Microsoft Investors May Eat Dividend and Have Price, Too

As Microsoft(MSFT Quote) prepares to spread a little preholiday cheer next month -- the distribution on Dec. 2 of a massive $3-a-share special dividend worth $32 billion -- shareholders are debating whether the stock will drop an instant $3 to reflect the lower level of cash on the company's balance sheet.

In theory, when a company transfers part of its assets to shareholders in a dividend, its stock price declines by the amount of the dividend on the ex-dividend date (Nov. 15 in this case), as Microsoft noted in its filings with the Securities and Exchange Commission. "For shareholders, any stock price decline is offset by the cash they receive in the form of the dividend," Microsoft explained.

The trouble is, a perfectly efficient market "ain't what we got," noted Charlie Di Bona, an analyst at Sanford C. Bernstein. Instead, some investors are valuing Microsoft on a price-to-earnings ratio, or a multiple of net income. And Microsoft already lowered its outlook for earnings this year to reflect the drop in investment income resulting from shedding $32 billion -- the largest special dividend in the history of the Standard & Poor's 500 index.

Analysts have adjusted their estimates accordingly, which means Microsoft is already trading on an expectation of lower investment income, Di Bona argues. "In other words, under this valuation methodology, MSFT is effectively trading ex-dividend already, which implies that there should be no further EPS or valuation adjustment, which in turn suggests that investors would get the $3 per share of cash but would not see the theoretically appropriate offsetting $3 reduction in MSFT's share price," he wrote in a note late last month.

(Di Bona has an outperform rating on Microsoft; his firm doesn't do investment banking, but its parent, Alliance Capital, holds Microsoft shares.)

Goldman Sachs analyst Rick Sherlund, meanwhile, said investors may tend to ignore a company's excess cash when calculating a P/E ratio. "The company may therefore effectively be able to give the $3 per share away and see very little real net impact in a lower share price," he wrote in a note last month.

Sherlund noted that Microsoft's P/E ratio falls to 19.1 times his estimate for calendar year 2005 earnings when subtracting out the $3-a-share dividend. That lower P/E, he says, is an attractive discount to a median 21.7 P/E of software peers. (Sherlund has an outperform rating on Microsoft stock and his firm has done banking with Microsoft.)

Indeed, he further suggested that if the stock does drop by $3, some portion may be recaptured by investors who then view the lower P/E ratio as more attractive.