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There is a very strong sentiment among Apple (NASDAQ:AAPL) investors that the stock is undervalued because the P/E ratio is lower than that of other companies in the tech industry, which is understandable. In a negotiated transaction of Apple shares, a very strong case can be made that the P/E multiple should be 23, the average P/E of the S&P 500, which would value Apple at $810 per share. If the price continues to rise at the current pace of 70% in 12 months, it will be $990 by March 2013. Using trailing earnings, the P/E ratio would be about 28, which would still be reasonable given its current growth and strong balance sheet.

But let us take one step back and review how P/Es and stock prices really work, absent a negotiated sale. P/Es are simply the end-product of Share Price divided by Earnings Per Share (annualized). The price is actually set by the operation of market forces of supply and demand. So while a P/E of 20 or 30 may be reasonable, investors will only pay what they believe is a fair price given their expectations of the company's returns, and the risk associated with those returns. In the meantime, long term investors can hold on to their shares while they appreciate in value and the E/P approaches the mean, or not; all that matters to the investor is that the price keeps going up, especially with $0 dividends. For short term and intermediate term traders, E/P multiples have very little to no significance.

The other problem with using P/Es for valuation purposes is that there has to be an appropriate benchmark to compare the ratio against. There is currently no company with the same performance and operational metrics as Apple to compare it against. But if we take the P/Es of other technology companies like Dell (NASDAQ:DELL): 9, Hewlet Packard (NYSE:HPQ): 9 and Microsoft (NASDAQ:MSFT): 12, then Apple already appears to be priced at a premium.

This highlights the limitation of P/Es for valuation purposes; because the selection of an appropriate benchmark involves an element of subjectivity, whatever P/E is ultimately used will only arrive at an estimate of fair value. For all intends and purposes there is simply no better measure of fair value than the current market price.

As long the price of Apple shares keeps rising faster than its earnings growth, a much higher P/E is possible, unless Apple starts missing earnings estimates. A collapse in earnings will cause the P/E to spike in an instant, even as the share price falls. That is unimaginable at the moment but there is no telling how deep a correction Apple might experience in such a scenario.

Also, P/E ratios for growth oriented companies are always in flux and usually do increase when earnings fall. Amazon (NASDAQ:AMZN) is a case in point which has fallen from a 52-week high of $246 to $184 while the P/E ratio has actually risen from 113 to 134. The P/E indicates Amazon is getting more and more OVER-valued, yet the price found support at $170. A higher than expected earnings figure will most probably cause the P/E to go down before investors bid the shares higher. Increasing the denominator, EPS, without a corresponding increase in the numerator, Share Price, results in a falling P/E ratio.

A rising P/E ratio does not necessarily translate into a higher valuation. In fact, the P/E ratio tends to decrease as a company matures, and as its valuation peaks.

While the P/E is a good measure for assessing whether or not a stock is more expensive relative to other stocks and investment options, it should be used with caution when assessing absolute valuations. I dug up some information from the archives on ycharts.com and found this: The highest P/E ratio in recent records for AAPL was 286 in December 2002 when the stock was trading at $8 a share. The average P/E ratio for the S&P 500 at that date was 32. Based on the P/E, Apple was way over-valued at less than $10. Now fast forward 10 years... With the benefit of hindsight, Apple was dirt cheap then. P/E ratios are just not the be-all and end-all of stock valuation. Share prices are not a product of some perceived reasonable P/E.

In conclusion, the investor must realize the limitation of the P/E in determining absolute valuations. And for purposes of assessing relative valuation, it still must be used with caution. A lot of factors have to be considered in selecting among alternative investments, including growth forecasts and how long that can be sustained, the competitive landscape, and product mix. In fact Apple does acknowledge significant risks to the business in its annual reports. It would be unwise for the investor not to.

I would not recommend anyone short Apple for I think it is headed up in the foreseeable quarters, but as a trader I would seek a more optimal entry price of say 10% below its all time high of $600. Any investor who strongly believes Apple is undervalued because of the P/E reading should also consider that there are risks that may result in earnings coming short of expectations. For those clamoring that the market is undervaluing Apple, take this as an opportunity to accumulate Apple shares. The investor will probably be rewarded, regardless of where the P/E ratio goes from here.

Source: Apple's P/E Ratio As A Case For Undervaluation