When companies engage in share repurchase activities that change the number of outstanding shares in a meaningful way, it can cause common measures of value to become less than fully representative of actual results. In such situations, the manner in which the financial community calculates trailing twelve month (TTM) earnings per share (EPS) and the resultant price to earnings (PE) multiple, yields metrics that are less favorable than they should be.
With large buybacks, the community's simplistic calculation methodology results in a TTM EPS and resultant PE that is meaningfully different from reality. Similarly, historical prices measure a different level of market capitalization in these repurchase scenarios and this simple math is typically overlooked. Currently, Apple (NASDAQ:AAPL) illustrates both points.
Apple is in the midst of conducting the largest dollar volume stock repurchase in history. Apple's share count (after adjusting for its June 2014 7-for-1 stock split) has been declining since September of 2012. In the twelve months preceding its most recent quarterly report, Apple's after tax earnings totaled $39.15B. If we divide those earnings by the average diluted number of shares reported as outstanding in the July 2014 report or 6.05B shares, we arrive at a TTM EPS of $6.48. Seems straightforward right? However, no financial website or market analysts that I can find reports the TTM earnings for Apple as $6.48 per share. The vast majority report it as $6.19 which is the commonly accepted number for Apple's TTM EPS as of this writing.
The discrepancy is in the math. The commonly accepted number simply adds the reported EPS for the latest four quarters. This method does not account for the decrease in share count between the earliest quarter of the period and the current quarter. Certainly the reasonable investor would want an up-to-date representation that divides the trailing twelve months earnings by the current outstanding share balance.
In this up-to-date world, Apple would have a TTM EPS of $6.48 per share. The PE ratio of the stock trading at $95 per share today would not be 15.35 as is commonly reported, but rather 14.67. For small repurchase programs, the discrepancy is typically insignificant. For the largest share repurchase in history, it may be meaningful. Would the opinion of valuation experts change if they recognized that Apple's actual PE is below 15 as it gets nearer to a massive rollout of new products from what its' SVP Eddie Cue recently called Apple's best product pipeline in the last 25 years?
A similar error occurs when chartists and technical analysts look at the historical prices for Apple stock. They have no issue adjusting for the 7-for-1 stock split, because clearly the market capitalization did not change due to the split. It is also easy to divide the historical prices by 7 and recreate the charts. Nevertheless, most technical analysts make no similar adjustment for the declining share balance. Intellectual honesty should drive us to account for both the split and the declining share balance. After all, many technicians point to the historical highs as magical numbers around which sophisticated theories can predict market reactions.
Consider the all-time intra-day high AAPL reached on September 21, 2012 of $705.07. Using the July 2012 report for diluted shares outstanding of 947.095M, the company's market cap at this all-time high was $667.77B. Due to the dramatic decline in outstanding shares and the stock split, reaching that same market capitalization today, would require a share price of $110.35, not the $100.72 ($705.07÷7) that is commonly used as the comparative figure.
Again, common financial metrics are simply not built with the assumption that the number of shares outstanding can change. They are not up to date. Nevertheless, should Apple's stock price approach $100 per share again, CNBC, Bloomberg, and the financial news will be littered with people talking about Apple eclipsing the all time high. Just remember, the company's valuation would actually need to rise 10% more to reach that milestone.
What can the investor conclude from a deeper understanding of the math and the simple fact that the declining share balance is not accurately represented in these common figures of Apple's valuation or its all-time high selling price? At the least, you can conclude that Apple is a stronger valuation play than most believe. At the most, if you believe in the company's future, you may conclude that Apple is a screaming buy. The actions of the company's board of directors support the latter assessment. The company still has $39 Billion allocated to the repurchase program between June 30 of this year and the end of calendar 2015. My guess is that the company is a large purchaser of its own stock this quarter. Should you be too?
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.