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Tickers in this Article: MSFT, YHOO, GOOG, RHT, SAP, ORCL, TWX
Yahoo (Nasdaq:YHOO) is scrambling to avoid being swallowed by Microsoft's(Nasdaq:MSFT) software empire. The Wall Street Journal reports that Yahoo and Time Warner (NYSE:TWX) subsidiary AOL are edging towards a deal aimed at spoiling Microsoft's takeover plans.

Of course, Microsoft has a lot to gain from a buyout of Yahoo, but Microsoft investors shouldn't be overly dismayed if Yahoo escapes its clutches. Even without the internet company, Microsoft's stock is still strong. By my reckoning, Microsoft, sans Yahoo is still substantially undervalued.

Less Than The Sum Of Its Parts
Microsoft provides plenty of disclosure and guidance on its various software business realms, so let's consider the value of the sum of its parts. Start with Microsoft's client business, which concentrates on the Windows operating system. Of course, this would continue as a quasi-monopoly that pumps out loads of cash. Assuming sales growth of 13% in 2008, operating systems will produce about $16.9 billion in sales and operating profits of about $13 billion. Valued like a regulated monopoly, with an operating multiple of say 14, this group is worth $183 billion.

For convenience, we can lump together Microsoft's Office software unit with its enterprise server and tools business. Together they represent another cash cow. Assuming 17% growth this year, it will bring in about $40 billion in sales and operating profits of about $8.9 billion. Valued on the same conservative utility multiple, it's worth $124.6 billion. Give it a valuation multiple along the lines of software peers like Oracle (Nasdaq:ORCL), SAP (NYSE:SAP) or Red Hat (NYSE:RHT) and you get a higher number.

The online business holds Microsoft's email and instant messaging services, plus its internet offerings such as Live Search and the MSN portals and channels. While this group has yet to show signs of profitability, it ought to deliver more than $3.4 billion in revenue in 2008. Of course, it won't fetch Google's (Nasdaq:GOOG) 9-times sales multiple, or even Yahoo's multiple of 7. But even valued at just 4 times sales, the online business is worth nearly $13.6 billion. Throwing Yahoo into the mix yields a much bigger online business and valuation.

The final group holds Microsoft's new-fangled entertainment and device businesses, including the Xbox video games. Growing at 32% this year, sales could swell to $7.7 billion. Operating profits should top $900 million, easily justifying a multiple of 20-times and price tag of $18 billion.

The total value of the sum-of-the-parts, not including Microsoft's $23 billion cash pile, amounts to $339 billion in market value more than 23% higher than the stock's price today. (For a crash course on these calculations, check out Use Breakup Value To Find Undervalued Companies.)

Bottom Line
A market value of $339 billion, or $35.67 per share, represents a multiple of 16.5 times 2009 earnings. Considering that Microsoft is expected to lift its bottom line EPS to $1.87 from $1.43 this year, and to $2.11 in 2009, it's fair to say the stock is trading at a sizable discount.

Investors shouldn't be shaken by the uncertainty surrounding Microsoft's pursuit of Yahoo The outcome doesn't change the fact that the software titan has a low valuation on its side. That alone should be enough to get investors to take notice.

To learn more, check out Conglomerates: Cash Cows Or Corporate Chaos?

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