Apple: Undervalued at $400

Jul.26.11 | About: Apple Inc. (AAPL)

It is easy to get dizzy when looking at Apple's (NASDAQ:AAPL) stock climb during the last ten years (+ 3800%). But when you dig deeper into the story, you see that the business is growing even faster lately. This brings us to the notion of P/E compression (P/E stands for share price divided by one year earnings per share). Now there are many variants of P/E: 12 months trailing, or with respect to forecasted next year's earnings (let us write it P/FE), or computed excluding cash from the share price (denoted P-$/E). Using trailing P/E and another indicator, PEG, which stands for P/E divided by y/y earnings growth, I predicted one year ago that AAPL was poised to rise (Philip Elmer-DeWitt wrote this article and the statistics about other companies are his work).

When I made my prediction, the share price was around $260; it's up more than 50% since then. Trailing P/E was 19.6 and trailing P-$/E was 17.6. PEG was .25, which by historical standards means the stock is undervalued (a value around 1 is considered fair value and above that, overvalued). But trailing PEG was lower than during the darkest days of the global financial meltdown - yes, Apple was growing earnings even then.

Trailing or Forecasted?

One of the big debates around the aforementioned article in Fortune was that trailing PEG does not have much of a meaning (unfortunately, those comments are MIA). I argue that Wall Street analysts' forecasts regarding Apple are as useless as Apple's own guidance. They always miss by a long shot to the short side when predicting next quarter's earnings. See here, here, here and here, for example. But when it comes to longer term predictions, they are less reliable than a dart thrown in the dark. They have predicted future growth slowdown to around 20% y/y for many years now, when Apple has done this (Q1 for Apple is ending in December):

click to enlarge
Click to enlarge
The quarterly y/y earnings growth is drawn in blue. Trailing 12 months y/y earnings growth is in green.

What is analyst consensus predicting now? A quick look at Yahoo Finance gives a P/E of 15.56 and P/FE of 12.43 (this is for the fiscal year 2012, 5 quarters in the future). This implies earnings growth of 25.2% in 5 quarters, or about 19.7% in one year (going to logarithmic scale and back to account for compound growth). At least they are consistent in their historic error, always near 20% forecasted growth. This would mean less than during the worst days of the recession. Holy cow.

Trailing P/E

Considering the price range of AAPL for the periods between earnings reports, we have the following evolution of this indicator. The minimum trailing P/E is in green, the maximum in blue.

We are now at recession levels valuation with quadruple earnings growth. Put another way, AAPL has IBM's P/E. But Apple's growth is flirting with triple digits (122% for the last quarter, 90% for the trailing 12 months) while IBM's is barely in double digits.

As Apple has such a large cash (and equivalents) position, over $76B now, P-$/E gains its own significance. It's what you pay for the business, that is, future earnings (thus excluding cash and other assets). P-$/E is now about 12.4.

I do not argue that somehow investors will wake up and give Apple's stock a fairer valuation. Only that growth will be strong for some time and P/E cannot go much lower. This will drag the share price higher.

Trailing PEG

One can use trailing PEG only to detect trends without giving it the usual significance (with respect to the value 1). But looking at the earnings growth graph, we see that past performance is a way better indicator for future performance than analysts' forecasts (the baseline at 20%). Take it with a grain of salt if you wish, but here is what it looks like:
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PEG is now .17 and P-$EG is .14 (that is, PEG computed using P-$/E instead of P/E). These are absurdly low levels by any standard. They are a direct consequence of the concomitant P/E compression and earnings growth acceleration. Unfortunately, there are no real reasons those values should go up anytime soon.


In order to be conservative and to avoid ridiculously high valuation predictions, I will assume further P/E compression (12 and 10) and earnings growth cooling off in 2012 and 2013 (respectively, 80% and 60%). Barring any market meltdown, I predict that one year from now AAPL will be at $550 or more, $650 by the end of 2012, and at least $850 by the end of 2013.

Disclosure: I am long AAPL.

Additional disclosure: I leverage my AAPL investments with call options.