I want to scream every time I see or hear another one of those ridiculous claims that Mr. Market doesn't understand Apple (AAPL), doesn't respect it, doesn't get it, etc. Actually, Mr. Market has shown himself to be consistently on top of what's happening at Apple -- the company has grown magnificently in recent years and so, too, has the stock.
The ones who don't get it are those who act as if reading a section on P/E in a for-dummies book makes them expert in stock valuation, and take on enough hubris to think Mr. Market is unaware of Apple's low P/E. Trust me, everybody knows how low Apple's PE is. This is the information age. We no longer have to look up PEs by going to the library hoping to find a copy of Value Line, and hoping again that the page we need hasn't been torn out buy somebody else.
So why is Mr. Market tolerating Apple's incredibly low P/E (which, as of this writing, is 11.3 measured on the basis of estimated EPS and likely to shrink if, as seems probable, estimates rise). Could it be that Mr. Market never looked at "Valuation for Dummies" or whatever other source of investment education people are using? Or might there be some other concern causing Mr. Market to refuse to bid Apple up to a higher P/E?
We don't have to dig deep to find a red flag that bothers Mr. Market: Apple's very high price/sales ratio. As of this writing, this metric stands at 3.1 for Apple, versus medians of 1.5 for the S&P 500, 1.7 for the Technology sector, 0.6 for the Computer Hardware industry, 2.0 for Amazon.com (AMZN), which we need to also consider given how iTunes reflects the way Apple aspires to an Amazon-like business model, and a 0.9 median for the retail sub-industry in which Amazon is included.
"Valuation for Dummies" may not cover this, but in fact, there are many things to consider when valuing stocks and it's often the case that different situations call for closer attention to different things. It is true that at the end of the day, it's earnings we care about, so P/E is often going to get a lot of attention. But the earnings we need to consider are those that come in the future. Being human, none of us knows the future so we look at other factors that help us refine our assumptions about future earnings. Price/Sales got a bad rap because it was misused by shady characters to pump dot-com garbage a decade ago, but that doesn't diminish its importance when correctly used (just as we don't stop driving cars because some idiots drive recklessly).
It is true that both of these price-based ratios reflect market expectations regarding future growth. High P/E ratios indicate market expectations of strong EPS growth and vice versa. High Price/Sales ratios indicate market expectations of strong Sales per share growth and vice versa.
Usually, these signals point in the same direction. But sometimes, as is the case with Apple, they don't. Apple is not alone in this regard, as can easily be seen with a bit of stock screening. Specifically, I screened for U.S. companies with revenues above $1 billion (I want to focus on well-established concerns) whose P/E ratios ranked in the lowest 20% relative to their respective industry groups and whose Price/Sales ratios ranked in the highest 20% relative to their respective industry groups. Naturally, Apple made the screen. So, too, did 38 others, including such well-known names as Cisco Systems (CSCO), QUALCOMM (QCOM), eBay (EBAY), Corning (GLW) and 3M Company (MMM).
Figure 1 presents the result of a 3/31/01 through 1/24/12 backtest of the screen (assuming the list was rebalanced every four weeks).
That's not bad. High price/sales ratios don't seem to cause problems. In fact, we might go so far as to recognize how high price/sales ratios reflect expectations of strong sales growth, and think of this screen, the one inspired by Apple's back-of-the-envelope valuation profile, as being a value-growth model. This can be good, especially for someone like me who is a big devotee of stylistic blend.
But are both factors, low P/E and high Price/Sales contributing equally to results? Figure 2, which shows backtest results for two stripped down versions of the value screen, one based solely on the P/E and the other based solely on price/sales, provides the answer.
The purple line tells us high price/sales may be OK. It's a growth strategy (with Mr. Market's sentiment serving to point out growth potential), not a value strategy. That's OK. Growth is good -- very, very, very good. I'd like to think I can build a better growth screen by adding other factors, but it's interesting to see that high price/sales relative to industry peers may be a good place to start (which can be particularly noteworthy, since I'll bet that few, if any, who build growth models consider this factor as a positive).
But that's not the whole story. Look at the green line, the one that depicts the results of the pure low-P/E strategy. It's a heck of a lot better than the strategy based only on price/sales.
While the Apple valuation-combo (low P/E and high price/sales) is not the end of the world, the high/price/sales ratio does seem to look a bit like a source of drag.
Apple is within the strategy depicted by the green line, the one based solely on low P/E. It is not included in the brown line, the one that depicts the purer value approach (low P/E and low price/sales). OK, no big deal. Low P/E is serving AAPL well.
But think about the orange line, the weakest (by far) strategy based on high price/sales and high P/E. Apple is not there. But Apple "fanboys" and others who wish Apple's P/E were higher than it is are whining and carping that it should be there.
Imagine what would happen if the market were to start bidding Apple's PE higher. Suppose Apple stock doubles at the snap of a finger, meaning the P/E would go from 11.3 to 22.6. But at the same time, the price/sales would go from an already-very-high 3.1 to an insane 6.2, Not only would that plant Apple solidly within the weakest orange line, it might make Apple the worst stock in the group. Even a sudden 50% jump (P/E = 17.0; price/sales = 4.7) would be troublesome. You'd think a 25% gain wouldn't be too much to ask (P/E = 14.1; price/sales = 3.9), but even that would seem challenging, to say the least. No wonder Apple is up only 6.2% (as of mid-day) following such a spectacular positive earnings surprise.
By now, it should be obvious that discussion of Apple's P/E is a waste of time. We should be talking about Apple's price/sales ratio. The charts above suggest high price/sales is not the end of the world (remember, this factor alone could point to some measure of positive performance relative to the S&P 500), but it does appear that the relationship between high price sales is somewhat ambiguous, requiring further examination of why Mr. Market is talking out of two sides of his mouth. I'll address that in my next article.