When it comes to investing in a company, the current market capitalization is important. Investors must not open a long position in a company that is at the upper limit of the company's possible valuation because this will lead to virtually zero growth in the share price over the medium term. This happens because the share price is directly correlated with the market capitalization of the company. Market value, however, is not dictated by the past. In fact, to the contrary, because the market value of a company is also based upon future earnings potential this means the value of the company may be higher than the market capitalization.
While the market capitalization is simply based upon the number of outstanding shares multiplied by the current share price, the actual value of a company is based upon several variables. This is where the share price to earnings (P/E) ratio comes in handy because the P/E ratio indicates how close the particular stock trades to the actual earnings of the company. For instance, a forward P/E ratio of 1 indicates the stock is trading according to earnings, which also means investors are expecting the company to virtually cease growing.
The two biggest companies are Exxon Mobil (NYSE:XOM) at $382 billion and Apple (NASDAQ:AAPL) at $362 billion. But the question I propose is whether each company deserves this valuation and what potential does either company offer for the future? It is important to note there are dozens of ways investors can value a company, but I will focus upon cash flows and income to determine the potential of either company. In doing so it will be possible to estimate a future value of an initially invested sum of money. I will end with a discussion regarding each company's share price over the past five years in order to determine the potential of each respective company's stock price based purely on historical trends.
Cash flows allow investors to determine how efficient the company is with revenue and it indicates how a company is spending the valuable net income. The more cash inflows a company generates the more revenue the company is amassing, but also higher cash inflows indicate the company is using the net income wisely for financing and investment activities.
Exxon has outpaced Apple in the cash flow department year to date by about $4.116 billion. I will be using the first three quarters of 2011 in order to properly assess what the future may hold for each company and because each company has a different fiscal year. As of the end of the September quarter, Exxon has generated about $17 billion more than Apple in terms of cash flow from operations. Apple also trails Exxon by $8 billion in the cash flow from investments category. Luckily for Apple, the company generates strong cash flow from financing activities. Apple comes out ahead of Exxon by $22 billion in this category.
Keep in mind that Exxon pays about $2.25 billion in dividends each quarter, which accounts for roughly $6.77 billion in dividend payouts after the first three quarters. Also, Exxon has bought back over $16 billion in securities during the first three quarters, which accounts for the negative cash flow from financing activities. Therefore it appears Exxon is spending the company's cash on shareholders, while Apple builds up the cash pile.
This is an opportune moment to briefly mention each company's cash on hand. As we know, Apple has more cash at the company's disposal than the U.S. Treasury. But the vast majority of this cash is locked away in long term investments. Apple has roughly $55 billion in long term investments, and about $25 billion in cash and short term investments. This trumps Exxon's meager $11 billion in cash and short term investments. Exxon also has $35 billion in long term investments which brings Exxon's total cash on hand to roughly $46 billion. Therefore it is obvious Apple will soon double Exxon's cash. But is this a buy sign for investors?
Obviously the possibilities for Apple are tremendous. But with only about 930 million common shares outstanding, a share buyback is likely not going to happen. Maybe a special dividend is in the works during a weak economic period to keep the share price inflated? This is mere speculation, and Apple may simply keep the cash and use it for an opportunistic buyout of a company in the future.
How does this affect each company's valuation? Cash flow may not directly affect market capitalization, but it is an important factor for a company's long term valuation because analysts look at cash flows when determining a company's price target; therefore cash flows indirectly affect share price.
It may seem like a moot point to discuss each company's chart beginning in 2006 because this is right before the recessionary crash in the equities market, but this is important for three reasons. The first reason is it will enable us to see how inflated each stock was prior to the recession. We can determine this because the higher the volatility on the way down the higher the inflation level for the particular security prior to the collapse. The second important reason is it will enable us to view how each respective share price has grown since reaching an oversold state in 2008. Please note Exxon faced an abnormal dip in 2010 due to the Deepwater Horizon oil spill. Lastly, viewing the five year chart will allow us to estimate how far each stock will slide during periods of weakness.
I will begin with Apple. Over the past five years shareholders have seen Apple's share price grow 327%. This should not come as a surprise. What is important to note is the weakness Apple's stock faces during times of weakness. From December 2007 through January 2009 Apple's share price underperformed the Nasdaq index by about 15%. This weakness illustrates the point I made earlier about how the inflation of a particular share price can be determined based upon the volatility of the stock as it plunges during weak periods. Therefore we can state Apple's share price was inflated and is likely inflated currently; which explains the wild fluctuations in the share price recently.
On the other hand Exxon's share price outperformed the stock's underlying index by about 10% during the same period of weakness. This is important because what Exxon lacks in overall share price growth, the stock makes up for in strength during weak periods. Another important note to make is that Exxon's investors only lost 32.1% (with non reinvested dividends included) from the pre recession high to the mid recession low; compared to Apple's 60.8% drop over the same period. This is an example of how a stock that trades close to realistic earnings (thus less inflated levels) reacts to weakness very well.
This is important for two reasons. First, it indicates that Exxon may be the better play over the next 8-12 months due to the worldwide economic uncertainty. However, on the other hand, if everything clears up Apple's share price will surge. It may be difficult at this point to argue Exxon is the better long term choice because Apple has clearly outperformed Exxon every year over the past five years. But if you look forward one or two decades, Exxon may be the better choice; especially with the increasing dividends.
