In this article, I will share my viewpoints on why investors price certain stocks at higher or lower multiples against market-defying conventional wisdom, which suggests that higher (lower) growth stocks should fetch higher (lower) multiples than that of the market. I offer empirical evidence suggesting that few consistently outperforming technology companies get valuation treatments that defy conventional wisdom. I will then introduce three simple rules of investment and evaluate each company's financials and corporate strategy.
I will conclude by suggesting that a clearly articulated long-term strategy, along with measurable corporate goals, plays an equally important role together with the company's financial track record and market-beating performance in winning investors' heart (and getting higher multiples). To help me illustrate my viewpoints, I assembled a small group of traditional tech companies, including Apple (AAPL), Oracle (ORCL), Hewlett-Packard (HPQ), Microsoft (MSFT), IBM (IBM), SAP (SAP), and Google (GOOG). I selected the S&P 500 as the market comparison.
Click to enlarge images.
As of Oct. 19, the S&P 500's trailing P/E and estimates for forward P/E were 17 and 13.8, respectively (source: Bloomberg). AAPL's 52-week return of 50.5% has markedly outpaced the same period return of 9.95% for the S&P 500 (see table below). In addition, AAPL's earnings growth has substantively outpaced that of the S&P 500 for five straight years (see chart above). So I started to wonder why AAPL's trailing and forward P/E multiples of 14.3 and 11.4, respectively, trail that of the S&P 500. Is there a crisis looming for AAPL that could be bigger in magnitude and impact than those faced by the financial markets, including the neverending debt crisis in Europe, a worsening slowdown in China, and an already unraveling fiscal cliff in the U.S.? So, why are investors not pricing AAPL using the multiples of the S&P 500 at the minimum?
In a peer group comprised of four enterprise software tech companies -- SAP, IBM, ORCL, and MSFT -- SAP has the highest trailing P/E and also the highest price/sales ratio (see table below). SAP's forward P/E of 19.7 is nine points higher than that of ORCL, 11 points higher than that of MSFT, and eight points higher than that of IBM. In addition, SAP's forward and trailing P/E multiples are also higher than that of the S&P 500. So why are investors willing to price SAP stock at higher multiples than the others in its peer group, including the S&P 500? Interestingly, SAP's multiples are also higher than that of AAPL.
Dropping HPQ Into the Mix
HPQ's TTM revenue was $61.9 per share (see table above). Its stock is trading at a meager P/S multiple of .2 times and has a forward P/E multiple of just 4. This is not hard to explain as there is no love left between HPQ and its investors who have suffered heavy losses (the stock has dropped almost 50% just this year alone). In addition, at such lower multiples investors are definitely pricing in a catastrophic scenario.
For all these companies, I assembled the last five years' income statements and I reviewed their revenue growth rates (see table below). Nothing jumped out that could have suggested why AAPL should have lower multiples than the S&P 500, GOOG, or SAP. Clearly, there is something else at play, which traditional valuation approach is not explaining.
Source: Morning Star and Yahoo Finance.
Investors' actions in HPQ, AAPL, and SAP and its peers can be justified by applying following three simple rules of investment:
- invest in companies you know, understand, and believe in
- invest in companies that are going to persist, pursue positive NPV projects, and successfully sail with the wind (market trends)
- invest in companies for the mid- to long term
Investors closely scrutinize, more than one would desire, company management's effectiveness in articulating its future and corporate goals and its trustworthiness. This is where the "believe" part in the first rule comes in. Let's put each company through this evaluation and discuss the outcome.
First up, AAPL: For AAPL, I can safely conclude that the first two rules are securely in the bag. Investors understand the company and its hugely popular products. It has successfully sailed with the wind for the past decade, and I might even argue that it brought fresh wind into the sails of the tablet and smartphone segments. But when it comes to applying the third and final rule -- i.e., investing in AAPL for the mid- to long term and thus paying a reasonable multiple -- investors are certainly hesitating to act. From investors' point of view, the investment decision boils down to the following two points:
- AAPL gets a fresh lease on life every year when it upgrades its "iLine" (iPads, iPhones, iPods, and Macs) of products
- But other than this routine, AAPL management is highly secretive about its vision for the future of the company
For AAPL investors, it is challenging to see beyond a one-year horizon. The investors are asking larger questions of AAPL, including: What does AAPL want to be in five years and where will it be? Will AAPL dominate some market segments as it does today, and if so, what is that longer-term strategy? Until AAPL addresses these questions and clearly articulates its strategy and the goals tied to its strategy, it will be difficult to see why investors would apply S&P 500-like or higher multiples to AAPL.
Next up, ORCL: For ORCL, I would start by arguing that ORCL is suffering from a credibility problem with investors. Investors get ORCL's enterprise software and hardware business, which is attractive and growing at a secular rate. ORCL has accepted that the inorganic growth model (via acquisition) is the way to move its business forward and to stay current on the technology innovation front. Besides all this, its earlier position on cloud technologies (calling it a fad) and then turning into a true cloud believer (with the acquisition of RightNow, Taleo, and its own investments) has sent mixed messages to investors.
