Apple: P/E Debate Rages, But Sales Growth Will Fuel Next Rally

| About: Apple Inc. (AAPL)
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Over the past number of weeks and months, there has been a wide range of opinions about the valuation and future movement of Apple (NASDAQ:AAPL). Especially on this site, we've gone from one extreme to another, from authors claiming that Apple is the most undervalued large cap stock in America, to others saying the bubble will burst and it's worth less than $100. Now, we need these opinions to have an "efficient stock market". We need buyers and sellers. But sometimes, the debate gets so crazy, we lose track of what's really important.

When I've covered Apple recently, I've mentioned and used P/E numbers to analyze the company. Mostly, I've used them for my price targets going forward, and also suggested to use P/E levels as good entry points (10, 11, etc.). Now, I'm not going to argue here that earnings are not important for Apple. They are. But we've gotten to the point of where the P/E debate is head-scratching. Is it too low, is it too high? Who knows. It is what it is. So today, I'm going to focus on a different angle. Apple's sales, and a few reasons why they may be the true determining factor in Apple's next major rally.

1. Over the last six years, Apple's stock growth mirrors sales growth, not earnings growth:

Do you think it all comes down to earnings? You'd be surprised that it doesn't. Let's take a look at some Apple numbers going back to 2005. Numbers are in billions, except stock price.

2005 2006 2007 2008 2009 2010 2011
Sales $13.93 $19.32 $24.01 $32.48 $36.54 $65.23 $108.25
Earnings $1.33 $1.99 $3.50 $4.83 $5.70 $14.01 $25.92
Price $53.20 $76.98 $153.47 $128.24 $182.37 $292.32 $404.30

Apple has done a great job over the last seven years of growing its sales, earnings, and stock price. Everyone wishes they could have bought as much Apple as possible at $53 in 2005, or even at $128 in 2008. But here's the main point, let's look at what this growth looks like in percentage terms.

Growth 2006 2007 2008 2009 2010 2011 Total
Sales 38.65% 24.29% 35.30% 12.49% 78.52% 65.96% 677%
Earnings 49.77% 75.77% 38.27% 18.00% 145.67% 84.99% 1852%
Price 44.70% 99.36% -16.44% 42.21% 60.29% 38.31% 660%

Over time, Apple's sales growth is a lot closer to stock price growth than earnings growth. Now, if you want to question that time period, I'll look at these numbers since the end of the 2008 fiscal year. Over the past three years, Apple has seen its sales rise 233%, its earnings rise 436%, and its stock price rise 215%. Since Apple has matured into one of the largest companies over the past five or so years, you'll see that sales growth has driven stock price, not earnings growth.

So what does this mean going forward? Well, let's assume that Apple's stock price rises as much as sales do. I know that the numbers aren't 100% matching above, but sales is closer than earnings. Let's assume that Apple currently grows sales as expected: 28.5% in fiscal year 2012, and 15% in fiscal year 2013. That gives us the following numbers below. Average is the average closing price of the stock during that fiscal year, and end is the closing price on the last day of Apple's fiscal year. If Apple's stock grows equal to sales, we'll see about $520 by the end of September 2012, and $600 by that time in 2013. That's quite a lot of growth ahead, if shares keep up with sales growth.

2008 2009 2010 2011 2012 2013
Sales 32.48 36.54 65.23 108.25 139.12 160.04
Average $163.57 $119.96 $229.39 $341.94 $439.39 $505.30
End $128.24 $182.37 $292.32 $404.30 $519.53 $597.45

2. Earnings aren't what they used to be, and EPS numbers can easily be manipulated:

Everyone says that it is all about earnings. To an extent, they are right, but you have to be careful when you talk about earnings. Do you mean actual earnings, as in the dollar amount earned, so in Apple's case in billions, or the earnings per share of stock? There's a big difference here.

In Apple's case, earnings aren't what they used to be. On a dollar amount, Apple is earning much more than it did in the past. Apple had net income of $3.5 billion in 2007 (fiscal year), while in 2011 it posted profits of nearly $26 billion. But all earnings are not created equal. Apple right now is not buying back stock, while several other large tech companies such as Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO) and Intel (NASDAQ:INTC) are. What is the point? Share count. Over the past four years, Apple's outstanding share count has risen from about 872 million to 929 million, a growth of more than 6.5%. That means a dollar of earnings isn't what it used to be.

In fact, let's look at Apple versus those three above mentioned names. In 2007, a billion dollars of profit meant nearly $1.15 in earnings per share. Today, that number is under $1.08. Every dollar of profit for Apple is earning less per share each quarter, as the share count rises due to stock options and other factors. Looking at the table below, you can see how over the past four years, a billion dollars of profit has changed for these four names. These four names are buying back stock and actively reducing share counts, so their profits mean more per share now. Apple's mean 6% less.

9/29/2007 $1.146 $0.107 $0.164 $0.171
9/24/2011 $1.076 $0.119 $0.186 $0.195
Change -6.13% 11.24% 13.24% 14.05%

Now, until Apple starts buying back stock, the outstanding share count will grow by the quarter. As a matter of fact, if you use the compound annual growth rate over the past five years, Apple has probably added about 2 million more shares this quarter already. If the rate continues at past levels, Apple could have over a billion shares outstanding by 2015 or 2016. That's 60 million more than currently outstanding, and that means that each dollar of profit means less.

What does this have to do with my point about sales growth? Well, everyone is clamoring about P/E multiples here and there, that x number is too low. Well, one of the two components of the P/E multiple is earnings per share. That number can be manipulated by Apple. If Apple decides to start buying back shares, either to maintain the share count from growing any further, or to start reducing it, EPS will either increase over time or just not decrease. The value of that billion will stay the same, or be greater, as others are doing.

A buyback can easily change the earnings per share number, making the P/E argument change with it. If a buyback increases earnings per share faster than the share price can rise, that trailing P/E of 14 and forward P/E of 10 could fall further.

Conclusion: When looking at Apple, focus on the sales.

I hope that I've made my point clear by now. Earnings do matter, but earnings per share is a number that can be toyed with. You don't have that flexibility with sales figures. I'll leave you with one more table to prove my point. The following shows Apple's price to sales and price to earnings ratios over the past three fiscal years. The average number is based on the average daily closing price during the year, and the end number is based on the closing price on the last day of the fiscal year. You'll notice that the average price to sales number barely moves in comparison to the average price to earnings ratio. The ending price to sales ratio moves more than the average, which is expected since it's based on just one point, but even then, it moves much less than its price to earnings counterpoint.

P/S 2009 2010 2011
Average 2.93 3.20 2.92
End 4.49 4.11 3.47
P/E 2009 2010 2011
Average 18.78 14.89 12.19
End 28.77 19.11 14.49

Currently, Apple is trading at 2.61 times fiscal 2012 sales and 11.29 times fiscal 2012 earnings. Both of those numbers are a bit below the above numbers. So while everyone out there continues to fight over whether or not Apple's P/E is too high, too low, or whatever, maybe we should start looking at sales growth to determine where the stock is going.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.