One of the most commonly used arguments for why a stock is a poor investment is past price performance -- specifically, that a company's stock has stayed flat or gone down over some preceding period of time. Critics have frequently employed that argument to describe Microsoft (Nasdaq: MSFT ) , which has fallen since its all-time high in 2000.
Microsoft was hardly the only company caught up in a bidding frenzy in 2000. During the frothy dot-com bubble, companies such as Akamai Technologies (Nasdaq: AKAM ) , Alcatel-Lucent (NYSE: ALU ) , and JDS Uniphase (Nasdaq: JDSU ) also reached astronomical valuations. All came crashing down from those heights, and each has yet to recover.
Digging deeper
One of the first reasons I hear about Microsoft's unsuitability for investors' portfolios is that the stock price has gone nowhere over the past 11 years, so the stock must be a bad investment today. Before we draw such a conclusion, let's look at the company's results over that period.
Source: Capital IQ, a division of Standard & Poor's. All dollar amounts in millions.
The first thing that pops out is how fantastically expensive Microsoft was in 2000. The company ended fiscal 2000 trading at mind-boggling multiples of 45 times earnings and 18 times sales. Those are rather high multiples to pay for a company whose market cap was already over $400 billion at the time.
Fast-forward to 2011, and we see a different picture. Not surprisingly, the company's market cap has dropped like a rock. However, there's a bigger story here: A glance at the numbers shows that the company has performed quite well. From 2000 to 2011, Microsoft tripled its already high sales numbers, while more than doubling net income. Many people would be surprised to see that the company's numbers are indeed quite strong.
It's clear that those who badmouth Microsoft based on stock performance alone are not presenting the full picture. The company has continued to improve virtually every financial metric over the past 11 years. Unfortunately, investors' excessively high expectations still doomed the stock to failure.
All told, it took 11 years of falling share price and improving earnings for the stock to finally trade at a reasonable valuation. In fact, Microsoft currently trades at 8.7 times this year’s estimated earnings, much lower than it did a decade ago.
Foolish bottom line
The next time an investor points to a stagnating stock price as a reason for avoiding a stock, don't be swayed. One should examine a company's earnings power and its growth over time before making any claims that a company is unsuitable for investment. A falling stock price may signal dwindling earnings, but there's a chance it could instead reveal an extremely high past stock price that's reverting back to a more realistic level.
If Microsoft can continue to increase its numbers as it has in the past, the stock price should reverse its decline and move meaningfully higher. Whether that'll happen, however, remains anyone's guess.
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