Sell Apple And Buy Alphabet Lookback: Why Valuation Matters

Feb. 15, 2021 9:57 PM ETApple Inc. (AAPL), GOOG, GOOGL400 Comments
Ray Merola profile picture
Ray Merola
13.52K Followers

Summary

  • Last August, I advocated selling Apple and buying Alphabet.  The thesis was based upon the underlying comparative valuation story.
  • Six months later, since touching $500, AAPL investors gained 8.6 percent. Buying GOOGL at $1503 yielded a 39 percent return.
  • It's a tale of two tremendous U.S. companies; within their respective industries, probably the best in show.
  • But the best in show doesn't mean the stock is a buy at any price.

About six months ago, Seeking Alpha editors published an article I wrote entitled, “Sell Apple and Buy Alphabet.” It generated considerable reader interest.

This is a follow-up article.

Background

In mid-August 2020, I scaled out of Apple (NASDAQ:AAPL) stock and used the proceeds to purchase Alphabet (NASDAQ:GOOGL)(NASDAQ:GOOG).

I closed the Apple position at $500 a share, or the equivalent of $125 post 4-for-1 split.

I believed $500 a share was just too rich for the stock. To be fair, I also sold some Apple shares in June, at lower prices. But the premise of the article was Apple Inc. at $500 a share was just too rich. The underlying fundamentals didn't support it. So I pulled the plug on a position first opened in 2010. The stock was held in a tax-deferred account.

Meanwhile, I took the AAPL proceeds and doubled my position in Alphabet.

I purchased shares between the middle of August and the first few days of October. The average bid price on the incremental position was $1503.

Subsequent Price Action

Now I will be the first to tell you six months doesn't prove a thesis definitively. As an investor (versus a trader or speculator), I generally hold a stock for at least 18 months. Through experience, I've found this to be the minimum amount of time I like to hold a stock in order to give an original investment thesis the "chance to be right.” Exceptions are cases whereby the original investment thesis is busted. If that happens, I don't wait and hope for things to change. I get out. Alternatively, if a stock runs up much too far, too fast, I may also exit a position early.

Nonetheless, the six-month return delta between AAPL and GOOGL is so stark it seems a reasonable call out.

Since I sold the balance of my AAPL stock, the price improved from split-adjusted $124.99 to $135.40. That's an 8.3% increase in six months. Including two dividend payments, the total return would have been 8.6 percent. That's not bad.

On the other hand, GOOGL shares moved from $1503 (my aggregate purchase price) to $2095. That's a 39% gain.

The upshot isn't to point out making a good six-month call. It's to evaluate the decision-making process behind the call, then plot a path forward.

Apple Shares Were Dear And Remain Dear

In August 2020, my contention was AAPL prices got way ahead of the fundamentals.

At the time, fiscal year 3Q 2020 (period ending June 30) corporate cash flow was up sharply. Apple Services revenue and margins were advancing nicely, but Apple Products margins were sagging. The Street forecast $15.02 ($3.76 split-adjusted) EPS for 2020 fiscal year, and $18.09 ($4.52 split-adjusted) operating cash flow per share.

Shares were trading at over 35x earnings, and 26x cash flow.

Now, with the benefit of two additional quarters behind us, we find the full-year EPS came in at $3.26 and cash flow at $4.60 per share: earnings results were light, and cash flow recorded a modest beat.

Adding in an additional set of quarterly results (for the period ending 12/31/20), shares now trade at 37x trailing earnings, and 27x cash flow.

The long-term P/E and P/OCF multiples have been ~16x and 12x, respectively.

Therefore, while registering an 8.6% total return since mid-August, AAPL shares now appear even MORE overvalued than before.

Two F.A.S.T. Graphs illustrate the foregoing:

For a good growth stock, it's customary to look at forward EPS. Based upon current Street estimates, Apple Inc. is trading at 30x this years' EPS, and 25x cash flow. These multiples are still far above the long-term average.

Note I selected charts whereby the actual long-term growth rates approximate the current expected two-year forward growth rates.

Alphabet Stock Is No Longer A Bargain

Meanwhile, back in August 2020, analysts were setting up Alphabet investors for an off year. The COVID-related economic slowdown certainly affected the business: primarily Google advertising revenue.

Alphabet met or exceeded 2Q and first-half 2020 numbers; however, revenue, margins, and operating income were contracting.

Back in August, analysts called for full-year (ending December 31) EPS and cash flow per share to be $44.61 and $78.02, respectively. The Street expected declining year-over-year figures.

GOOGL shares were trading at 33x EPS, and under 20x operating cash flow. The long-term trimmed averages were 28x and 22x. The earnings multiple indicated approximate Fair Value, while the shares were inexpensive on cash flow.

So what happened?

Indeed, Alphabet's numbers rebounded faster than expected. The Street underestimated the snap-back.

But the real story was valuation.

GOOGL posted full-year EPS and cash flow per share figures of $58.61 and $88.82, thereby stomping Street consensus.

