I am going to come right out and say it: VMware (NYSE: VMW) is overvalued.  Its price premium may have made sense in a world where VMware faced little competition; it pretty much stood alone in the virtualization market since it was initially founded in 1998. However, software giants Microsoft (Nasdaq: MSFT) and Oracle (Nasdaq: ORCL) have gained massive ground in the last two years. Microsoft has captured 25% of the virtualization market since it introduced Hyper-V in 2008 and with a recent update has added some missing must-have features. Oracle is also making a major play in virtualization with its recent release of Oracle VM Server for x86, and its all-in-one "cloud" appliance the Oracle Exalogic.

Small miss, big impact
A quick scan of VMware's financial data shows it trading at 104 times earnings at the time of this writing, which is more than double the computer software and services industry's already lofty average of 46. Stocks with such a high P/E ratio relative to their industry also tend to make massive corrections off relatively minor amounts of bad news. Just take a look at the most recent example of Equinix's (Nasdaq: EQIX) 33% drop on news of a 2.2% earnings miss. Even more alarming was VMware's 9% decline on the same news. VMware took another hit this week when it released earnings with weak operating cash flow figures. Even after a couple of rocky days, shares of VMware have still climbed 66% in the last year, and with the skittishness investors have shown lately, there's little margin for error in coming quarters.

Putting all their eggs in one basket
VMware derives 90% of its all-important licensing revenue from data center products like vSphere, its enterprise virtualization suite, which is being directly targeted by Microsoft, Oracle, and Citrix (Nasdaq: CTXS). It seems to be missing a marketing opportunity by ignoring the consumer market. With Intel releasing six-core CPUs to the desktop today, and many more to come in the future, virtualization is a natural use of the available computing power.

VMware is not "The Cloud"
There is a lot of hype surrounding cloud computing. There are huge benefits such as cost savings, flexibility, and the ability to scale when your business grows. However VMware does not target this cloud demographic. Instead it is going after "private clouds" promising cost savings through better utilization and lower maintenance. There is a problem, however. As IT administrators move all of their hardware into virtualized clouds, they are simply replacing the cost of hardware with the cost of software. However, businesses still need to buy enough hardware to handle peak load. I just don't see them shutting down servers when they are not needed to save on power costs. This is where the public cloud comes into play. Public cloud providers can sell that extra processing power when it is not needed by a client, getting closer to full-utilization nirvana, and few of the major providers are using VMware products.

Wrapping it up
With its sky-high P/E ratio and vulnerable revenue stream, VMware is bound for a correction. As IT administrators start to scrutinize the real cost of VMware and compare it with lower cost and free offerings they may have to decrease their price. Lastly, the private cloud may not be all it's cracked up to be and VMware just is not a player in the public cloud. Put them all together, and you have a stock that is overvalued.

Mike Gurtzweiler own no shares of any company mentioned. Intel and Microsoft are Motley Fool Inside Value picks. VMware is a Motley Fool Rule Breakers recommendation. Motley Fool Options has recommended buying calls on Intel. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Intel, Microsoft, and Oracle. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.