I have not done a serious deep dive into Microsoft’s financials, so let me preface this discussion with a caution that anyone choosing to invest in Microsoft should do further research before making a long-term buying decision.  With that said, let us take a quick look at what is on the surface:

What I like at first glance:

• Microsoft is one of the few major technology companies that pays a dividend – currently weighing in at 2.25%.  This is a major positive in my mind because of how few technology firms do this.  Microsoft finally realized a few years ago that massive piles of cash were not in its shareholders’ interest – I wish Google and a few others would take this lesson to heart.
• Microsoft is in excellent financial condition with almost no debt — 5% of equity — and plenty of cash flow to weather any storm.
• It has a long history of positive earnings growth, though growth rates have understandably slowed a bit in the downturn.
• With a return on invested capital (ROIC) of 35.7% (anything over 10% is excellent) — a measure of management’s effectiveness at leveraging its capital in profitable ventures– Microsoft is outstanding at putting its assets to good use.  This also holds true for all of Microsoft’s margins – 42.47% return on equity, 25.86% net profit margin, and so on.

Honestly, none of this is surprising for a large tech firm these days.  From a sector-blind viewpoint, it is incredible that Microsoft has managed to mantain high, if declining, growth rates as such a massive company.  More surprising is another measure of potential value:

• One method of looking at whether a high growth company such as Microsoft is a decent value is to look at its PEG ratio, or price-to-earnings to growth ratio.
• This ratio measures whether a stock is undervalued relative to its growth (PEG less than 1) or overvalued (PEG more than 1).  I prefer to use a modified version that accounts for dividends so: . 
  Microsoft’s dividend-modified PEG is currently a respectably low 0.64.

What I don’t like:

• Using traditional measures of value, P/E and price/book ratios, Microsoft is very expensive.  While Microsoft’s P/E ratio of 13.37 is reasonable, especially for a technology firm, its price/book is not at 5.57.  This makes Microsoft’s so-called PEB ratio (my term – P/E times price/book) a stratospheric 74.47.  That is more than three times higher than my target of less-than 22.5.
• Microsoft price/sales ratio is high at 3.36, but not outlandish.

Summary of Fundamentals

Based on the financials above, I would say that Microsoft looks like a moderate value for a high growth firm.  I am a bit hesitant to say it’s a substantial value given its very high PEB.  Alernately, high price/book ratios are no stranger to technology firms given that they have very little physical capital (such as manufacturing facilities), and this explains the very high PEB.  At the same time, I am always hesitant to make exceptions to good rules when there are plenty of stocks that have all of the glowing characteristics above and have low PEBs.  After all, some of the same arguments were once used to explain the dot-coms in the 1990’s, and airline stocks in the 1950’s – of course, unlike dot-coms or airlines, Microsoft makes money.

Corporate Culture

I believe that corporate culture is important, especially in a highly competitive industry like software.  It is a company’s key asset in retaining good talent, encouraging and monetizing ingenuity, and staying competitive.  This is one area where I am questionable of Microsoft’s competitive position.  Relative to its major competitors (albeit smaller) – Google, Oracle, Apple – Microsoft is downright stodgy.  Its overgrown, bureaucratic largesse is legendary in the technology arena — something that notably affected profits with the poor showing in Vista.  I recall reading an article about how something absurd like 30 committees were responsible for different elements of the shutdown/restart menu.

The verdict remains out though.  Bing suggests considerable marketing and development savvy, even though it is not likely to dent Google’s armor, but may hurt Yahoo and Ask.com.  Windows 7 looks like it is going to be what Windows Vista should have been, and in a fraction of the time.  These developments suggest that perhaps Microsoft’s management has shifted gears, injected energy, and streamlined the bureaucracy.

Behind the Curve?

Nevertheless, Microsoft remains behind the curve in many areas.  Its overwhelming revenue generators are Windows and Office — the same two products that were its major sources of revenue ten years ago.  In meantime, Microsoft has developed no major innovation, developed an advantage in any new market where someone else had not already beaten them to the punch or stolen any major profit potential from under their noses.  Examples abound — Apple with the mp3 player, Google with search, Apple with the smart phone, Google and Salesforce with cloud computing, and so on.  While Microsoft has profitable products in some of these areas, it has not provided any major innovation with its products that has led it to dominate any new market segments.

As a result of this continued behind-the-curve-ness, along with problems with Windows Vista, Microsoft’s brand image has suffered mightily.  Google can walk into a crowd of developers, especially on college campuses, anywhere in the world and get people on board to develop applications for its initiatives.  Microsoft on the other hand has a negative association among many young developers, and long-term, it is developers that make or break a software firm.

Leadership

Like culture, the verdict is still out on Microsoft’s leadership.  My read on Steve Ballmer is that he has taken the notion of injecting energy into the company literally — manifested by his unnervingly flamboyant and eccentric developer conference speeches.  I may be a bit unfair here, but I don’t think running around like a mad man on stage inspires anything but discomfort for those watching.  The proof of effective leadership will be when Microsoft shows that it can identify a potential market, create a truly great product, and set the tone for that new market.

As a quick aside, I also do not like the massive amount of stock options that Microsoft, most tech firms, and many other companies today issues its employees.  I will write about this at greater length in the future, but I fail to see the value added for the shareholder.

Crystal Ball

Very long-term, Microsoft may be in trouble if it cannot learn to reinvent stale product lines and develop effective new products early enough to matter.  Any continued image degradation will cannibalize Microsoft’s future developer pool and further reduce its competitiveness.  Microsoft may have also missed the boat entirely in some tectonic shifts in technology — principally smart phones and possibly cloud computing.  If these two technologies truly start replacing the Microsoft PC as we know it today, that could be the end for the company’s glory without new significant revenue streams.

I could be wrong.  Microsoft has been a successful firm for sometime, and all odds are in its favor for it continuing to be successful.

Invest or Not

Based on this look, I would say that it is worth considering investing in Microsoft.  I personally would prefer a more traditional value play (that high PEB really does unnerve me), but by most measures, Microsoft is an excellent buy at current valuations.  While there are several things I don’t like about how the company has been run in the recent past, there are signs of improvement, and buying in now could be incredibly profitable.

Assuming its financial statements do not reflect any major sources of concern, I would be confident buying a stake in Microsoft — reassessed annually — for up to five years.  Beyond that, I would have to have seen some major improvements in management and product development to continue my investment further in the future.

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