This will be one of the most important articles I'll ever write on Apple's (NASDAQ:AAPL) valuation, and it's the one piece that every individual investor should read. There seems to be a tremendous amount of confusion among market participants as to which valuation metrics actually matter in assessing the present and future value of stock prices in general and Apple's in particular. I hope this article will help correct a lot of these very critical mistakes that many individual investors tend to make when attempting to forecast Apple's future value. This applies to nearly all tech stocks.
I'll come right out from the get-go and say that the vast majority of mistakes made by investors stems largely from their unwavering stubbornness to use non-ubiquitous valuation metrics in order to justify some theoretical or abstract future value that the broader market simply does not accept.
I have repeatedly stated that the only valuation metric that matters is the one the collection of fund managers care about. Everything else in between is not only counter-productive, but designed to trap investors into an investment thesis based on a theoretical and flawed future value that simply does not exist.
The two biggest theoretical valuation models that have the highest likelihood to mislead investors are the Price-to-Earnings Ratio x-Cash (P/E x-cash) and the Price-to-Free-Cash-Flow (P/FCF). I'm not saying that these two valuation ratios are inherently evil or bad valuation ratios, but what I am saying is that these two are by far the most highly misused metrics. Apple's cash and cash flow play a very significant role in its valuation, just not in the way that 95% of individual investors think that it does.
Forgetting Preconceived Notions of Valuation
In his Discourse on the Method, French Philosopher Rene Descartes reduces all of his preconceived notions of reality to one principle certainty -- "in trying to deny my own existence, I exist" -- and then rebuilds his knowledge upon that which he knows to be certain.
I think it's important for us as investors to forget everything we know about valuation to get at the heart of how the market actually functions. It seems investors have gotten too carried away with this highly contagious idea that valuation is some sort of a force field that somehow prevents stocks from falling below a certain price level or as a source of impetus that somehow pushes stocks beyond a particular threshold. Investors have become so enthralled by this idea that they have overlooked the inner-workings of the market's pricing model.
I remember reading an article a year ago where the author said "it's impossible for Apple to fall below some price x, because its P/E ratio would be too low."
Impossible? What happens if we have another significant financial crisis much worse than the one in late 2008, and funds must raise capital to meet redemption requests? Do funds care if Apple is trading at an 8 P/E when they have major American institutions demanding the return of their capital? When financial institutions start failing and need to raise capital reserves to maintain their credit rating, do they care that Apple is trading at an 8 P/E?
1. Market Price is nothing More than the Function of Supply & Demand
While these hypotheticals might seem silly, they do help demonstrate a very important lesson about the realities of the financial markets. A reality that is blind to the vicissitudes of valuation. And that is the fact that all stocks regardless of their fundamentals are bound to a market price as determined by the laws of supply and demand.
It's simple. There are more buyers than sellers in shares of Amazon and Netflix above a 50 P/E ratio, while there are more sellers than buyers in shares of Apple above a 17 P/E ratio. Is it crazy from a comparative fundamental standpoint? Absolutely. Does it change anything about the reality of Apple, Netflix and Amazon's market price? Absolutely not. Amazon and Netflix continue to trade at lofty valuations and have done so for a very long time.
Even in the midst of the financial crisis, Amazon traded at a 39 P/E ratio and 20.66 times its cash value. Apple, on the other hand, traded at a mere 13.97 P/E ratio and only 3.79 times its cash value. This, in spite of the fact that Apple was growing its EPS, grew its EPS and continues to grow its EPS at a far greater rate than Amazon (see here) or Netflix.
Apple was radically more undervalued than every other large cap tech stock during the lows of the financial crisis. Yet, the stock still continuously traded at very depressed valuations between October 2008 and March 2009. Why?
Because market price is, once again, the function of nothing more and nothing less than supply and demand. The fact that Apple was trading at a 9 P/E made not one bit of difference as to the supply-demand imbalance leading to its depressed stock price. Supply-demand is in not beholden to valuation.
I cannot stress how important it is for investors to understand this concept. It is the most fundamental principle, the first axiom, the 1+1=2 foundation underlying the financial markets. Apple is not "given" a stock price based on its valuation. It trades at a stock price based on whether on balance, there are more buyers than sellers of the stock at a particular price point. Are more people convinced to buy the stock here at $343 a share or are there more sellers at this price level? The why, the reason, the logical argument doesn't matter at present value.
Obviously, we all anthropomorphize the market and speak in terms of the market as an artificially intelligent entity giving stocks a price based on logical reasons. But this is merely a fiction created for the convenience of analysis and communication. A convenience that is not without its flaws. Especially when investors tend to forget what the stock market is, and what exactly determines the current price and future value of any stock.