ORCL has done a poor job of laying out its long-term vision for investors, and investors are unhappy because they are unable to see a clear path forward. Does ORCL want to be like its big brethren IBM and package hardware, software, services, and cloud infrastructure together for its customers? What does ORCL want to be? What are some of its growth plays? ORCL has attempted to articulate its vision to investors and analysts, but the reduced trustworthiness and the past delays in strategic investments have kept investors skeptical at best. ORCL needs to win the credibility back from its investors and shy away from sending mixed messages to investors and its own customers.
Next up, HPQ: I don't know where to begin with this company. Let's start at the very top, the board. HPQ's board has had major credibility issues for many years now because of the scandals and terrible decisions that have resulted in billions of dollars of losses for investors. The epic stumbles such as the launch of Palm-based tablets/smartphones (and then the immediate pull out), the public display of flip-flopping decisions on a spin-off for the Personal Computer unit, and then having three CEOs at the helm of HPQ in less than three years have not pleased investors.
In addition, HPQ's core businesses continue to suffer, resulting in heavy losses because it has been slow to respond to the shift in technology spending to cloud and mobile technologies. HPQ's market cap has dropped by more than 80% since peaking at approximately $120 billion in 2010. Investors have little to no confidence in HPQ and are pricing in a rapid erosion of its customer base and sales (which is reflected in a low price/sales ratio of 0.23).
Next up, GOOG: GOOG has wide range of interests resulting in a large array of investments, including the investment in driverless cars. Not all of the projects GOOG has undertaken in recent years have been positive NPV projects, and as a result GOOG's stock has same P/E multiples as that of the S&P 500. GOOG wants to be a technology company and all the investments GOOG makes have this common origin. This is a fact, but why aren't investors comfortable with it? Is GOOG not effective at convincing investors that this approach is right and will bear fruit?
Is GOOG going to be a media company, or a mobile company, or a hardware company, or an Internet bandwidth company, or a search company, or an enterprise software company, or all of the above (i.e., a tech conglomerate)? Apparently, GOOG's vision and road map are not very clear to investors, which is why GOOG had lackluster performance for the first six months of 2012 prior to the Q2 earnings announcement. I believe that investors have adopted a wait-and-see approach on GOOG, which is a mature company now but surrounds itself with a high number of uncertainties.
Next up, IBM: IBM is securely in the bag using the rules I laid out earlire. By 2015, IBM will generate $20 in non-GAAP EPS -- this is IBM's corporate goal for 2015. I believe that investors should love the simplicity of IBM's singular goal. IBM has done a nice job in articulating its corporate goal for 2015, including the key growth plays that will drive IBM forward to its goal. The key growth plays from IBM are emerging markets, analytics, cloud, and Smart Planet initiatives. IBM has also articulated that it will pursue higher-margin opportunities (i.e., software) and use share repurchase programs to boost EPS. IBM's EPS in 2011 was $13.4, which would have to rise by 50% in four years if IBM were to accomplish its goal of producing $20 EPS by 2015.
Both AAPL and IBM are iconic and trusted brands. IBM has provided a clear vision and a path forward, but AAPL has not. Therefore, I am not surprised to see that both IBM and AAPL received similar trailing and forward P/E multiples despite the fact that AAPL's earnings growth is nothing less than spectacular.
This brings me to the last company I will discuss here, SAP: Just like IBM, SAP is also securely in the bag. SAP is a global brand and plans to reach 1 billion people in an attempt to become a household name. I have found SAP to be a goals-driven company, and it is taking all the necessary steps (both organic and inorganic growth opportunities) to track toward these goals. This is similar to IBM's approach, but more clearly spelled out. Here are the goals that SAP has laid out for 2015:
Additionally, just like IBM, SAP has also clearly articulated its growth strategy and the five market categories it plans to expand into. These categories are: applications, analytics, mobile, database and technology, and the cloud. SAP's management has not sent mixed messages to the market (unlike ORCL) since sharing its vision and goals for the future, and is gearing up to ride both the mobile (with the Sybase and Syclo acquisitions) and the cloud trends (with the SuccessFactor and Ariba acquisitions).
SAP is not the only company growing its revenues at a double-digit rate for more than 10 quarters, but it is logging that performance on a consistent basis and tracking toward its 2015 corporate goals. Investors are cheering this steady performance and have bid the stock up by more than 35% YTD in 2012, higher than every other stock in the group except AAPL (see chart below):
Source: Google Finance.
The majority of public companies, if not all, develop a vision, lay out a clear strategy, and announce goals to realize that vision. But some do a better job than others in articulating and sharing this on a regular basis with their investors. Companies that clearly articulate their vision and strategy to all their constituents -- including customers, employees, partners, and investors -- earn respect almost instantaneously. And when these companies publicly track progress against their vision, they benefit tremendously by winning the trust and credibility from each and every constituent (including investors). This allows them to attract top talent, new customers, new partners, and new markets to help them grow their business.
Disclaimer: All numbers are approximate and the underlying analysis is preliminary. This article is not intended for offering any investment advice. This article has benefited from discussions with my friends and colleagues Jens Doerpmund, Ryan Leask, and Rajani Aswani on this topic.