Apple $400: A look at Apple's fundamentals, Part II
In Part I of this series, AppleInsider contributor and independent analyst Andy M. Zaky discussed the general risks of using valuation as a basis for placing short or intermediate price targets on Apple (AAPL), and how having a long-term viewpoint is the only appropriate way to rely on fundamentals for investment decisions.
That the day-to-day fluctuations in Apple?s stock price are more determined by the larger concerns of the broader market than they are with the company?s strong fundamentals. So keeping these concerns in mind, what investors want to know is: what is Apple worth and is the company currently undervalued? The short answer - Apple is definitely undervalued, and it should be trading at around $400 come 2012.
Traditional Valuation Metrics: Trailing & Forward P/E Ratios
The very first thing investors learn about fundamental analysis is that stocks are generally valued on a price-to-earnings ratio, and that a stock?s growth rate is what determines the multiple it receives in the analysis. For example, on a traditional trailing 12-month P/E valuation analysis where one multiplies Apple?s $15 in EPS by its 70% growth rate, Apple ?should be? worth about $1,050 a share on a trailing basis come this October.
Yet, as anyone who takes valuation seriously knows, stocks are seldom valued on their trailing P/E ratio. Instead, the market tends to value stocks based on their future expected earnings and long-term expected growth rate. In other words, key to the equation is what will Apple earn over the next 12-months, and what is expected out of the company in terms of growth over the next 5 years. Cash also plays a very important role in the analysis, but not in the way one would expect. We?ll get to cash in a moment.
So setting aside the issue of Apple?s enormous cash position, Wall Street analysts are generally modeling for Apple to earn $14.43 in EPS for fiscal 2010 and approximately $17.47 for fiscal 2011 ? that?s about 21% earnings growth. Moreover, when looking at what is expected out of the company over the next 5-years, analysts are modeling for about 18% earnings growth. Thus, based on these conservative variables, Apple should be currently trading at about 18 times next year?s earnings of $17.47 in EPS or about $314.46 a share. That?s about $54.46 above Friday?s close.
Looking at the future trailing P/E to beat Wall Street
Yet, simply analyzing Apple?s (AAPL) forward P/E ratio doesn?t really tell anyone what the company ought to be worth in the future. It only tells us whether the stock is currently undervalued, and what it ought to be trading at today. To get an idea of what the company will be trading at in the future, it is vital to ascertain not only what type of trailing P/E the market is likely to give Apple in late 2011 or early 2012, but what the company will actually report in earnings. This is precisely where investors can beat Wall Street at their own game, and sums up the value offered by independent analysts who consistently outperform Wall Street in forecasting Apple?s earnings.
If there is one thing that readers should take away from this article it?s that you should never fight Wall Street?s valuation metrics. Instead of relying on some alternative way to valuate the company to determine future price targets, embrace the market?s valuation but beat it on the earnings front. For while the market might continue to give Apple an 18 to 20 trailing p/e ratio well into the future despite Apple?s enormous cash holdings and robust 50-70% growth rate, the one thing that is not determined by the market is the earnings variable of the P/E ratio.
For example, let?s suppose that Apple continues to trade at a 19 to 20 trailing P/E come October 2011. Right now Wall Street analysts are modeling for Apple to earn roughly $17.50 in EPS. At that earnings level, Apple would be trading between $332 and $350 assuming a 19 or 20 multiple. Yet, nearly every independent analyst knows Apple will probably earn about $20 in EPS in 2011.
This is where investors can beat the street in forecasting a more realistic and achievable price target. Based on $20 in EPS for fiscal 2011, Apple should be trading between $380 and $400 in late 2011 early 2012 assuming a 20 multiple. This price-target beats the street by nearly $70 in share value, is based exclusively on the market?s current valuation of the stock, and presents a conservative, simple, and straight-forward analysis of Apple?s valuation.
Basing Price Targets on Wall Street Valuation Metrics not on P/E(x-cash)
Yet, if I ended the analysis right here, I would get no less than 40 messages in my inbox by disgruntled investors explaining to me that it?s irresponsible to valuate Apple on a retroactive trailing P/E basis without backing out Apple?s cash from the analysis.
