About two weeks ago, I wrote an article in which I mentioned that I had decided to hold onto my investment in Apple (NASDAQ:AAPL). My evaluation of Apple was largely positive; though looking at the comments I received, you might think I hated the company. I quickly noticed a trend in the responses to articles about Apple that did not call for immediate and significant increases in share price. I was troubled by the commenters who seemed convinced that Apple would be heading to $125, $150, or in some cases $200 per share, in a short amount of time. In this article, I hope to highlight the importance of valuation when attempting to determine future stock prices.
Just to make sure we are all on the same page, I own shares of Apple. I do not agree with those who think Apple's share price will decline. If I didn't think the share price could go up, I would have sold. I am not trying to disparage Apple; rather, I aim only to convince those who are anticipating rapid price appreciation to temper their expectations. This article will discuss basic valuation and how it applies to the price of Apple's stock. For those who are certain that Apple's share price is destined to rise quickly, please read this article in its entirety before commenting something to the effect of "$300 by July".
As I'm sure many of you know, the P/E ratio is one of the most common ways to evaluate a company. I recognize that the P/E ratio is not the end all be all of valuation, but this article will focus on Apple's valuation using the P/E ratio. As a reminder, the P/E ratio shows how much investors are willing to pay for every dollar of earnings. Currently, shares of Apple are worth $90.83 and the company has generated $5.98 in earnings per share over the past twelve months. Using these numbers, Apple's P/E is 15.19. Looking at the graph below, Apple's P/E has not been much higher than 17.50 in the past three years.
When using a P/E ratio, share price is the product of earnings per share and the earnings multiple. Therefore, increases in the share price are caused either by multiple expansion or an increase in earnings. For those who do not know, multiple expansion occurs when investors are willing to pay more for the earnings of a company. If a company trading at 10x earnings suddenly found itself trading at 15x earnings, the share price would increase by 50% if earnings remained unchanged. At current levels, I think Apple has room for multiple expansion. However, I believe it's important to make conservative estimates when looking into the future. Consequently, I would not assume that Apple will trade at more than 17.5x earnings. I recognize that the S&P 500 (NYSEARCA:SPY) currently has a P/E of around 19.5 and I don't mean to imply that it is impossible for Apple to be valued at more than 17.5x earnings. Rather, I am merely unwilling to anticipate a valuation that is higher than anything that Apple has seen in recent years.
Earnings growth also has an impact on share price. In order for the earnings multiple to remain constant, as earnings increase, share price has to increase. Apple has been posting solid growth and the company is expected to grow at 15% over the next five years. For fiscal 2014, which ends in September, Apple is expected to generate EPS of $6.31. For fiscal 2015, analysts expect Apple will generate $6.88 in EPS. Growth is good, but not all growth is created equal. In many cases, investors prefer growth that is driven by increased revenue or margin improvements rather than buybacks. As shown in the graph below, Apple has repurchased a sizable portion of its shares over the past year and a half. This explains why Apple's recent financial statements show EPS growing at a faster rate than net income. The company plans to repurchase an additional $90 Billion worth of shares by the end of 2015, so the repurchases show no sign of stopping.
Separating the Realistic From the Ridiculous
In the beginning of this article, I mentioned that a number of investors seem to think that Apple is headed towards $125, $150, or $200 per share. Using analyst EPS estimates for fiscal 2015, it becomes apparent that these price targets aren't particularly attainable even more than one year in the future. To be priced at $125 per share, Apple would need to trade around 18.2x 2015 earnings. Previously, I mentioned that in the interest of conservatism I will not assume that Apple will be valued at more than 17.5x earnings. However, there is always the chance that the company beats analyst expectations. Even assuming a slight earnings beat, Apple would need an incredibly lofty valuation in order to trade at $150 or $200 a share. Under what I consider an incredibly optimistic scenario, it seems Apple will still struggle to reach these price targets. Even if the company trades at the highest multiple it has seen in the past few years and it beats analyst expectations, only one of these estimates seems attainable. Since I own Apple, I hope I am wrong, but these price targets do not seem realistic to me over the short term.
Apple is a quality company that is expected to grow its earnings nicely over the next few years. However, I would argue that many of my fellow Apple owners are asking for too much with their expectations for share price. Apple is the largest company in the world and it has already seen significant price increases over the past year. At some point, investors need to stop and think about how much more the share price can increase. If Apple's share price increases 10% over the next year, I will be satisfied. However, to those who bought Apple thinking they would quickly double their money, relatively moderate gains would probably register as a disappointment. I believe in Apple, but I think that some are expecting too much, too quickly.
Disclosure: The author is long AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.