- Decomposing the earnings multiple offers insight into how investors value growth.
- The ongoing Capital Return Program at Apple is restricting the earnings multiple from expanding.
- Growth in Operating Income, Reinvestment Rate, and Free Cash Flow should drive multiple expansion.
Investment pundits have increasingly argued over the low valuation multiples for Apple (NASDAQ:AAPL). These experts argue that Apple should trade at multiples relative to the similar technology firms, such as Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), and Intel (NASDAQ:INTC). In my opinion, this valuation gap has developed because Apple holds too much cash and growth prospects are lower than what they used to be. Examining the correlations between the existing P/E and the growth forecasts inferred from the market prices reinforces this opinion.
Apple's earnings per share grew from $1.56 in 2005 to $40.24 (trailing twelve months), while Google's earnings per share grew from $5.02 to $38.13 at the end of 2013 - its P/E has compressed from 83x to existing levels of 33x. The chart below illustrates succinctly the phenomenon of "P/E contraction" for Apple and Google, where P/E dropped as earnings per share grew.
(Source : Company 10-K)
Decomposing market level P/E ratio into a no-growth component and a growth component (present value of growth opportunities) yields the market's expectation of growth in the future. The chart below depicts the earnings multiple for existing and growth assets for Apple and Google. The reason I view valuation with this perspective is it offers insight into how investors value the growth opportunities for the company. The no-growth component for both the companies stayed remarkably constant, whereas the growth component contributed to the most variance in the total P/E for both companies. Higher volatility associated with the growth component implies the risk associated with growth in future.
Decomposed Multiple Key: Dark Blue: Apple's Existing Asset, Red: Growth Asset, Yellow: Google's Growth Asset, Light Blue: Google's Existing Asset (Chart created using Market Cap data and 10-K)
The chart below highlights the decline in the growth expectations for Apple and Google since 2005. A rise in the expected growth rate for Apple during FY 2007 and 2010 followed the rapid revenue growth Apple enjoyed with the launch of iPhone and iPad, which currently account for 70 percent of the company's total revenues.
My simplistic attempt to understand the catalysts for multiple expansion was to analyze the correlation between the price/earnings multiple, return on equity, reinvestment rate, and expected growth in operating income.
Based on this correlation matrix, here are the conclusions I would draw:
- Artificially raising the return on equity either through share buybacks or by modifying capital structure negatively affects the earnings multiple for Apple.
In 2004, Apple had shareholders' equity of $5.07 billion. At the end of 2013, shareholders' equity had grown to $123.5 billion. During the same time, earnings grew $36.7 billion, from $276 million to $37 billion. By dividing the additional earnings of $36.7 billion by the additional $123.5 billion in capital, we can see that Apple earned a return of 31 percent on its investment. During the same time, Google's earnings grew $12.5 billion, and its shareholders' equity had grown by $84.4 billion, earning a return of 15 percent on its investment.
Last April, Apple announced an increase in the capital return program, expanding its share purchase authorization from $10 billion to $60 billion. In total, Apple has bought back more than $42 billion of its own shares over the past two years, retiring nearly 9 percent of the total shares outstanding since it launched its repurchase program. Massive share buybacks can boost the earnings per share higher, but it doesn't signify an increase in the underlying performance or value of the business. Essentially, the company's operation did not change, its return on operating capital stayed the same after the buybacks. In effect, buyback de-consolidates the company into two distinct entities: one with the operations, and second with the excess cash. Once the excess cash is paid out to shareholders, its P/E will converge to match with the operating business. Share price increases from a buyback, in theory, result purely from the tax benefits of new capital structure rather than any underlying operational improvement.
On the other hand, declining return on equity coupled with the declining reinvestment rate for Google raises concerns about its ability to generate sustainable earnings growth. Rapid growth in goodwill and intangible assets over the last several years explains shareholders' equity rising faster than the net income. Wide distribution of future growth expectations in Google indicates that the company will have a more volatile ROE in the future. Although the market expects Google to have higher growth, the outcome can be unpleasant.
2. Expectations of higher growth in operating income is the most important driver for multiple expansion.
Noticeable from the matrix is the correlation between the market P/E, its components, and the expected growth rate. When expectations for growth accelerate, investors "pay up" for higher future cash flows and earnings multiple expands. Too often, investors are myopically focused on the earnings per share rather than the operating income of a company. Over shorter periods, changes in earnings per share can have a substantial impact on equity returns, but over a longer term, sales growth and the capability to generate strong cash flows from operations account for a majority of total return.
3. Reinvestment Rate
Ultimately a business's growth is determined by how much it reinvests into the future, and the quality of these re-investments. Apple has reinvested approximately $21 billion into the business since 2004 to drive growth. The strong correlation between P/E and the reinvestment rate should not come as a surprise to investors, as Apple has successfully demonstrated the quality of returns it generates on its investments.
Apple has demonstrated successfully its capability to innovate and create market-disrupting technologies, but the vacuum created by the lack of new products is causing a disconnect between the reason and the rationality. So far, the market is correct in restricting Apple's earnings multiple from expanding. As the company's operational capability and its stock performance diverge, it is presenting investors with an opportunity to add to their portfolio a stock which offers future growth as a pure bonus.
Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long AAPL through options.