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The first rule of smart investing is know what everything means.

There is a single fact that I believe not all private investors know. It relates to price/earnings (P/E). In every analysis of a share that lands in my inbox, it usually has some hacked up explanation of a stock's over or under valuation based on its P/E value. Just today, I received a Seeking Alpha notification containing this:

If you are not buying Apple, the largest, most profitable, best business model company in the world, then you shouldn't buy any stock because none have Apple's growth rate and ecosystem or profit potential as well as absurdly low P/E.

An 11.5 times P/E is absurdly low? It is quotes like this that lead me to believe that half of stock analysts have no idea how to use P/E. P/E is a tool. It is not a general indicator for direct comparison, but rather an indicator to interpret inside of its complete context. Just for clarification, I find it best to think of P/E as follows:

The P/E multiple is the number of years to pay back the investment in a company if its earnings remain stable.

What does this mean and where does it come from?

In private business, if I go out to acquire a company, the rule of thumb for what I will pay for said company is three to five times earnings. This means that my investment will be repaid over a three- to five-year term if earnings remain the same. Manipulation of P/E ratios for acquisitions corrects for contextual information -- mitigate for risk (decrease P/E), assets (increase or decrease), research and development (probably increase), industry outlook, etc.

Typically, a stable public company will trade for a slightly higher P/E multiple (usually around 10 times), but it really should not. As a company matures and stabilizes into its market, typically you will notice the P/E fall dramatically as the expectation for considerable gains decreases.

Since Apple (NASDAQ:AAPL) is one of the most controversial stocks right now and one of my personal favorites, I'll use it as an example.

Apple on Dec. 31, 2007

Apple was trading for around $190/share. EPS was around $4.25 with a P/E of about 45. The P/E indicated that investors had the confidence in future gains to value the company at 41 times EPS more than a "typical" investment that I will ballpark around 4.5 times EPS. Forty-one times EPS is a significant risk to incur for the hope of significant future rewards.

Apple's current EPS is around $44.20.

$44.20 x 4.5 P/E = approximately $199.

This means that at a standard acquisition P/E (4.5 times), Apple is only now justifying its share price from Dec. 31, 2007. I should not have to explain the almost unbelievable growth that Apple has undertaken to achieve its current EPS in five years, but it makes you wonder what its EPS would need to be to justify today's evaluation.

Apple on Dec. 27, 2012

  • Price: $513.00
  • EPS: 44.16
  • P/E: 11.62

Remember: price / 4.5 = future EPS for a "typical" acquisition.

$513 / 4.5 = $114

Apple has to reach an EPS of approximately $114 to justify its current price at a 4.5 times P/E -- a typical acquisition ratio.

This raises the question: Does Apple have what it takes to achieve a 260% increase in its EPS? Its business is facing a serious problem: Apple has been so successful that it is hard to imagine how they can keep exponentially growing. The iPod exists, the iPad exists, the iPhone exists, the Mac user base exists, the retail stores are wildly successful, the mobile division is seeing an increase in serious competition for the first time, the App Store is facing serious competition for the first time, it is in petty fights with Google (NASDAQ:GOOG), patent wars with what feels like everyone, competition has become so serious that it is being forced to crunch margin, and Steve Jobs is no longer.

That long-winded sentence is my way of justifying the following statement: Apple is no longer a growing concern, but rather a concern that it will not grow.

The smart money is walking on Apple right now because there has been no indication of Apple's standard wizardry to continue its trademark upward swing. Maintaining the status quo will only certainly be a negative ROI for new investors. Do yourself a favor this holiday season and put your money in company that can justify its P/E valuation with a hope and a dream like the one Apple once had.

I am sure many of you are thinking I'm crazy (have you seen its balance sheet?), so just in case you doubt me, I called this crash in Apple's share value in July.

Source: The First Rule Of Smart Investing