35% payout ratio may give room for nice dividend growth over the medium term. There is a notable mismatch between the headline risk posed to the company compared to the profits it continues to pump out. As the price of Microsoft stock has been beaten down to $31.40, it has reached the point where it does not take a whole lot to go right over the next five to ten years in order for shareholders to do well, as they potentially stand to benefit from some combination of: (1) future growth above pessimistic expectations, (2) an acceleration in the dividend payout ratio, (3) an expansion in the P/E ratio above 12, and (4) the utilization of the $77 billion in cash for something like a substantial buyback program.

Source: Why Microsoft Just Became A Compelling Investment Opportunity