As

Microsoft

(MSFT) - Get Report

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.

In addition, the stock may avoid falling a full $3 because many investors believe the cash is better in their wallet and not in Microsoft's. "Some people might say, 'Well, good, that means Microsoft can't waste the money on an acquisition that might not be so good,'" said David Merkel, a senior investment analyst with Hovde Capital and columnist for

RealMoney.com

. "So it might actually make Microsoft's stock price go up a little bit." (Merkel's firm does not hold Microsoft shares.)

"Cash is worth more in my hand

than the company's hands almost always," Merkel added.

Indeed, some investors may ultimately plough the cash they receive from the special dividend right back into Microsoft stock, which could also result in the stock recapturing lost ground. "I might as well just reinvest

the dividend in Microsoft," said one Philadelphia-area fund manager who holds Microsoft shares.

The fund manager, who asked to remain anonymous, noted that a decline in the share price would reduce his Microsoft holdings as a percentage of his portfolio. So to rebalance his portfolio, he'll likely buy more Microsoft shares, he said.

The experience of other companies that have paid out significant one-time dividends also suggests that Microsoft shares will drop less than $3 after the ex-dividend and may enjoy a modest run-up heading into the ex-dividend date, noted UBS analyst Heather Bellini. Microsoft shares have been virtually flat since Oct. 1, while the

Nasdaq

has edged up 2.2%, and the Goldman Sachs Software Index has enjoyed a 7% climb.

In a review of five other companies that offered special one-time dividends in the past year, Bellini found that their stocks gained an average of 2% during the 30 days before the ex-dividend date and rose an average of 1% during the one week before that date. On the ex-dividend date, the stocks on average fell by less than the dividend amount, or 81% of the payout.

"The run could ... be due to potential arbitrage opportunities offered by the trading patterns of such stocks on the ex-date," Bellini wrote. "We would not be surprised to see a slight run-up in MSFT going into the ex-date for its one-time dividend."

After the ex-date, all the companies Bellini tracked traded down -- by an average of 2% the day after the ex-date, 5% one week after, 3% one month after and 1% three months later. The declines in all cases except one, however, were lower than the amount of the special dividend.

"While we expect MSFT to trade down on the ex-date, we believe it could fall by an amount less than $3," Bellini concluded in her note.

However, "how much the stock goes down depends how much it runs up going into the ex-dividend date," Bellini added in an interview last week. (Bellini has a buy rating on Microsoft and her firm has done banking with the company.)

So if Bellini is correct, investors should keep a close eye on the stock heading toward the Nov. 15 ex-dividend date to determine if the $3-a-share preholiday gift from Microsoft ends up being fully offset by a drop in price.