Currently, Alphabet shares now trade at 36x trailing earnings and 24x cash flow.

Long-term P/E and P/OCF multiples are 26x and 19x, respectively.

Another pair of F.A.S.T. Graphs paint the picture:

On a forward basis, GOOGL is trading at 30x EPS and 18x operating cash flow.

Indeed, after the big run-up, Alphabet stock has gone from fairly valued / inexpensive to fairly valued / moderately overvalued.

Summing It Up

Here's a recap summary table comparing Apple and Alphabet valuation metrics today versus August 2020:

Apple versus Alphabet Valuation Summary

Apple (Feb '21)

Apple (August '20)

Alphabet (Feb '21)

Alphabet (August '20)

Blended P/E

36.5x

35.6x

35.0x

32.8x

Historical P/E*

16x

15x

26x

28x

Blended P/OCF

28x

25.9x

22.8x

19.6x

Historical P/OCF*

12x

11x

19x

22x

Projected EPS growth FY 2021

35%

19%

19%

27%

Projected EPS growth FY 2022

5%

7%

15%

21%

Projected OCF growth FY 2021

19%

8%

27%

21%

Projected OCF FY 2022

2%

1%

17%

20%

AAPL stock was heavily overvalued in August 2020. Based upon trailing twelve-month multiples, the shares remain overvalued today. Looking ahead, the most recent 2021 earnings and cash flow growth forecasts have risen significantly, while 2022 estimates remained about the same. On a forward basis, AAPL stock trades at 30x EPS and 25x cash flow. That's still far above historical averages.

GOOGL stock was undervalued on cash flow in August 2020. It's a mixed bag now; Alphabet isn't in the bargain bin. Based upon TTM multiples, shares are trading above Fair Value today. Looking ahead, 2021 and 2022 EPS estimates have fallen since August. The 2021 cash flow forecast is higher, and the 2022 forecast is a bit lower. To be fair, I believe current EPS forecasts have decreased due to the company crushing estimates over the past two quarters. Based upon 2021 estimates, GOOGL stock is trading at 30x earnings and 18x operating cash flow. That's a little high on EPS, and about on par for OCF.

What's actionable now?

Investors make forward decisions upon where a company's earnings and cash flow are going; not where they've been. We've already looked at forward P/E and P/CF. Now, let's look at PEG ratios. When evaluating a growth stock, the PEG ratio is often one of the most helpful signals. It's determined by taking the current P/E and dividing it by the forward growth rate. When determining the forward growth rate, I like to look out two years. While some PEG ratios look up to five years out, I believe this is too speculative. The Street has a hard enough time forecasting EPS just two years out. Five years out? It's just a guesstimate.

A PEG under 1.0x indicates good value. If the PEG is between 1.0x and 2.0x, it suggests fair value. When the PEG is greater than 2.0x, a stock may be considered overvalued.

Currently, the Street marks Apple's two-year EPS growth forecast at 19 percent per annum. Therefore, the PEG2 ratio is 1.9x. That's no bargain.

Over the next two years, Alphabet is projected to grow earnings by 17 percent a year. The PEG2 ratio is 2.0x. That's not a bargain, either.

Based upon my knowledge of the business, I place more emphasis upon Alphabet's ability to generate operating cash than net income; however, that's still not enough to get me overly excited about buying GOOGL stock at $2095 a share.

The Bottom Line

With the benefit of hindsight, moving money out of Apple and into Alphabet stock turned out well. Over the past six months, Apple stock advanced 8.6% while Alphabet broke out with a 39% gain. Back in August 2020, the decision to sell one and buy the other was based upon valuation and probabilities. These two companies are two of the best-run businesses on the planet. AAPL and GOOGL are great stocks to own: but not at any price. Valuation matters.

Apple Inc.'s shares are still too rich for me. I'm not excited unless AAPL drops to less than $84. Today, it's not in the right zip code.

Alphabet was a solid buyback in late summer 2020. Analysts were fretting about COVID-19 ad contraction; even if correct, the phenomenon was likely to be transient versus terminal. The stock appeared to offer far better value than Apple. Nonetheless, after a big runup, GOOGL isn't a bargain pick. After a six-month 39% run, it's time to take a little off the table, wait for lower prices, then seek to repurchase the shares. I lopped an eighth of my position off at $2090, and plan to sell another eighth if the stock breaks $2100. GOOGL starts looking attractive again ~$1700 a share.

Please do your own careful due diligence before making any investment decision. This article isn't a recommendation to buy or sell any stock. Good luck with all your 2021 investments.

This article was written by

Ray Merola profile picture
13.52K Followers
Individual investor focused upon a limited number of diversified stocks. Seeks stocks selling below fair value estimates; favors dividend growth and/or income. Advocates fundamental investment analysis, supplemented by the technical charts. Options strategies primarily employed to generate additional income or hedge risk. If interested, you may find out more about my investment philosophy in the I.S.S. (Investment Strategy Statement) found in my listing of published articles.

Disclosure: I am/we are long GOOGL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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