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I am a two-decade veteran of the investment business and am especially interested in technology investments.
  • Apple's Valuation Conundrum 0 comments
    Oct 15, 2010 4:09 PM | about stocks: AAPL

    If CNBC's Mark Haines asks one more pundit if Apple's valuation is a "tad bit bubbly," I am going to have a mind snap.  Apple, as is too well known by now, is second only to Exxon in market capitalization among U.S. companies.  Market capitalization is derived by multiplying the number of shares outstanding by the stock's current price.  It is not rocket science.  Much was made of the fact that Apple recently surpassed Microsoft in market cap and now that the gap between Exxon and Apple is narrowing every day, Apple's market cap is once again naysayer news. 

    To these naysayers, Exxon is an industrial giant and a vital cog in the machinery that propels our economy while Apple seemingly is nothing more than a maker of electronic curiosities and other consumables that are nice to have, but certainly not vital.  Under that rationale, Apple, they say, could not possibly be more valuable than other stock titans like General Electric, Pfizer, or IBM.

    Stock prices are comprised of many components, but two components that are central to any stock price valuation metric are earnings and expected earnings growth.  Investors generally are willing to pay for a share of stock a multiple of earnings that roughly is equivalent to the future growth of earnings over a projected period of time.  This is where the valuation gets tricky.  No one, of course, can precisely project future earnings. 

    So, back to Apple.  Apple has something like 910,000,000 million shares outstanding.  While this is a large number, it is less than 1/8 the amount of shares that Microsoft has (8.6 billion) and 1/5 Exxon's 5 billion shares outstanding.  If Apple reports $4 per share in earnings on Monday, it will have earned $14.51 per share in FY 2010.  Divide that by the current stock price of $310 and you get a price-earnings ratio of 21.36.  Does that p/e ratio make Apple an expensive stock?  Well, let's look at the other component–the earnings growth rate.  In FY 2009, Apple earned $9.08 per share.  The FY2010 number will be known Monday, but let's just say it comes in at $14.50.  At $14.50, Apple will have grown its 2010 earnings by 60% in FY 2010.

    The "science" of stock price valuation, however, does not place as much emphasis on past earnings as it does on future earnings.  I have seen earnings estimates of anywhere from $18-22 per share of Apple for the 2011 FY.  If Apple were to earn $20 per share next year, this would represent FY2011 earning growth of 38% over FY2010.  If you believe that Apple can earn $20 per share next year, you will use that as the "e" in your p/e calculation.  Doing so reveals that Apple currently trades at 15.5X expected 2011 e.p.s. of $20 per share.  In other words, you would be paying 15.5X earnings to buy a company that is exhibiting a growth rate of at least 30%.  That, my friends is not only GARP (Growth At a Reasonable Price) but also borders on being an outright "value" in the world of Growth vs. Value investing. (Standard and Poors pegs Apple's future three-year compound-adjusted earnings growth rate at 33%, by the way.)

    People–Mark Haines included–just can't seem to get their minds around this fact.  If Apple were a small company boasting such a growth rate, investors would most likely be paying a hefty premium for this type of growth.  But because Apple is a market cap behemoth and the prevailing wisdom is that large companies just are not able to show–much less sustain–such growth rates, Apple trades at a discount to both its current growth rate and its projected long-term assumed growth rate of 30+%.

    The valuation argument would be compelling if Apple's P/E was 50 or more, but because Apple is trading at a P/E that is both in line with the market's overall P/E and at a significant discount to it's own earnings growth rate, the valuation argument is nonsensical.  To me, anyway.

    Yes, Apple is a huge company, but its valuation is completely in line with its fundamentals.  Someone astutely pointed out the other day that Apple is a small player in two HUGE businesses–computing and telecom.  There are other companies that have much more market share in each of these industries than does Apple and thus Apple has a significant opportunity to both increase that market share and by extension increase its earnings.  To do so, the company will have to continue to differentiate itself from the competition through innovation and the delivery (at an acceptable price point) of products that consumers didn't know they needed but find intensely useful once they do.

    Respected non-professional Apple analyst Andy Zaky has written that you will be disappointed if you expect the investing community to have an epiphany and suddenly be willing to pay for Apple a price that is commensurate with its earnings growth rate.  He says that one should instead play the "e" side of the p/e equation.  Apple's earnings estimates get ratcheted up regularly, as professional analysts come to realize that Apple is not going to sell 2-3 million iPads in 2010, but instead more like 8 million, and perhaps as many as 40 million next year.  Play that side instead.  If the investment community is only willing to pay 15X earnings for Apple, that's just the way it is.  However, every dollar that analysts tack on to Apple's projected earnings means another $15 to the target price if 15X is indeed the threshhold above which Apple investors will not go.

    While Apple is not "stupid cheap" like it was earlier in the year, it is my supposition that the stock price is supported by the company's fundamentals.  Claiming that Apple is expensive merely because of its market cap ranking seems to me to be overly simplistic.  We all will know much more about this story come 5PM on Monday. 

    Disclosure: Long AAPL

    Stocks: AAPL
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