After its latest earnings release, Apple (AAPL), one of the hottest growth stories on Wall Street, is now officially priced as a zero growth stock. To illustrate why, we have to first look at how to price a zero growth company in the first place. Get ready to get your hands dirty, because we're about to dig into some entry level financial theory.
To begin, we use the average annual return of the US stock market over the past decade to establish an expected rate of return for our investment. The CAGR of the S&P 500 over the last one hundred years is roughly 10%, so that will be our starting point. A fairly priced stock will return 10% a year to investors - no more, no less.
Now the question becomes, at what valuation will our hypothetical zero growth company return 10%? A company with no growth prospects will be expected to return all its earnings to shareholders in dividends at a 100% payout ratio. After all, there's no point in retaining and reinvesting earnings if your company has reached absolute maturity and growth is no longer possible.
Since the company will never grow, capital appreciation of its stock is expected to remain pretty much flat over the long run. Therefore, the only way for our hypothetical company to generate shareholder value is through dividend distributions (and share buybacks, but since a buyback is the same as a reinvested dividend when the shares are purchased at fair value, we'll ignore them for now). For a no growth company paying out 100% of its earnings, the total return of its investors will be equal to its yield. To achieve a 10% yield at a 100% payout ratio, the company's P/E must be equal to 10. And there we have it: a no growth company, all other factors being equal, is fairly valued at a P/E of 10.
Using P/E 10 as a base line, we can examine the valuations of stocks on the market and use them as a means to judge investors' predictions about the company's future. For instance, Microsoft (MSFT) trades at almost exactly 10. Investors are bearish about the company's future growth prospects, though the company isn't seen as anything close to a bankruptcy risk just yet. Though Microsoft is a cash flow machine with enormous market share in computer operating systems and productivity software, its management has proven to be slow to react to technological trends. Much like cell phone giant Nokia (NOK), Microsoft is seen as a relic of a past age, though neither company is out of the game just yet (there was even a time last year when the rumor mills were set ablaze with talks of a merger between the two tech titans).
At the high end of the spectrum is a stock like Sirius XM (SIRI), with a P/E of 50. The satellite radio company has recently emerged above the break even line to begin to turn a profit, Lynx 2.0 is supposed to be the next stage of evolution, Howard Stern is Howard Stern, and investors are bullish about the company's long term prospects. They believe that the company's current earnings vastly understate its future earnings potential, and the stock is awarded a rich valuation as a consequence.
At the opposite end of the spectrum is BlackBerry manufacturer Research in Motion (RIMM), priced at a dirt cheap 3.5x trailing earnings. RIM has been bleeding market share to Apple's iPhone and Google's (GOOG) Android handsets quarter after quarter and its two co-CEOs just resigned from shareholder pressure. Investors are betting big that the company is not only going to fail to achieve growth, but that there's a very high chance that its earnings will significantly decline and that bankruptcy may even become a real risk.
What does any of this have to do with Apple? After the latest record-smashing earnings release, the Cupertino technology company's trailing annual profit is equal to $32.9 billion, over a diluted share count of $941 million, for a trailing EPS of roughly $35/share. Multiply this by a P/E of 10, our zero growth multiple, and we get a price of $350/share. Add in Apple's cash hoard of $100/share, and we arrive at a per share price of $450: exactly where the after market left the stock yesterday after the company released its earnings numbers.
Is it right for a company that's just posted over 100% year over year bottom line growth to be valued like a zero growth stock? Let's face it: there are pages after pages of articles published, here on Seeking Alpha and elsewhere, about what a fantastic company Apple is. Hell, I've even written a bunch of them. There's no need for another one. This article's sole purpose is to analyze the stock's valuation and reconstruct the market's true sentiments towards Apple based on that valuation.
Despite being labeled a Wall Street darling and frequently being tossed in with "growth stocks" that are actually valued like growth stocks like Amazon.com (AMZN), Mr. Market really doesn't think Apple is capable of further growth, even though he won't admit it (when was the last time you read a bearish article on Apple?). Is he right or is he wrong? That's for you to decide.
Disclosure: I am long AAPL.