Is Microsoft Your Path to 100% Returns?

Given the dominant position that Microsoft (Nasdaq: MSFT) has in the PC world, it's a little funny to see the software behemoth become the object of ridicule from almost all directions.

Some of the derision is definitely unfair. For instance, traders complaining that the stock has been "dead money" for the past 10 years conveniently ignore the fact that it's spent the better part of that decade adjusting its valuation down from stratospheric levels during the dot-com boom. The company's operating profit over the past 12 months is up 150% from its 2000 fiscal year.

Perhaps some of the belittling is a bit more earned. Obviously, it's too early to tell, but it looks to me as if Mr. Softy paid an awfully big price for Skype, and the purchase may reek just a bit of desperation.

But as a Motley Fool Inside Value pick, a stock that The Motley Fool owns, and, most importantly, a stock that I own, could Microsoft be a good buy right now?

Earnings expectations
As I outlined in a previous article, a good way to get a baseline for growth expectations is to check on what Wall Street analysts expect and how fast the company has grown in the past.

Source: Capital IQ, a division of Standard & Poor's. Historical growth based on operating earnings.

Considering the way many people talk about Microsoft these days, it may be surprising to see how solid its growth has been -- particularly over the past year. Of course, the concern is about Microsoft's future, not its past, and specifically the threat of having tablets and smartphones eat away at the company's market for PC operating systems. And perhaps that threat makes analysts' 12% long-term growth target a little hard to swallow.

Notably, analysts usually base their long-term growth targets on earnings per share, whereas the historical growth numbers that I've presented are based on operating profit. Over the past decade, Microsoft has reduced its share count by an average of 2.5% per year. Fewer shares means more profit gets allocated to each share, so that could provide an extra growth booster going forward.

Falling share count or not, though, I find myself a bit skeptical of Microsoft's ability to grow at a 12% rate over the next five years, so I set that as my optimistic case for the company. For my base case, I set growth at 7% per year, while my downside case calls for 3% annual growth.

And to put that downside case in perspective, since 2000, Microsoft's worst five-year stretch for operating-profit growth came in the 12 months ending in December 2003, when the company racked up an average annual growth rate of 2.6%.

Pinning down valuation
Valuations are a moving target that can be tough to predict, but, as with growth, using a range of values can give us a view of our potential returns without requiring a Miss Cleo-type prescience.

In creating our range, a good place to start is where the stock is trading right now and what its historical trading range has been. Microsoft's stock currently changes hands at roughly 10 times trailing earnings. This is a clear low point for the stock, as the range of annual average earnings multiples was 13.8 to 46.7 during the stretch between 2000 and 2010.

For broader context, we can also look at how similar companies trade.

Source: Capital IQ, a division of Standard & Poor's.

Obviously, these companies are not all the same as Microsoft, but they can give us some good perspective on how investors think about the larger ecosystem that Microsoft operates in. We can see the "PCs are in trouble" theme being underscored here, as Dell and Hewlett-Packard have been tagged with low growth expectations and earnings multiples while iPad and iPhone slinger Apple is viewed more positively (though I still think there's room for that stock to deliver very solid returns).

In general, I think many of the stocks in this group are victims of investors' current preference for small caps and therefore could warrant broadly higher earnings multiples. But I think that with analyst-estimated growth of 12%, even as things stand, there's a solid argument that Microsoft's stock deserves a higher multiple.

I set my base-case multiple at 13, and I could see investors paying as much as 17 or as little as 8 times earnings five years hence.

Dividends and share count
Our final stop is to consider how much we'll get paid through dividends and whether changes in share count will affect our bottom line.

We've already touched on share count, and my main concern -- that I'll end up with a company that dilutes my ownership stake -- is basically nonexistent with Microsoft.

As for dividends, Microsoft doesn't have a particularly long dividend history (it initiated its payout in 2003), but I'm pretty confident that with the company's impressive balance sheet and apparent commitment to returning capital to shareholders, it will not only continue paying its dividend, but also grow it.

My base case has the dividend growing at 10% per year, above the five-year 7.7% rate, but below the 12.4% three-year rate. I'm using 12% as my upside case and 8% as a downside case.

The verdict, please!
The end result is the returns we can expect under the various scenarios. Here's what my three scenarios would look like.

Source: Author's calculations.

Let's now go back to that question that we started with: Could we squeeze a 100% return out of Microsoft's stock? I think so. My mid-case average annual return of 15.4% would represent just over a 100% return, while the upside case would offer considerably more.

If you think this sounds a little crazy, you're in good company -- I think the same thing. However, the assumptions I've used are far from starry-eyed optimism. I think the market has simply given up on Microsoft's stock right now, and the next few years may prove that view to be misguided.

Of course, the future is an ever-changing picture, so you need to keep on top of what's going on at Microsoft to see which set of numbers the company and stock are able to live up to. And you can do just that by adding Microsoft to your Foolish watchlist.