Microsoft today struggled to convince investors that its next generation of products will be worth the wait as the market instead focused on the prospect of shorter term financial targets being missed.

Shares in the world’s largest software company plunged as much as 13 per cent in trading in New York, their biggest drop for more than five years, on a badly received set of quarterly results and a disappointing outlook.

Microsoft said overnight that third-quarter net profits came in at $3 billion (£1.67 billion), 16 per cent up on last year but below Wall Street estimates.

Sales rose 13 per cent to $10.9 billion as Microsoft saw a sharp rise in demand for other software targeted at corporate users. Its home-entertainment unit was helped by higher sales of its Xbox video game player.

However, those gains were overshadowed by comments from Microsoft that suggested investment to take on a growing band of rivals – including electronics groups Sony and Apple, internet companies such as Google, and Linux software – would hurt future earnings.

For its fourth-quarter, the company predicted a profit of 30 cents a share on revenue ranging between $11.5 and $11.7 billion. On average, analysts’ current estimates put Microsoft’s fourth-quarter profit of 34 cents a share on revenue of $11.64 billion.

Looking ahead to 2007, Microsoft expects profits of between $1.36 and $1.41 a share, well short of previous analyst estimates.

"This effectively takes the wind out of the sails of investor sentiment at a time when investors were beginning to warm up to the prospects for accelerating earnings momentum," analysts at Goldman Sachs said.

The world's largest software company is preparing to release a string of fresh products including a new version of Windows, the operating system that runs 90 per cent of the world’s PCs.

Vista, the new operating system, has stoked optimism - along with the next version of Microsoft's Office software - that the company will see improved growth. However, the new products' entry into the market has been far from smooth, with Vista undergoing several embarrassing delays.

Analysts suggested that short-term pain was the price Microsoft hoped investors would endure for longer-term gains.

"Microsoft is in a transition period and it’s important for investors to note that," Todd Lowenstein, who co-manages the HighMark Value Momentum fund, told AFX

Investors had pushed Microsoft shares up 5 per cent this year on hopes for the new products. However, shares in the company, which has been criticised for being slow to spot the potential of the internet, is just 10 per cent higher than it was three years ago, trailing far behind a 60 per cent gain in the tech-heavy Nasdaq Composite Index.

Overall, the tech-rich Nasdaq Composite Index fell 10 points, or 0.4 per cent, to 2,335. The Philadelphia Semiconductor Index was marginally up, 0.6 per cent, to 523.4.

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