Microsoft Bull's Rebuttal
by Jim Surowiecki ([email protected])

Figuring out how to value a company's earnings is probably the most important and the most difficult task any investor faces, as the disagreement between Pauly and I makes fairly obvious. We both agree that Microsoft is an excellent company, that its long-term prospects are solid, and that its earnings will continue to grow for the foreseeable future (though I think they will probably grow faster than Pauly does). What we disagree about is whether all those things add up to a valuation that justifies a P/E ratio of greater than 60.

Ideally, of course, one wants a company's trailing P/E to equal its expected growth rate in earnings over the next five years, which for Microsoft will be somewhere between 25-30% under the best circumstances. On the other hand, at the stratospheric levels at which nearly all stocks are trading these days, finding companies -- other than cyclicals or turnarounds -- that trade at discounts to their growth rates is a near-impossible task. In that context, Microsoft on its own terms looks like a reasonable buy, especially when you factor in the relentless consistency of its earnings performance and the steady upward movement of its margins.

That, you might say, is the weak case for buying Microsoft. But there is a much stronger case, which is that this is simply one of the best-run companies in the world and a company with a de facto monopoly over the operation of what is fast becoming the basic tool of the Information Age. Couple that with Microsoft's strong moves onto the Internet and into networking software, and with the premium with which investors have endowed the stock -- as they have endowed Gillette and Coca-Cola -- and it becomes easy to see why it's worth paying more than the PEG or YPEG ratio would recommend for a share of Microsoft. This is a blue chip. It will be a blue chip five years from now and it will be a blue chip ten years from now, and the appreciation in its share price over those periods will be greater than the appreciation in the price of the S&P 500 or the Dow. Bank on it.

Pauly does an excellent job of raising all the relevant concerns, and certainly having the Justice Department sniffing around is not the most comforting spectacle ever. But while Justice may get Microsoft to stop some of its more questionable anticompetitive practices, none of these practices have much current impact on the company's bottom line, and none of them will have any real effect on its rapid growth going forward. As long as its control of Windows and its plans for Windows NT are unthreatened, Microsoft will be just fine, no matter what Washington plans to do.

Finally, just a quick glance at the company's results in the last quarter provides some sense of why this is as close to a sure thing as can be found. Microsoft's earnings grew 28% in the last quarter, beating estimates that had already been revised upward, while its profit margins incredibly rose to 35%, which is up 12% on a sequential basis. The company now has $12.3 billion, not $10 billion, in cash. Its operating margins are actually up to 51%, which is simply unimaginable for a company of its size. And the thing to keep in mind about all these numbers is that it's enjoying this kind of growth at a time when it has essentially no new products. Every product that made a substantial contribution to Microsoft's revenue in the last quarter had been out for at least eight months. Yet the company's earnings are growing at a pace that is far beyond that of most other established firms. (By contrast, remember that the S&P's earnings this quarter have risen just 3.3%). Intel, for instance, is a company with a brilliant long-term future as well. But in this last quarter, its earnings actually fell.

What impact will Windows 98 and Windows NT 5.0 have, then? It's hard to see how they could do anything but accelerate earnings growth, even if margins will probably decline slightly (an effect that will be outweighed by the increase in revenue). And then a couple of years later we'll have Windows 2000, and some new Net product, and Microsoft will by that point have made a strong move into e-commerce, and so on and so on. Valuation matters, but in this context it doesn't matter as much as the certainty of Gates, which is to say the certainty of profit.

Next: The Bear Responds