Is Apple Ready to Explode or Implode?

| About: Apple Inc. (AAPL)
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Recently, Clem Chambers on CNBC stated that Apple (AAPL) was overpriced and should be trading closer to $200 a share than $360 a share. I don't think either price for a share of Apple is appropriate. I will make a case for Apple stock being undervalued by the stock market. Just remember, no matter how good a stock is, never fall in love with it and always diversify your investments.

For the last 14 years, since Steve Jobs re-assumed the helm at Apple, he and his team have turned Apple into the premier large cap growth stock performer. Microsoft (NASDAQ:MSFT), the old number one, hit its high on December 1, 1999, and is currently nowhere near it today.

Has Apple seen better days? A Schwab quote on Apple shows a price earnings ratio of 20.07 times earnings and 15.74 times future earnings. Microsoft, in its prime, traded over 70 times earnings when it was a large growth company in the late 1990's. Of course, its leader, Bill Gates, was not facing the health issues that Steve Jobs is currently facing (at least, we assume he is). There was also a technology and internet bubble in stocks, which undoubtedly contributed to Microsoft's high price earnings ratio.

But is Apple only worth 20 times trailing earnings and 15.74 times future earnings? According to Schwab's valuation summary tab, it far exceeds its peers in all investment metrics except one - price earnings ratio. You can get the premier growth company for a mere pittance, because everyone is fearful, and its price is $360 a share. I smell opportunity here.

Now we need to compare Apple with some other companies and their current price earnings ratios and see which we would prefer to own:

Company Name Symbol Stock Price Current P/E Future P/E Total 3yrs Earnings Growth Percentage Stock %
Price Appr 3yrs
Apple (NASDAQ:AAPL) 360 20.07 15.74 285 172
Microsoft (MSFT) 26 11.2 10.28 49 -5
Dell (DELL) 16 11.65 9.22 12 30
Intel (NASDAQ:INTC) 23 10.84 10.5 60 5
eBay (NASDAQ:EBAY) 32 24.21 16.57 92 -16
Amazon (NASDAQ:AMZN) 172 67.85 49.97 125 155
Exxon Mobil (NYSE:XOM) 85 13.65 11.87 -14 -1
Google (NASDAQ:GOOG) 601 22.83 17.4 98 30
McDonald's (NYSE:MCD) 76 16.6 15.15 59 39
HP (NYSE:HPQ) 43 10.9 8.12 4 -11

The earnings growth rate is for the 3 years ending with the 2010 corporate year end. The stock appreciation period is from February 28, 2008 to February 28, 2011. The earnings growth rate is calculated from Schwab's normalized diluted earnings per share. Stock prices, current P/E and future P/E are from the Schwab quotation system as of the close of business March 4, 2011.

There are some really interesting things to be learned from this table. First of all, Apple is far and away the fastest growing company. However, Amazon has the highest price earnings ratio, a little over 3 times Apple's; yet Apple has grown over twice as fast as Amazon. That is amazing and is contrary to everything I have learned about the pricing of a stock. Google is growing at about 1/3 of Apple, yet its P/E is slightly higher. Also, eBay is growing only about 1/3 of Apple, but its P/E ratio is 30% higher than Apple's.

This means that the Steve Jobs' health penalty, Apple's $360 per share price, and/or Android's smartphone competition has resulted in this stock being undervalued by the stock market. Based on Apple's, eBay's and Amazon's P/E ratios, Apple has been discounted at least 20 to 47 times its current earnings. Either that or Google, eBay, and especially Amazon are overvalued.

Amazon is growing at a somewhat similar rate as Microsoft was in the late 1990s and early 2000s, considering the recession we are coming out of. If you compare the two, the value is somewhat similar. Everything being equal, Amazon may be moderately overpriced but not completely out of reality. If a company is increasing earnings at 40%, it should be trading at 40 times earnings. It is exceedingly hard to determine if the growth will continue many years into the future. If it does not continue to grow at 40%, then the stock of any company would be overpriced and its P/E ratio should be lower.

However, there are a lot of other things that go into determining the P/E ratio, as we are learning with Apple's pricing. If you consider Google's and eBay's prices, they appear undervalued in relation to Amazon and overvalued in relation to Apple. In Google's case, this could be caused by competition with Apple and Microsoft.

The market is telling us that Apple is going to go down like Microsoft has this past decade, while for the next few years, Amazon is going to grow as fast or faster than it has in the last few years, and that eBay is going to continue growing close to its present rate. The market is also telling us Google is going to under perform the market, but not near what Apple is going to under perform it by. But is the market correct in Apple's case?

Let us examine the reality. The three major drivers of Apple's growth are the following:

  1. iPhone
  2. iPad
  3. The associated services - apps, advertising, iTunes, books and other.

