Microsoft dominated the PC era, but the Internet poses new threats to its business. The company has a solid history of exceeding investors' expectations, but an uncertain future raises the question of whether or not the stock is a compelling value. To succeed, Microsoft will need big wins with its .Net platform, Xbox video-game console, and MSN.

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By John Del Vecchio (TMF Fuz)
February 22, 2001

Shares of Microsoft Corporation (Nasdaq: MSFT), the largest software vendor in the world, were up 9,562% in the 1990s. These days, every company wants to be the next Microsoft, including Microsoft. However, the shift toward Internet computing has forced the software giant to retool its business and reinvent itself as an Internet powerhouse.

Investors fear that Microsoft will be left in the dust as the Internet evolves, threatening to erode the company's position at the center of the computing universe. The antitrust litigation also compounds the concern of investors because a possible breakup could erode Microsoft's competitive advantages even further. The legal wrangling, slowing revenue, and propaganda disseminated by the likes of Larry Ellison of Oracle (Nasdaq: ORCL) and Scott McNealy of Sun Microsystems (Nasdaq: SUNW) has led to a substantial decline in Microsoft's stock price. But is the company undervalued?

Assessing the value of a company like Microsoft is difficult to accomplish. Many factors play a role in its valuation, including its competitive advantages, the antitrust litigation, and the pace of technological change. Let's look at these issues so that some reasonable expectations about Microsoft's future can be created.

Measuring competitive advantage
A company's competitive advantage period (CAP) is the amount of time it is expected to create value by earning a return on invested capital (ROIC) in excess of its cost of capital. Financial analyst Michael Mauboussin has pegged Microsoft's CAP at as short as three years at the time it went public to as long as 25 years when Mauboussin wrote his report in 1997.

Putting all of the arcane mathematics aside, it is obvious that Microsoft's CAP has shrunk over the past year. Concerns over whether or not the company will emerge as the dominant player in the Internet era and the possibility of a breakup has put pressure on its stock, causing it to decline precipitously from a high of $115 to a low of $40 per share.

Increasing returns
How did Microsoft create so much shareholder value and will it continue to do so in the future? I believe that answer lies in an interesting phenomenon called "increasing returns." W. Brian Arthur of the Santa Fe Institute developed the theory that once a company gets a market share lead, it continues to get further ahead while competitors fall further behind. As more copies of software are sold, such sales increase the likelihood of that software becoming the standard, spurring even more sales of the software and reinforcing the growth cycle.

Microsoft has locked in increasing returns in the desktop operating systems and personal productivity markets by becoming the standard. I believe this phenomenon explains why Microsoft has created so much shareholder value over the past 15 years, and can help us determine whether or not it will continue to do so.

While many independent software vendors dislike working with Microsoft, they do have the software giant to thank for lining their pockets with profits for so many years. According to a 1998 study conducted by the consulting firm McKinsey & Co., Microsoft only garnered 4% of the total revenue of the markets it dominated. This means that the other 96% went to its partners. Based on Microsoft's 1998 revenue, the "Microsoft Economy" was about $383 billion in 1998 (with $15.3 billion of that going to Microsoft) and $573 billion (22.9 billion going to Microsoft ) in 2000, holding constant Microsoft's 4% cut of the action.

This means Microsoft has created considerable wealth for many other companies. Now it needs to leverage this "Microsoft Effect" and build momentum around its Internet-era applications. The .Net platform (next-genearation Windows) is a bet-the-company strategy for Microsoft as it attempts to capitalize on emerging technologies in the new millennium. Should Microsoft be able to create this momentum, it could stymie the growth of upstart companies that may have better technologies but lack the financial clout and partnerships to make their vision become reality.

A peek at valuation
As I said before, valuing a company like Microsoft is not easy. Borrowing from the Rule Maker Portfolio's 2x/5y concept (double your money in five years), we can make some assumptions about Microsoft's future.

I am assuming net profit margins of 35% five years from now (this is 4% lower than what Value Line  estimates) and 5% share dilution each year (Value Line is assuming no share dilution). Based on these assumptions, a required compounded return of 15% for five years, and an estimated P/E of 35, Microsoft would have to grow revenues 17.9% compounded annually. If we assume that the market will award Microsoft a P/E of 30, then the growth rate increases to 21.5%. A P/E of 40 would require 14.7% compounded growth in revenue. All of these scenarios require Microsoft to accelerate its growth rate in order to double in five years.

Estimated   Implied Revenue
P/E Ratio     Growth Rate  
   30           21.5%
   35           17.9%
   40           14.7%

To justify these expectations, Microsoft will have to succeed on several fronts. First, the success of .Net will be crucial. It's not clear what the revenue potential will be, but it will likely be much larger than in the PC era because it will encompass PDAs, cell phones, tablet PCs, and a variety of other devices. Second, the company must gain a significant share of the video-game market through its new Xbox console and games -- a $15 billion industry within a couple years. Third, the company must effectively use the Microsoft Network as a portal to distribute its products and services in order to grow its revenue. If Microsoft fails on these fronts, then I think the company will not be able to grow its top line enough to justify 2x/5y. Microsoft has a long history of exceeding investor expectations. However, I think whether or not Microsoft can exceed expectations in the future boils down to successfully executing on .Net, the Xbox, and MSN.

John Del Vecchio is notorious for his bad timing. At the time of this writing, he owned shares of Microsoft and Oracle. To see his other holdings, visit his personal profile. The Motley Fool is investors writing for investors.