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It's Tough To Make A Bearish Case Against Apple

|Includes: Apple Inc. (AAPL)

Summary

Apple's valuation ratios compare favorably to ten other large cap technology companies.

Apple's PEG Ratio is considerably better than its peers and offers a lot of upside to at least $180.

A reasonable bearish case for Apple would see a downside of only 5% to 10%.

Apple Inc. (NASDAQ:AAPL) is probably the most talked about stock in the investment community. Within those conversations I have heard a lot of negative sentiment about the company and the stock but the arguments seem to be very qualitative. In this article I will take a quantitative approach to see how realistic and profitable bearish expectations are for Apple relative to its peer group.

Below is a chart comparing AAPL to ten large caps that can be broadly categorized as technology stocks. The final column is a simple average between these ten companies, excluding Apple, which I will use as a basis for comparison to it.

Source: Yahoo Finance

Apple generally compares favorably in P/E and EV/EBITDA to Alibaba, Cisco, Facebook, Google, Hewlett-Packard, IBM, Intel, Microsoft, Oracle and Qualcomm when considering stock prices at market close on February 13, 2015. Using forward P/E and EV/EBITDA as a basis, you could reasonably expect AAPL to increase around 15% just to align to the average of its peers. But the metric where Apple really stands out is the PEG Ratio. The PEG Ratio takes the P/E and divides it by the 5-year expected growth rate of a stock's EPS. It's a valuation equalizer between high-growth and low-growth stocks and an easy way to illustrate how stocks like Alibaba and Facebook can trade at P/E ratios of around 30 while IBM trades at less than 10.

Apple's PEG Ratio is just 1.16, leading the group of eleven and well under the average PEG Ratio of the other ten at 1.67. Applying a 1.67 PEG Ratio to Apple would imply an increase of 44% to the stock price, or $182.

What does a PEG Ratio of 1.16 mean? It's easy to take a number from Yahoo Finance and compare it to other stocks to make a simple conclusion, but investors should be aware of what a 1.16 PEG Ratio implies so they can judge for themselves how realistic this expectation is for the company. The chart below illustrates what Apple's growth trend could look like based on analyst expectations mixed in with my own calculations.

At a stock price of $127.08, the P/E ratio for 2015 will be 14.81 if the analyst EPS expectation is met at $8.58. The 5-year annual EPS growth rate is expected to be 12.76%. Dividing 14.81 by 12.76 results in the 1.16 PEG Ratio. The EPS expectation for 2016 is $9.16, which is only a 6.76% growth rate so analysts expect next year to be an off-year for the company despite the 12.76% average annual growth rate from 2016 to 2020.

2020's EPS figure can be calculated with the analyst expectations as follows:

2020 EPS = 2015 EPS x (1+growth rate) ^ number of years

$8.58 x (1.1276)^5 = $15.64

EPS figures for 2017 through 2019 and 2021 are my estimates that would fit within the context of these analyst estimates. In order to hit a $15.64 EPS, Apple's EPS needs to grow around 13-15% every year after 2016. Investors need to assess if they think such a target is achievable. If so, then they should be confident in holding the stock to at least $180.

Note that for 2016 the PEG Ratio drops to 0.98 assuming a static stock price. The 5-year growth rate is for 2017 to 2021 as the weak growth year of 6.76% drops off. I assumed that the growth rate from 2020 to 2021 remains relatively flat to previous years at 13.48%. That results in a 5-year annual growth rate of 14.15%. Dividing the 13.87 P/E by 14.15 leads to the 0.98 PEG Ratio.

If AAPL was to reach $180 by 2016, the PEG Ratio would be 1.39. The stock would have another 20% room to grow before hitting the PEG Ratio of 1.67 to come in line with Apple's peers.

The bearish case scenario for Apple based on fundamentals

The bearish case for Apple is based off the threat that the company will get complacent, particularly for the iPhone. Smartphone margins will decline, Apple will lose market share or the replacement purchase cycle will slow as wireless companies have been moving away from subsidy models to handset financing models. Fair enough, one could argue that expectations of a 13-15% growth rate every year for a company as large as Apple is going to be a challenge to maintain. Here is the same chart as above, with the expected 5-year growth rate at 8%.

To put it in perspective, Microsoft's 5-year EPS growth estimate is 8.37% so 8% can be seen as a pretty standard growth expectation for a large consumer technology company. To assume that Apple will grow much slower than that is assuming that a company with a history of innovation, a strong market presence and a large loyal brand following really messes things up.

An 8% EPS growth rate expectation for 2016 to 2020 leads to a 1.85 PEG Ratio. Comparing that to the 1.67 average of Apple's peers, that would imply the company is 10% overvalued. A 7.82% EPS growth rate expectation for 2017 to 2021 leads to a 1.77 PEG Ratio, 6% overvalued to its peers.

A bullish view of a 12.76% 5-year annual growth rate (that's in line with analyst expectations) points to an upside of 44% this year and an additional 20% next year. A more bearish view of 8% (in line with expectations for Microsoft) points to a downside of 10% this year, with about half of that downside eroding in 2016. Fundamental valuation of Apple points to far more upside than downside.

Shorting Apple offers inferior profit potential compared to the risk assumed

Shorting Apple does not provide a good risk-to-reward investment profile based on the numbers above. The best reason to short Apple in the near-term is if you think the entire market is going to go down. Since Apple makes up such a large component of the market and can be seen as a bellwether stock, any decline in it is going to lead to the market falling as well. I believe it's a better risk trade-off to go long inverse-market ETFs or buy puts on market-tracking ETFs than to short Apple.

Since Apple is so large, it could underperform a highly bullish market that rewards small caps that have underperformed large caps for years as they finally catch up. But that doesn't help someone who is shorting Apple. They still lose. And based on the analysis above, there is plenty of reason to expect that Apple could outperform a bull market. In a bear market, Apple will almost certainly outperform the market (lose less) because of its strong cash position and low valuation multiples. So if an investor is bearish on the market, they will probably make more money betting against the market at large than on Apple individually.

Conclusion

I am not an Apple investor nor am I a big consumer of the company's products (the only Apple devices I've ever had I got for free). With my investing capital limited to my own personal portfolio and being fairly young, I prefer to focus on more aggressive small cap tech stocks with high upside. If I was managing a multi-million dollar fund with a focus on technology stocks, I would definitely invest a portion of that fund into Apple.

I don't believe this is a good time for anyone to bet against AAPL as the fundamentals for a short don't start to make sense until it hits at least $180. I wish the stock continues to do well because I believe its success will create a safety net on the market for which bullish positions on smaller tech stocks will benefit. Actually, I don't need to wish anything - my analysis on the stock leads me to believe that it will do just fine in the foreseeable future.

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

Additional disclosure: I have not received any compensation for this article and all opinions reflected herein are my own. The information provided herein is strictly for informational purposes only and should not be construed as a recommendation to buy or sell, or as a solicitation of an offer to buy or sell any securities. There is no guarantee that any estimate, forecast or forward looking statement presented herein will materialize and actual results may vary. Investors are encouraged to do their own research and due diligence before making any investment decision with respect to any securities discussed herein, including, but not limited to, the suitability of any transaction to their risk tolerance and investment objectives.