One Reason Not To Ignore Microsoft Stock

Dec.22.11 | About: Microsoft Corporation (MSFT)

With Apple (NASDAQ:AAPL) products flying off shelves and the price of the stock shooting through the roof this past decade, it's easy to understand why most investors have been quick to hold up Microsoft (NASDAQ:MSFT) in comparison and conclude that Microsoft represents a vastly inferior investment. That may or may not be true, but I want to discuss one reason that people often bring up in discussing Microsoft that has absolutely no bearing whatsoever on whether Microsoft represents a good investment going forward. I'm talking about the declaration: "Microsoft shares have gone nowhere over the past decade."

I've included a chart to give you a look to compare the annual high per share price of Microsoft during each year since 2000; along with the corresponding earnings per share, earnings per share growth, and P/E ratio during the time represented. The first thing that struck me as quite absurd is that investors were willing to pay $58.60 per share of Microsoft for $0.85 in earnings, or a P/E of 68.94. Sometimes it's easy to forget just how ridiculous valuations got during the dotcom bubble, but it would be very unreasonable to expect market-beating returns if you initiate a position with a 1.45% earnings yield. That is especially absurd considering that Microsoft was the largest company in America at the time, with over 10 billion shares that valued the total company at well over $500 billion dollars-if the investor who paid $58.60 per share wanted to double his money, Microsoft would have had to become worth over $1 trillion dollars.

And although 2000 provides the most egregious example of the overpriced nature of Microsoft shares, the next four years weren't much better. From 2001 to 2004, Microsoft shares still hit price points that evaluated the company from 42x earnings to 29x earnings, and that type of evaluation still priced the company to perfecting-2.38% to 3.44% buy-in earnings yields are not usually conducive to success for companies of Microsoft's size.

As a company, Microsoft has done quite well from an earnings growth perspective. The company increased earnings 11.50% in 2005 and 18.30% in 2007, and produced phenomenal growth of 31.60%, 29.63%, and 28.09% in 2008, 2010, and 2011, respectively. But although the earnings for the most part did well (the most noticeable exception being 2009), the overvaluation of the shares from 2000 to 2007 ensured that shareholders would not be able to earn market-beating returns.

This is a sharp contrast to today. At Wednesday's market close, shares of Microsoft were trading at $25.76 based on $2.69 of earnings, for a P/E ratio of 9.57 and an earnings yield of 10.44%. As Benjamin Graham once said, "Price is Paramount," meaning that the single greatest determinant of shareholder returns is the initial price paid for those shares. There is a very big difference between buying Microsoft at a 1.45%, 2.38%, or 3.44% earnings yield and a 10.44% earnings yield. If you buy Microsoft today, each share that you buy represents 3-4x as much profit as shares bought in the early 2000s did.

That's why I'm always skeptical when I hear someone mention that shares of Microsoft have stagnated over the past decade, as if that somehow is supposed to guarantee that Microsoft will continue to underwhelm over the coming ten years as well. It's not an apples to apples comparison. The valuation of Microsoft shares were priced beyond perfection during the early 2000s, and that's why investors who bought at the height have still not recovered their money today-it's not the growth of the company that has been the problem (after all, Microsoft tripled earnings over the past eleven years), but rather, the price of the shares relative to the growth expected. Now shares of Microsoft trade at a much more reasonable 9.57x earnings, making it unfair to suggest that this valuation is in any way similar to the grossly overpriced nature of the shares during the first few years of the 2000s.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.