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Carnevale: Microsoft Too Cheap to Ignore

Consequently, Microsoft's stock price, along with many other high-profile technology names, represented massive overvaluation. In other words, even Microsoft's exceptional earnings power prior to and subsequent to 1999 and 2000 could not justify its absurdly lofty valuation. At its peak valuation, Microsoft was trading at PE ratios exceeding 80, while earnings only justified a fair value PE of 15.

Therefore, Microsoft's stock price had nowhere to go but down until price eventually aligned with earnings, by Feb. 2008.

This was just in time for the Great Recession to sink most all stock prices to below fair value (the orange earnings justified valuation line). Moreover, I believe that earnings growth for 2012 and 2013 has been temporarily reduced due to the launch of Windows 8 (see each year's growth rate calculation at the bottom of the graph).

Currently, 35 analysts reporting to Capital IQ forecast five-year forward earnings growth of 10% per annum.

My final earnings and price correlated graph on Microsoft paints a clear picture of a fiscally fit blue-chip technology bellwether. The massive overvaluation that the company had suffered with for so long is now gone. Today I believe that Microsoft offers investors growth and an above market (with potential annual increases), dividend yield of 3.2%. Microsoft's balance sheet is strong, and cash flow generation high. But most importantly, with a blended PE ratio of only 10, Microsoft appears to be bargain priced based on fundamentals. Perhaps there's a lot of fight yet left in this dog.

Summary and Conclusions

At current levels, I believe that Microsoft offers long-term investors three proverbial kicks at the profit cat. I expect future price gains to be generated based on above-average earnings growth (10% per annum), a potential expansion in the PE ratio from its current below-market PE of 10 to a market average PE of 15, and finally the opportunity for above-average and growing dividend yield. Add it all up, and I believe Microsoft offers the prudent long-term fundamental investor above-average growth and income, plus a margin of safety based on its low valuation.

At the time of publication, Carnevale was long MSFT, although positions may change at any time.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
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