Let's get one thing straight. As long as there continues to be more sellers than buyers here at $340 a share, the stock will continue to trade at this level into perpetuity. Apple can report $40 in earnings, and be trading at a 8 P/E ratio, but if no one is convinced in the cheap valuation story, the stock is not going to just simply magically force itself higher because logical reasoning dictates that it should.
Look at Research in Motion (RIMM) for instance. The stock continues to grow at an enormous rate despite underperforming in the smartphone sector. Yet the stock trades at only 6 times last year's earnings. From a purely profit standpoint, that is total insanity. But it doesn't change a solitary thing because no one believes in the story anymore, no one wants to touch it with a 10-foot pole and no one seems to care that it's severely undervalued. The stock will very likely be either bought out or taken private.
The company is still very profitable playing in a sector that is growing dramatically. While RIM's piece of the pie might be steadily shrinking, the size of the whole pie is growing dramatically.
RIM's story should be a blatant warning to investors who invest believing the market's irrationality has its limits. It certainly does not. The bases upon which market participants make investment decisions is probably the most irrational of any field on the planet. RIM should not be trading anywhere close to a 10 P/E ratio. Yet, despite this obvious conclusion, it trades at half of that value nonetheless.
2. The Traditional Trailing P/E Ratio: The Only Valuation Metric that Matters
The current market price of any stock is largely the function of supply and demand and is the key principle underlying the nature of 'valuation.' Valuation is a relative term comparing the current state of supply and demand with the future state of supply and demand.
When we say things like, Apple is currently trading at a discounted, cheap or depressed valuation, what we are essentially concluding is that the current market price as determined by the current state of supply-demand parity is underpricing shares of the company based on some higher projected future value.
When making the claim that Apple is undervalued, we are in essence making a prediction as to the future state of supply and demand. And this is precisely where individual retail investors really screw things up. They either create or rely upon valuation metrics that the market simply ignores or does not care about.
The only valuation metric that matters is what the market finds to be important. It's the market as a whole that determines the future value of Apple's or any other company's stock price. Thus, what the analyst really needs to look for here is what the market finds to be the important factors in determining whether Apple is a sound investment based on its current market price.
Obviously, the market doesn't think that Research in Motion's revenue, earnings or earnings growth or the fact that it's getting very close to cash value to be of any importance. In fact, it appears the only issue the market cares about with regards to Research in Motion is how the company is performing relatively to other names in the smartphone sector. The market does not value individual company growth. So, as much as Research in Motion investors might get carried away with the term "undervalued," the market doesn't view it that way.
If not enough market participants focus on Apple's P/FCF or depend on Apple's P/E x-cash when making value judgments, then those two metrics are entirely irrelevant from the perspective of judging and/or making predictions as to the future state of supply and demand. If the majority of the market cares about revenue growth, then revenue growth is the key valuation metric.
If the market cares about EPS growth, then that's the key factor. If the market on balance cares about stable gross margins, then that is the basis upon which we make such judgments as to future demand. If, alternatively, the market cares about whether Apple changes its name from Apple Inc. back to Apple Computer, then that is the basis of predicting future value.
As it happens, there is one universally relied upon metric of valuation toward which the market as a whole has tended to gravitate. And that is and always has been the traditional trailing P/E ratio. When push comes to shove, the basis upon which the vast majority of funds make their investment decisions has centered around the focal point of determining whether Apple's trailing P/E ratio is too high or too low.
If a fund thinks that the market is valuing Apple too cheaply as expressed in its trailing P/E ratio, that fund might take an investment under the expectation that Apple's P/E ratio will inflate in the future as a result of future expected demand. If a fund manager thinks that Apple will likely experience future P/E compression, he/she might sell the stock on the expectation of a future supply overhead.
It's the reason why Yahoo! Finance, Google finance, CNBC, Bloomberg, the Wall Street Journal, Seeking Alpha and other financial publications display every stock's trailing and forward P/E ratio. You don't see these sites displaying P/FCF or Apple's P/E x-cash.
3. Forecasting Price Targets Depends on Two Key Variables
Forecasting price targets for Apple requires an ability to predict two entirely separate variables that fall within two entirely different disciplines -- (1) Apple's earnings per share at some point x in the future and (2) Apple's trailing P/E ratio at that same point in time.
The first variable -- predicting future EPS -- falls under the discipline of accounting, financial statement analysis, thought clarity and intuition. It is both an art and a science to be able to predict what Apple or any company will earn in the future and there aren't many people who have been able to do so with any level of consistency. Being able to predict the earnings outlook, however, is only one part of the equation.
The other even more important variable is being able to determine what Apple's trailing P/E ratio will be at some point 'x' in the future. One can miss their EPS forecast by $1.00 or even $2.00 ($0.50 a quarter which is a big miss) and that would have a significantly lower impact on forecasted future value than failing to accurately predict Apple's P/E ratio by a factor of even 1. There's a huge difference between Apple trading at a 14 P/E ratio at the end of fiscal 2012 and Apple trading at a 15 P/E ratio at that time.
