Apple (AAPL) has taken quite a hit the last couple of weeks, and closed Monday at $376.12 a share. While this may seem expensive, AAPL has resisted suggestions that it engage in a stock split and maintains a relatively low share count. Upon closer analysis, AAPL is ridiculously cheap, and is priced as if it were a company in decline.
With the enormous build-up of corporate balance sheet cash, I have developed a valuation method that I call EPEE - the ratio of Enterprise Price to Enterprise Earnings. I calculate market cap and then subtract net balance sheet cash to derive the Enterprise Price. I then calculate earnings and subtract net after tax interest income on the balance sheet cash to derive Enterprise Earnings. The ratio between these two numbers, the EPEE, gives an investor a calculation of what he is paying in the market for the operating company itself.
AAPL has built up an enormous cash hoard - at the end of the last quarter, it was roughly $82 billion, or roughly $88 per fully diluted share. Unfortunately, AAPL is not as adept in the money management arena as it is in the computer business. Its calendar year pre tax earnings on the cash hoard were roughly 44 cents a share.
If we view AAPL's cash as a separate company (like a closed end fund or a very conservative non-depository investment company), it is valued at roughly 200 times pre-tax earnings. This part of AAPL - lets call it Apple Investments - is growing rapidly as the computer company throws off huge amounts of cash every quarter. Of course, if and when interest rates go up, Apple Investments will likely become more profitable.
AAPL's other company, Apple Computer, is a very different story. The Enterprise Price for Apple Computer is $288 per share. Since the computer company generates almost all of AAPL's after tax earnings, its EPEE is very low. Using numbers for the just ended fiscal year, Apple Computer is trading at 10.5 times trailing earnings. Using consensus ratios for the current year(ending in September 2012), the EPEE is 8.3. For the fiscal year ending 2013, the EPEE is 7.5. These future estimates are probably conservative because Apple Investments will likely constitute a larger part of AAPL's market cap in the future as cash continues to build up on the balance sheet.
The EPEE ratios that we have derived are the kinds of ratios one would expect to see in a depressed, declining, cash cow industry like land line telephone service, dial-up internet service, or some sections of the print media. They do not make any sense at all for Apple's operating company, which is one of the most innovative and dynamic companies in the world today.
I have puzzled over this problem for more than a year now, and I have resolved it for my own investment purposes by buying AAPL on dips. Perhaps the current depressed valuation for AAPL stock is partly a product of uncertainty over the ultimate fate of the balance sheet cash - will AAPL somehow waste the money on foolish acquisitions or other mistaken ventures? It is also the case that balance sheet cash distorts traditional price earnings ratio analysis by adding a huge number to market cap while adding very little to earnings.
I have also begun to reflect on what all of this means for the overall market. In the mid and late 1990s, a stock like AAPL would easily have been trading for more than 20 times next year's earnings (that would be a price of roughly $700 a share) because of its solid growth track record. The fact that it trades at these depressed levels is, I think, a powerful indication that we are much closer to a market bottom than we are to a market top.