Smartphone sales are supposed to increase dramatically for the next 2 to 4 years, and Apple is poised to keep - or even increase - its share in this lucrative market. The iPhone is almost always sold with service agreements from AT&T (NYSE:T) and Verizon (NYSE:VZ) in the US, and many other providers internationally. At the end of the service agreement, you are eligible to continue with your current phone or get a new phone at a discounted price with a new 2 year service agreement. This new 2 year contract change usually results in new phones being purchased. A significant number of iPhone users may hate AT&T's service, but, for the most part, they love the iPhone. They may change providers, but will purchase new iPhones on a different network.

Also, the iPhone still isn't sold by all the major cellular providers in the US or the world, which gives the iPhone an untapped market for users who can't or won't switch cellular companies. The cell phone providers are also changing over to 4G service, which is going to further encourage people to purchase new iPhones, particularly if it is used primarily for business. So, no matter what happens in the next 2 to 4 years, iPhone sales should increase. The product cycle of the iPhone and the iPod are going to be completely different.

The iPad, in my opinion, will have a significant share of the fast growing tablet market for some time. Being the first tablet on the market, it will take some time for competitors to catch up. Apple's customers are fiercely loyal to all new Apple products. Apple has also been able to generate interest in the iPad through its very popular app store. The app store has now sold over 10 billion apps. Most will run on the iPhone, iPod Touch and the iPad, making the iPad a natural choice for people already using other Apple products. In addition, Apple is penetrating the education and business markets with all of its products, especially the iPad.

The associated services are growing very fast and will continue to do so for at least the next 4 to 7 years, even if the sales of the other products do decline slightly after the next 4 to 5 years. Apple's basic computer business is continuing to take market share because of its new products, which should continue into the future.

I read an article and saw a picture of a massive server farm that Apple built in North Carolina. It is four times bigger than Apple's current California one, which is very large. This building is 500,000 square feet. It was finished before the year end, but there is no information on it from Apple. Now, we all know that Steve Jobs is out of the office because of his health, or do we really? Apple never gave a reason for Jobs being gone. From what I can gather from news articles, he is working on this project with his team - integrating a TV service content deal, a cloud service, social network site, search service site, new iTunes website, and maybe a few other new things. There also appear to be new products in their pipeline, such as iPhones with 4G, possibly a new iPad mini, a new lower cost iPhone and the current products - all with 4G instead of 3G. When all these new products will debut is anyone's guess. Some, if not all, of these products and associated services should be ready for the Apple development conference in May.

This could have major effects on RIM (RIMM), Facebook, Netflix (NASDAQ:NFLX), Microsoft, Google, and some other major technology companies. I know one thing: I would not like to be competing with this company head on. Just ask Dell and HP. The only way Google has been able to compete is by giving away their software, and good old Microsoft has seen its market share in smartphones collapse, and they are not even in the tablet market. So far, Apple is thriving.

Back to the man on CNBC; he is right. At some time Apple will be a stock trading around 10 times earnings just like Microsoft, Dell, Exxon Mobil, and HP. It is just not happening at this time or, at the very least, for the next 3 to 5 years, unless you think there will be a far worse recession than we've been through - or a depression. I do not think Apple will implode.

I was watching Jim Cramer when he put a 400 dollar price target on Apple. He also did one other interesting thing; he adjusted the price earnings ratio for the cash and investments on Apple's balance sheet on December 31, 2010. The math works like this: take the stock price minus cash and investments per share, 360 - 56, which equals 304. Then you figure your current price earnings and future price earnings ratios, which are 17.24 and 13.51, respectively. This makes Apple an even better bargain. Of course, you would need to do this with all the other companies listed in my table, but none have anywhere near this much cash and investments per share. Although, some of the other ones do pay a nice dividend, which Apple doesn't.

I have been investing in the stock market for over 49 years, since I was 14 years old, and I have reviewed over 5,000 individual companies in Europe, Asia, Canada, Mexico, South America and, of course, the US. Never during this time have I seen a more undervalued stock of this size, quality and growth rate. I need to ask myself, would I rather own Amazon at 67 times earnings, or eBay at 24 times earnings, or Apple at 20 times earnings? Well, for me, it is Apple without question. This seems like a very low price earnings ratio for a company of Apple's quality and growth rate. If anything, I wouldn't be surprised if they actually pick up momentum with the economy improving and the product cycle they are in at the present time.

Warren Buffett, Wilbur Ross and all you hedge fund operators, what are you waiting for? This is a prime growth company at a once in a lifetime value. The essence of investing is buying at a good price and selling a stock when it is fully valued. Opportunity is waiting; you only need the guts and drive to purchase this stock. Having said all that, there could be a stock market pull back coming, but if not, this thing may explode and your opportunity may be gone.

Disclosure: I am long AAPL, GOOG.

Additional disclosure: I may buy or sell at any time some or all of these companies shares mentioned in this article based on world events or specific news about the company. Also remember that you should not fall in love with any stock and you need to diversify you portfolio. Not all stocks are appropriate for all individuals and you should consult your advisers and brokers before purchasing any stocks for a second or third opinion regarding these stocks.