The valuation applied to Micron Technology (NASDAQ:MU) looks literally absurd. MU stock now trades at a trailing price-earnings ratio, based on its adjusted earnings per share, of just 3.7. Meanwhile, Micron’s earnings more than doubled during its fiscal 2018, which ended on August 30. Yet Micron stock has dropped 31% just since late May.

But there are reasons why Micron stock is performing the way that it is and why its valuation looks like a misprint. I’m not saying that those reasons are necessarily correct; in fact, I’ve been bullish on MU stock for some time, and I think it looks far too cheap at less than $45.

However, even bulls need to understand the bear case, particularly at a time when Micron stock is dropping. As I’ve written before, MU stock should be cheap. The question is whether bears are right to argue that Micron stock should be this cheap.

How Can MU Stock’s Valuation Be So Low?

The core reason investors sold off Micron stock after its Q4 earnings is that the company’s fiscal Q1 guidance disappointed the Street. Specifically, the company’s non-GAAP EPS was projected to be in the range of $2.87-$3.02, versus the pre-release consensus estimate of $3.06.

The sharp decline in Micron stock would appear to be an overreaction. MU stock isn’t priced for growth, obviously. Yet the company’s guidance still suggests that its EPS will increase 17%-23% year-over-year. Modestly lower-than-expected growth hardly seems like a reason to sell off a stock that is already priced so low.

But bear in mind that the company’s Q1 earnings will be boosted by some non-operating benefits. The tax rate will be lower thanks to the U.S. tax cuts. And Micron’s after-tax interest expenses will also decline by a few pennies per share, thanks to debt repayments it made during FY18. As far as the operating business goes, then, it looks like Micron’s bottom line will be roughly flat. Moreover, in 2019 both NAND prices and DRAM prices appear to be headed lower.

So, again, Micron stock should be cheap. It’s very likely that its earnings will come down for the next two years, at least. Drops in NAND and DRAM prices come pretty much straight off Micron’s margins. Higher NAND and DRAM prices sent Micron’s earnings from negative to nearly $12 per share in several years. Weaker prices will have the opposite effect.

Indeed, that’s what analysts are modeling at the moment, as they expect its EPS to drop in each of the next two fiscal years. And a business with declining earnings generally isn’t going to get more than a single-digit EPS multiple. In other words, MU stock is going to look pretty cheap.

The Case for Micron Stock

What’s interesting, however, is that analysts expect Micron’s earnings to drop, and yet they are valuing MU stock at a reasonable premium to its current price. Analysts’ average target price at the moment is $80, suggesting roughly 80% upside from current levels. Those targets may drift down after last week’s Q4 report  (a couple of bullish analysts have already lowered their fair value estimates), but even something closer to $70 still suggests Micron stock has a ton of upside.

That argument seems to be generally correct. Micron’s earnings likely are at or close to a peak. But since MU stock is trading at a price-earnings ratio of less than four, that can be true and Micron stock still can rise further. In the near-term, Micron’s earnings are facing some pressure from one-time factors, including tariffs and a chip shortage at Intel (NASDAQ:INTC). Those headwinds will fade. Micron will be able to cut its costs. It should be able to lower its capital expenditures, boosting its cash flow.

And what’s particularly helpful to the bull case here is that Micron’s management is focusing on returning capital to shareholders. For a business that is potentially in decline, that has to be a priority (as opposed to spending that capital on acquisitions in a vainglorious attempt to “increase” earnings). Micron is buying back $10 billion worth of MU stock, enough to buy about 18% of the float at current levels.

And those repurchases are coming quickly, the company noted on its Q4 conference call. Micron is spending at least $1.5 billion in Q1 on scheduled buybacks of Micron stock and has more available for “opportunistic” purchases. Those buybacks could provide some near-term support to MU stock, while also reducing the float and helping raise its EPS.

Be Careful Out There

All told, there are enough positive catalysts for Micron stock to at worst muddle through. But investors need to understand the risks, which are still larger than they might appear. Earnings projections for MU can come down sharply and quickly. Indeed, we’ve been here before. Starting in late 2012, Micron stock went from just over $5 to $35 in barely two years, but it fell below $10 within eighteen months.

I do think this time will be different. Demand for memory should be stronger, as it has diversified away from being based largely on PC sales. Competitors like Samsung and SK Hynix hopefully have learned some lessons from the last price crash. But a bull case based on “this time is different” and “this peaking business is too cheap” is by definition risky. It’s certainly riskier than buying a stock with a price-earnings ratio of four would seem to suggest.

If Micron keeps funneling cash back to its shareholders, and its profits fall but remain reasonably intact, there’s plenty of upside here. But this isn’t Intel. It isn’t Advanced Micro Devices (NASDAQ:AMD) or Nvidia (NASDAQ:NVDA) or Qualcomm (NASDAQ:QCOM). This is a tricky stock whose extremely high operating leverage, at least in part, helps explain the very low earnings multiple. Investors need to understand that fact before backing up the truck for MU stock.

As of this writing, Vince Martin has no positions in any securities mentioned.