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I am a two-decade veteran of the investment business and am especially interested in technology investments.
  • Apple Dictates That Large Numbers Law Needs Revision 2 comments
    Mar 9, 2012 10:11 AM | about stocks: AAPL

    Apple's trailing twelve-month earnings now stands at $35.12. The

    company has cash equal to about $103 per share. At $450 per share, Apple trades at 12.8X those trailing earnings, 9.8X if you subtract the cash. I believe the market's overall P/E is just above 12, so depending on how you want to look at it, Apple is either trading in line with the overall market or at a significant discount to it. If you choose to believe Cramer who said this morning that Apple could earn $50 per share this fiscal year, then those valuations drop to 11.11X with cash and 7X without it. No matter which way you choose to look at it, Apple's valuation is a complete joke. Why? The lazy person's rationale is something called the "Law of Large Numbers." This "law," as it were, posits that as Apple grows, it will take an ever-increasing amount of revenue to maintain its growth rate. As Apple grows, the amount of revenue required will become so large that the rate of growth will have to decline. The secret is in divining just when a company reaches its growth apex. For several years now Apple's growth story has been hurt by the invocation of this "law." As Apple grows quarter after quarter, analysts become ever-more certain that the "law" is about to come into play. However, as was pointed out in this excellent article, Apple's revenue growth is accelerating, not declining.

    Even those whose analysis of the company is not clouded by whatever the current prejudice is are amazed by what Apple continues to do with its business. 2012 Q1 earnings surpassed even the most outrageously optimistic expectations of the amateur analyst community, a group whose whose predictions are not constrained by worries about job security. It is always dangerous to make the statement that "this time is different," but is this time really different? Can Apple overcome the prejudice directed at it by its position as the biggest company by market cap?

    I think the answer lies not in judging Apple's potential for growth by its current market capitalization but rather by the size of its addressable markets. Worldwide revenues for the global telecommunications market is expected to reach $2 trillion dollars this year, revenues for computing about half that. These are huge markets in which Apple has, by comparison, a miniscule presence. No one company is ever going to have a majority share in these industries but these industries' sheer size makes it possible for companies with small share to make enormous amounts of money. This is exactly what Apple is doing and what analysts and investors seem to ignore when they trot out the market cap argument.

    What is even more frustrating is that Apple's current valuation seems already to have factored in declining growth. How else to explain Apple currently trading at a cashless p/e of 9.8 and at a 20+% discount to the overall market? Look at this chart from the above-mentioned article:

    In every instance but one, Apple carries a lower trailing p/e despite posting rates of growth that are orders of magnitude greater. The one exception is Nokia and even there investors currently are willing to pay 5.2X for negative growth.

    My point is that, according to analysts who say that the large number law is what eventually will do Apple in, Apple will at some point suffer additional p/e contraction. Really? Investors now are only willing to pay 10X for Apple's 50+% annual revenue and earnings growth and analysts with the market cap argument are trying to make you believe that at some point investors will pay something less than that. Buyers right now are paying 10X for Microsoft's 5% earnings growth, so why should the Law of Large Numbers even be discussed as a future concern for Apple when it is apparent that investors already have priced the shares as though growth has ceased?

    The market cap argument against owning Apple shares is a specious one, conveniently trotted out by analysts who either are too lazy or too timid to make the bold call that the Apple story demands.

    Disclosure: I am long AAPL.

    Stocks: AAPL
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  • Sacto_Joe
    , contributor
    Comments (255) | Send Message
    Mac Daddy, I came to the conclusion a while back that the reason for the P/E compression of AAPL is simply that investors aren't buying Apple on the basis of a probable future; they're only buying it on the basis of proven earnings. Ergo, while there may be some runup or rundown in advance of earnings due to rumors or tidbits of information, most investment only occurs after earnings are known. (That also explains why there's such a rush to purchase or sell immediately after earnings are released.)


    But by definition, that means that the P part of P/E can NEVER catch the E part, since the E part isn't known until after the P/E ratio has already shrunk! It's kind of like continually shooting at an accelerating plane by pointing directly at it as it flies past. You keep shooting farther and farther behind the plane.


    In other words, we are in a downward spiral for the P/E that can only end when either (1) Apple earnings finally start to slow, or (2) investors start to gain faith in AAPL's ability to grow its earnings. That's the bad news, especially for people who have to sell Apple early (like people who've been let go and forced to crack open their nest egg). It may not be as bad for people who can afford to stick their Apple stock in a drawer for several years. For them, eventually that compressed P/E will unwind, supporting or even increasing the price of Apple stock even as its earnings slow.


    There is also the possibility, as Andy Zaky points out, of a "floor" being established beneath the P/E ratio as it becomes more and more obvious that it's too low. Being on fixed income myself, I can only hope that does indeed happen, and the sooner the better....
    25 Jan 2012, 06:02 PM Reply Like
  • Riverrun
    , contributor
    Comments (263) | Send Message
    Good article and comment...WS is like all of us, they just hate to admit they were wrong. I think Zaky and others are correct. The floor or foundation is being built under the stock. The greatest portion of the building will soon appear. I am a little long in the tooth, so a little gravy
    sooner would be nice....but....
    9 Mar 2012, 07:10 PM Reply Like
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