The Key To Apple's Undervaluation And Amazon's Overvaluation

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Includes: AAPL, AMZN, FB, LNKD, ZNGA
by: Paulo Santos

One of the great mysteries of today's market is the way Apple (NASDAQ:AAPL) stock trades at such a huge discount to Amazon (NASDAQ:AMZN) stock. In terms of price-to-earnings, Apple trades at a forward 2012 P/E of 12, while Amazon trades at a forward 2012 P/E of 193. This happens despite Apple growing revenues faster than Amazon, growing earnings, and growing estimates. Amazon not only has revenues that grow slower, but its earnings have been falling for two years straight. Amazon's earnings are also predicted to fall in 2012 vs. 2011, and its next-quarter earnings are predicted to fall 95% from the year before. Finally, Amazon's EPS estimates for the next quarter were slashed 90% just days ago.

Knowing this, it's hard to understand how Amazon can not only trade at a premium to Apple, but indeed trade at an earnings valuation multiple that is a full 16 times larger than Apple's. To put things into perspective, if Apple traded at Amazon's earnings multiple, it would trade at $9,000. Or if Amazon traded at Apple's multiple, it would trade for just $14.16.

So is there any explanation for this absurd disconnect? Yes, there might be one.

S&P 500 Weight

To understand what's happening, first we need to consider the weights of Apple and Amazon.com in the S&P 500. The S&P 500 is a capitalization-weighted index, which means the weights of the stocks on the index are proportional to their market capitalizations. After a change back in 2005, they're actually proportional to the market capitalizations only counting the free-floating shares. Those make up about 99.4% of the shares in Apple, but just 80.5% in Amazon, due to Jeff Bezos' 19.5% stake.

Taking into account these free-floating shares, the market capitalization of Apple ($529,619 million) and Amazon ($82,407), and the market capitalization of the entire S&P 500 ($12,235,603 million), we come up with weights in S&P 500 that are about 4.33% for Apple and 0.67% for Amazon. Apple should therefore have a weight that's 6.43 times larger than Amazon's.

Percentage of Shares Outstanding Held by Index Funds

Since the weight of a stock in a capitalization-weighted index is proportional to its capitalization, the share of outstanding shares held by index funds should be about the same for two stocks that belong in the same indexes. Correcting for the free float, this equality seems to stand for Apple and Amazon. As CNBC reports, 7.9% of Apple's shares and 6.4% of Amazon's shares are held by index funds. Dividing 6.4% by 7.9% equals 81%, which is consistent with Amazon's free float being about 81% of Apple's. So no surprise there.

The Surprise Comes Next

The proportionality we see regarding passive index funds, however, breaks down once we look into actively managed mutual funds. Here the true surprise emerges. Again, making use of CNBC's data, we find out that core growth funds hold 5.8% of Apple's outstanding shares and growth funds hold 3.3%, while aggressive growth funds hold 1.6%. The categories thus hold 10.7% of Apple's outstanding shares.

What about Amazon? The same categories hold 6.6% (growth), 6.4% (core growth), and 2.6% (aggressive growth) for a full 15.6% of Amazon's shares. And this is not taking into account that Amazon only has a free float of around 80.5% of its shares, so this percentage is more like 19.4% of the float -- or almost proportionally double what these funds hold in Apple stock.

This surprise is the true reason why Amazon manages to hold such a gigantic market capitalization vs. Apple. Although Amazon is showing much worse fundamental performance than Apple, the growth funds have a much larger weighting in Amazon than they do in Apple.

Typical Example

American Funds' The Growth Fund of America, perhaps the largest growth fund in the U.S. with $137.5 billion under management at the end of 2011, illustrates the surprise in spades.

As of March 31, 2012, 5.5% of The Growth Fund of America's assets were invested in Apple stock. 2.5% of it was in Amazon stock. While superficially it appears as if the fund weights Apple more, that's not really true because the proportion between Apple's free floating market capitalization and Amazon's is that Apple's is 6.43 times larger, yet this fund is allocating just 2.2 times more toward Apple stock. What this means is that The Growth Fund of America is strongly underweighting Apple and strongly overweighting Amazon.

Many funds doing the same thing as The Growth Fund of America end up producing the massive difference in valuation we then observe.

Possible Causes

Why is this happening? Aside from it being a possible pool, which would be impossible to prove, there are two effects that might be producing this phenomenon. These are:

  • The fear of having too much weight in a single stock, thus leading to reduced allocations toward Apple. Although Apple represents just 4.33% of the S&P 500, its weight when the universe is restricted just to growth stocks is much larger. This effect can already be observed in the way Apple represents close to 20% of the Nasdaq 100.
  • The lack of growth alternatives. Among the larger capitalizations there's a distinct lack of easily identifiable growth stocks that might be used instead of Apple. Amazon ends up gaining from that lack of alternatives. This effect was made even worse when several of once-considered large capitalization growth stocks such as Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO), Amgen (NASDAQ:AMGN) and Dell (NASDAQ:DELL) lost the growth status. As these fell by the wayside, those stocks that remained classified as "growth" -- such as Amazon -- were greatly favored.

What Might Change It?

Given this interpretation of why Apple and Amazon trade like they do, what might change this situation, namely regarding the large overvaluation we observe in Amazon?

One such event might be the pending Facebook (NASDAQ:FB) IPO. Facebook will achieve a market capitalization that should surpass $100 billion and at the same time will be seen as a credible growth stock. It's thus likely to get a large allocation in the growth funds that presently see little alternative than to hold Amazon.

The same might happen with other stocks that have already listed, such as Zynga (NASDAQ:ZNGA) or LinkedIn (NYSE:LNKD), though to a much lesser extent due to their much lower market caps.

This process will also be made much easier if any of these stocks -- especially Facebook, as it already carries significant profits -- manages to enter some relevant indexes, such as the S&P 500 or the Nasdaq. After all, even the growth world has a bit of closet indexing going on.

Conclusion

Amazon trades at a valuation differential to Apple that's impossible to rationally explain. The allocation of actively managed growth funds might be at the basis of this valuation discrepancy, since these funds are severely underweighting Apple vs. Amazon. At the core of this underweighting Apple/overweighting Amazon, we find that the too-large weight of Apple and the lack of large-cap growth alternatives might be plausible causes for the phenomenon.

Given these causes, the entry of new large-cap growth stocks into the market, such as Facebook, will help alleviate the phenomenon and thus reduce the valuation gap. This will become even more evident as these new large-cap growth stocks gain entry into the main indexes.

Disclosure: I am short AMZN.