What the Future Holds
With the past in mind, we can now discuss the future and which company's stock will best suit an investor's portfolio. The easiest way to determine a stock's potential over the next year is by looking at the trailing twelve months (ttm) and forward twelve months (ftm) P/E ratio in order to decipher how close the share price is to future and past earnings. It is important to discuss ttm earnings because this indicates whether investors are buying or selling over a longer term. For instance, if a company's ttm multiple is lower than the ftm multiple then it is safe to conclude investors are not expecting the company to grow at the same rate as the previous year; which is the case for many stocks.
Apple and Exxon fall into this situation. Apple is currently trading at 14.1 times the company's ttm earnings and 11.3 times the projected fiscal year 2012 earnings. If Apple were to trade at 14.1 times the company's current projected earnings for 2012, the share price would be roughly $487 per share, which is 25% above Friday's closing price.
It is clear Exxon will not be able to beat this type of growth, but we must go through the same steps as we did with Apple. Exxon currently trades 9.6 times above ttm earnings and 9.5 times above fiscal year 2012 earnings projections. If Exxon were to trade at 9.6 times the company's projected 2012 earnings, investors will see the share price at 80.73, which is merely 1.2% higher than Friday's close.
This makes Apple's stock look like a clear winner for the next year or so. But Exxon does have a current 2.5% per year dividend. However even with the dividend Exxon's stock will fall miles short of Apple over the next 12 months. Of course this assumes Apple's share price will grow 25% over the next year; which is unlikely.
There are two reasons Apple's stock will not reach this level. The first is the fact that Apple's estimates are growing slightly faster than the company's production. Therefore it is only a matter of time before the company falters. We already saw a brief episode of this scenario after Apple whiffed on the company's fourth quarter earnings report. With that said, this was due to the release of the new iPhone which historically causes consumers to wait before purchasing the older model if they know a newer model is coming soon. Therefore the next 2-4 quarters are very important for Apple's long term future because this period will indicate if Apple will continue to grow at previous levels or if the giant is cooling off.
The second reason Apple's stock will not grow 25% over the next 12 months is because, as mentioned above, investors are finding it difficult to believe Apple is worth more than Exxon. Therefore we may see a resistance point for Apple's growth that is determined by Exxon's market capitalization. In a sense this is a cross chart indicator that can easily signal a top in Apple's share price.
For now let us revisit Exxon. It is important to note Exxon's forward multiple decreases 1% when comparing the ttm and ftm which indicates the share price is stable and will not suffer any severe weakness, barring any catastrophic events such as the Deepwater Horizon oil spill. On the other hand, Apple's earnings over those same periods decrease 20% which indicates investors are currently concerned about the company's fast growth coming to a head. This also indicates Apple's stock is carrying a high volatility risk as we mentioned above. The volatility risk can be determined because a substantial decrease such as 20% in P/E (ttm) to P/E (ftm) indicates the share price is inflated compared to many companies such as Exxon.
After this analysis it appears both stocks have strengths and weaknesses. Where Exxon lacks in share price growth, the company makes up for in cash flows. Contrarily where Apple lacks in cash flows the stock makes up for in returns to investors. However one of the last important concepts to note is the future consumer market potential for each company.
Which company has the potential to bring in sustained revenue over the next decade or two? In this department I am inclined to side with Exxon for one major reason. This reason is that the world will always need energy. It is not even a question. The type of energy is arguable, but Exxon has its bases covered. Currently, Exxon operates in 6 continents with a focus on drilling and manufacturing crude oil and natural gas. And since natural gas will be the primary source for energy at some point, Exxon has a bright future.
On the other hand Apple's market can be crushed if another company produces a new innovative product. Another issue may be a lack of innovation by Apple similar to Research in Motion (RIMM). And as we know, the once unstoppable Blackberry producer is now on the borderline of being in shambles with the company's tablet being pulled from the market and Blackberry devices losing popularity. Could Apple fall to this same fate? Of course. This will not happen anytime soon, but will Apple have the firepower to stay at the top by 2030? I would be surprised, but I can confidently state Exxon will be at the top of the Energy sector in two decades.
On a more shorter term time frame, how will each company's respective share prices fare over the next 12 months? In order to answer this question I will assume the world economic system does not spiral out of control. But if this does happen, Exxon will be the winner. Nevertheless, over the next 12 months I expect to see Apple's share price move to the $467 range which brings Apple's market capitalization over $434 billion. On the other hand, I expect to see Exxon's share price at $91, which makes the market capitalization $440 billion. It is important to note, Exxon's dividends will return 17.5%-18% to investors compared to Apple's 20% return.
It may appear I am giving Exxon the thumbs up and Apple the thumbs down, but this is not true. This may be true for the extreme long term, but in the shorter term Apple will outperform Exxon. The problem is the cross chart resistance point will halt Apple's share price from reaching levels that make Apple's market capitalization higher than Exxon's. Another reason Exxon has an advantage is the price of gasoline will not decrease due to inflation and demand. Even though the cost of crude oil is not extremely high, gas companies will not lower their prices if consumers are willing to buy. Apple is the king of this because the company historically prices their products at the upper echelon of pricing.
However, what is clear is Apple is a stock with huge growth potential but also severe downside possibilities due to the inflated share price. Compare this to Exxon's stable share price and you have two strong stocks that will shore up any equities portfolio during market strength and weakness.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.