Are Apple Shares Overvalued or Undervalued?

| About: Apple Inc. (AAPL)

By Drew Nicholas

There has been a lot of hype around Apple, Inc. (NASDAQ:AAPL) since it recently passed Microsoft (NASDAQ:MSFT) as the world’s largest tech company. In this article we will find out what all the hype is about, who is listening, and if it is reasonable.

Over the past few years we have seen revolutionizing technologies come out of Apple such as the Ipod, Iphone and Ipad. Together, these products have transformed the company into a tech giant. They have also left the internet abuzz with popular reviews and rumors of the release of the newest gadgets. The fact is that each new release is highly anticipated and no matter if consumers just bought the newest model there is an always present demand for newer gadgets. With this in mind here are a few new releases and rumored near-future releases for Apple.

The Ipad 2 has just been released. An improvement on the first of its kind and wildly popular Ipad, the Ipad 2 is equipped with front and rear cameras, improved cellular radio, and a slimmer, lighter body. Its release has been met with a continued demand for the market-defining devices. However great the Ipad 2 has been received, the major hype has been around the “Ipad 3,” the next generation of the Ipad, scheduled to come out within the year.

Another gadget with improved generations expected soon is the Iphone. The release of the Iphone 4 was hugely popular - once the antenna issue was fixed. Even still this issue shows the relationship between the stock price and the successful launch of the new gadgets. For this reason, a successful release in 2011, of the “Iphone 5,” promises to bring a renewed jump in the stock price. Another testament to the vibrancy of the technology market is that while the “Iphone 5” has still not been released, the “Iphone 6” is creating huge buzz around the internet as well with a release date rumored sometime within 16 months.

The lesson to take away from this is there are seemingly endless improvements being made to Apple’s market defining gadgets, and with each improvement there is a loyal demand for the newest and best version. Though there have been common problems with some releases, most notably a supply chain lacking the capacity to meet the demand, we can assume Apple is working to improve these inefficiencies. This means that the stock price will rise with each new release, and there are plenty more releases coming in the near future.

Now that we have heard the hype around Apple, who else is listening? The top institutional holders of AAPL are basically a who’s-who of the investing world: J.P. Morgan Chase, BlackRock, Fidelity Investments, and T. Rowe Price. However Fidelity stands above the rest as the largest holder of AAPL with its Fidelity Contrafund (FCNTX). With a 20% return on investment this last year and a 12.5% return over its lifetime, this Contrafund is geared toward large growth, and Apple stock makes up the largest of its holdings. Because of the rapid growth of technology stocks over the past few years, the industry is attractive for Fidelity, with Apple its largest holding and Google (NASDAQ:GOOG) a close second. These tech stocks show qualities of growth that coincide with the goals of Fidelity.

The second largest holder of Apple shares is PowerShares (NASDAQ:QQQ). The name is different but the motives are very much the same. QQQ is geared toward large growth and once again saw a return of 20% last year. A look at its holdings reveals even more similarities. For example AAPL makes up its largest investment at about 12% with Microsoft in second and Google close behind in fourth. In total, nine out of the top ten holdings of QQQ are tech companies.

Technology stocks seem to be attracting funds geared toward large growth. In particular, the most valuable stock company, Apple, fits these aggressive funds well as it exhibits rapid growth potential.

We now know who is paying attention to the buzz around Apple, but what is this company actually worth? One of the best indicators is the P/E ratio; Apple’s historical average ratio is higher than its current ratio of 16.51, which suggests that the stock price is undervalued at this point in time. It is also helpful to compare this ratio to others in the industry. A P/E ratio of 16.51 is in the 61st percentile of the technology sector. This means that, compared with its peers, Apple is slightly overvalued; though this overvaluation is minor at best.

While comparing Apple’s P/E ratio leaves us with the conclusion that its stock is undervalued, another important metric brings this result into question. If we compare the free cash flow to the enterprise value, we see that perhaps AAPL is overvalued. The enterprise value of Apple has been on a steady incline for the past two years, showing no signs of slowing down. Its free cash flow on the other hand has remained relatively constant in comparison. The result is an ever growing EV/FCF metric, which signals an over valuation - and which I consider more valid because it measures cash flow instead of net income (which can fluctuate with the use of different accounting measures).

In all, Apple is an innovator with a loyal demand for its products. It represents the epitome of a rapidly growing tech stock and an opportunity for large growth. My reservation about Apple is that with the supply shortages and the fact that its EV/FCF metric is increasing rapidly, investors have over predicted the capacity for growth in the short run.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.