4. Predicting Future P/E Ratios
Thus, the question remains, how does one predict what Apple's trailing P/E ratio will be at some point 'x' in the future? What are the factors involved in making such a prediction? Well, there are a multitude of factors that go into making future P/E projections.
Some of those factors include (among countless others): (1) understanding how Apple's cash and cash per share impacts the trailing P/E ratio, (2) where the macro-economic environment is headed, (3) sector rotation, (4) supply-demand seasonality, (5) sector seasonality, (6) P/E contraction analysis, (7) market liquidity and (8) how widely owned Apple's stock happens to be.
I will be spending a considerable amount of analysis on projecting Apple's P/E ratio. I will also be providing an in-depth analysis on how to best capitalize on the obvious direction of Apple's stock price so as to maximize profits while reducing risk exposure to a negligible rate. Putting on spreads at the right times can lead to an eventual zero-sum risk exposure by reducing cost basis down to zero.
Hopefully, this article will help correct some of the most common valuation errors I see on a day-to-day basis. The biggest problem seems to be how investors deal with Apple's cash. Some investors believe that it is inappropriate to value Apple based on its P/E ratio due to its enormous cash and cash generating abilities. Yet, whether something is theoretically inappropriate is irrelevant to how the market values Apple.
During the financial crisis, Apple was required to defer and record its iPhone revenue over a 24-month period under what was then known as the subscription method of accounting. Under GAAP accounting measures, Apple didn't report nearly 60% of its revenue and earnings every quarter.
Yet, despite the fact that Apple's pro forma or adjusted earnings were 40-60% higher than what it reported under GAAP measures, Apple still traded at the same P/E ratio as many of its peers. One would think that Apple would have traded at a significant premium to other stocks in the sector given the fact that it was generating 40-60% -- in some occasions 70% -- higher income than what was being reported. Wrong.
The stock still traded at the same and even lower GAAP-based P/E ratio as many of its peers. In fact, in an article I published October 30, 2008, I noted that Apple was radically more undervalued than others in the tech sector. You can read the article here. In this article, I demonstrate how Apple was by far the most undervalued large cap tech stock when considering its non-GAAP adjusted earnings.
Yet, that made very little difference as to how the stock traded as Wall Street paid very little attention to Apple's non-GAAP earnings. I updated the tables in that article in January 2009 just to show how undervalued Apple became during the financial crisis. See the chart below:
By the time the market had bottomed in March 2009, Apple was trading at only 2.5 times its total cash on hand but was growing at 80-100% a year. In the financial crisis quarter itself -- October, November, December -- Apple grew its YoY EPS at 155% on an adjusted basis.
Interestingly enough, Apple is currently trading at a lower P/E ratio than anytime it did during the financial crisis based on GAAP-accounting. As you can see in the table above, under GAAP accounting measures, Apple's TTM-EPS was $5.36, and it was trading at a 16.9 P/E ratio in January 2009. Last week the stock was trading in the mid-15's. It has been trading between 15 and 16 all quarter long. Even on an adjusted basis, Apple's current P/E ratio is starting to get very close to the financial crisis lows. See the chart below which shows Apple's P/E based on non-GAAP measures during the financial crisis.
Apple's stock has been severely underpriced on a relatively basis since 2007 and continues to experience significant P/E contraction despite growing its earnings at 100% a year. The stock went from reporting a quarter of Microsoft's (NASDAQ:MSFT) revenue in 2008 to far surpassing -- nearly doubling -- Microsoft's revenue today.
Yet, it can't seem to get a decent valuation. The stock continues to trade at the lowest price-to-cash value than any other value or growth stock on the S&P 500 -- at the end of fiscal Q3, Apple will be trading at only 4.5 times its total net cash (and liquid assets) on hand.
So Apple is undervalued. It's undervalued and it's underpriced on a relatively basis. Investors have been paying significantly higher premiums to own other stocks than they have to own Apple. Investors would rather own Amazon -- a stock that has a much slower growth rate, reports less in revenue, less in income, less in EPS, has less cash on hand and trades at a bubble-type premium -- than Apple which grows at a 100% a year and will have more cash than its entire $300 billion market cap within four and a half years.
There's a very obvious reason the market is acting this irrational. A reason very rarely brought to light by anyone in the financial public or in the financial press. I'll be explaining in great detail why the market "appears" to hate Apple. It seems very irrational that market participants would pay over 5 times the premium to buy Amazon -- a stock that consistently misses on its earnings and has yet to eclipse Apple's earnings growth -- than to buy Apple. But there's a reason behind this which sheds incredible light on where Apple is headed in the future. I will be spending a considerable amount of analysis on projecting Apple's P/E ratio in the coming weeks. Stay tuned.
Disclosure: I am long AAPL.