Microsoft Bear's Den
by Paul Larson ([email protected])

I must be insane to have told Rick Munarriz, the Dueling Fools organizer, that I was bearish on Microsoft. A Fool that does not like Microsoft? Blasphemy! That's almost as bad as not liking Iomega! With the Cash-King folks adoring the company and some of the company's top brass taking time to chat with Fools in the past, I think it is safe to say that the majority of the folks clicking in here like Microsoft. Heck, I like Microsoft too! I happily use several of its products on a daily basis. Nevertheless, I find nothing to love in the stock's valuation.

I think what we are looking at here is, to borrow a phrase from Alan Greenspan, a classic case of irrational exuberance. Sure, there is a ton to admire in Microsoft, but where does admiration end and cognition of cash flow and earnings multiples begin?

It begins right here. Let's start by looking at the company's earnings multiple. At a recent $94, the company trades at nearly 65x trailing earnings. Did you hear me? Sixty-five times trailing earnings! Whether absolute or relative, historical or contemporary, this is a stratospheric valuation. Period. Certainly, a high P/E multiple alone is not a reason alone to avoid this or any stock, but the earnings number combined with limited growth is what should really give investors pause for concern about Microsoft.

I simply cannot fathom paying 65x earnings for a company that is expected to grow profits at less than 25% a year for the foreseeable future, no matter how much I admire the company. One of the cornerstones of the valuation techniques we teach here at the Fool is that growth companies should trade at earnings multiples roughly equal to their earnings growth rate. Microsoft by this standard is, frankly, off the charts.

Let's now examine some of the reasons for Microsoft's limited growth. The main limiting factor is simply the company's raw size. With Microsoft maintaining such a huge market share in the operating systems and applications businesses, there is little growth to be had by growing market share. In other words, the company is already at the top of the game in many areas, and you can't get any higher than 100% market share. Therefore, much of the company's growth in core products will be limited by the absolute growth of the computer industry.

Furthermore, outside of its core business Microsoft is on less sure footing than usual. Whether it is television, Web access, or online content, Microsoft is entering much lower margin businesses than it has been in the past. In other words, the incremental dollars needed to fund the growth are much less certain than the dollars generated from sectors in which Microsoft now dominates. At 65 times earnings, it is these less-certain businesses that will need to succeed in order to grow earnings enough to even come close to justifying the current stock price.

And then there is the Department of Justice factor. The company's growth in many sectors is going to be watched closely (and likely limited, when possible) by the government. The company has already gotten into some hot water for its alleged anti-trust and anti-competitive behavior. I don't think it's a matter of if the government is going to intervene in Microsoft's business, I think it's a matter of when the company will be more highly regulated. Microsoft has to tread very carefully with its future strategic decisions.

Whatever comes out of the current bouts with the government, it is safe to say that any further growth is going to be looked at with increasing scrutiny by the bureaucrats inside the beltway. While the company has essentially gotten away with its past behavior, the intent of the Department of Justice to keep a close eye on Microsoft is painfully clear. There is nothing positive that can come from this situation, only negatives.

To end, the market has rewarded Microsoft's stock with a premium price to its earnings due to the company's awesome performance in the past. The problem is that the premium is entirely too high relative to the slower growth that lies ahead. With valuations on the stock at nosebleed levels, there is a lot more air underneath the stock than above it. Someone wise once said that it is easier to fall out of the penthouse than the basement. It appears here that Microsoft has everything to lose and not much to win.

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