For example, my 2011 model calls for Apple to generate roughly $18 billion in cash in addition to the $45.8 billion already stockpiled in the company?s coffers. That is a total $63.8 billion or 39.3% growth in cash over the coming year. If one were to back out this cash from Apple?s expected (2011) market capitalization of $376.4 billion, Apple would be trading at a trailing P/E(x-cash) of only 16.6.
Some would even go so far as to argue that Apple should be assigned a 25 P/E(x-cash) in order to conform with a more realistic 5-year growth rate; and that based on an expected $20 in earnings, it should thus be trading at $600 a share on a 30 multiple.
Yet, it?s very unrealistic to assume that the market will suddenly wise up to Apple?s (AAPL) enormous cash position and higher growth rate, and give it a 30 trailing p/e when Wall Street expects Apple to report a mere 18% earnings growth over the next 5 years. For while some might argue that its unreasonable to suggest that Apple will grow at such a meager pace, the market is not so easily convinced. Even if Apple demonstrates that it will far exceed the 18% growth expected over the next 5-years, it will do very little to alter the market?s foregone conclusion to the contrary.
There seems to be this underlying notion with investors that there will be some glorious day deep in the future when Wall Street eventually gives Apple a valuation that is perfect in every regard, and which contemplates the full potential and thrust of Apple?s business model. Theoretically, Apple should have traded at a 50 P/E over the past 5 years, but has only seen that valuation level for only a few moments.
Research in Motion (RIMM) is a fundamental powerhouse growing at astonishing rates, but the market continues to hold the belief that iPhone and Android are going to destroy the Blackberry despite repetitive evidence to the contrary. Research in motion has repeatedly demonstrated its ability to keep up with the competition in the smart phone industry, but the market refuses to give the stock a P/E ratio higher than 10. Altering the market?s perception is no easy task.
Furthermore, the historical record indicates that Apple will likely see an 18 to 22 P/E well into the future. Horace Dediu, a rising star among the independent analyst community, recently published a chart comparing Apple?s stock price, trailing P/E ratio and trailing P/E ratio (x-cash), which I find to be essential in determining the long-term direction and valuation of stock.
From a brief analysis of this chart, one should notice that while Apple has fully recovered and even made fresh all-times highs from the lows of the financial crisis, its P/E ratio has barely even moved. In fact, it has remained relatively flat over the past year and a half indicating apprehension on the part of Wall Street to give Apple a multiple significantly greater than that enjoyed by other similarly situated mega-cap stocks.
Source: Asymco
The Market Capitalization & Return on Equity Problem
Instead of giving Apple the fairest possible valuation to determine the stock price, market participants are relying on Apple?s earnings to drive the stock higher. It is clear that the earnings part of Apple?s P/E ratio has been the determinative factor in the rise of Apple?s stock price over the past 18 months and not a fair valuation. While Apple will probably continue to grow in the 25% to 30% range over the next 5 years, the market is unlikely to give it a P/E any higher than 23 at the high end or 15 at the low end for any extended period of time.
Eventually, all large-cap stocks undergo an age of P/E compression in anticipation of the law of large numbers and lower long-term anticipated growth rates. Even large cap tech companies that continue to significantly outpace the growth of their valuation nevertheless experience major P/E compression. This acts as a ceiling to overall market capitalization and mitigates the problem of return on equity.
When discussing this issue with analysts, I hear the same repetitive concern about Apple?s market capitalization. That despite Apple?s growth rate, business potential, and staggering piles of cash, the fact that its market capitalization is about to surpass Exxon Mobil (XOM) to make Apple the largest company in the United States raises questions about its expected return on equity (eROE). And this is precisely where the issue of cash, expected cash flow and trailing P/E(x-cash) becomes front and center in the equation.
Whenever one debates whether Apple (AAPL) should have a larger market capitalization than Exxon Mobil (XOM), Wal-Mart (WMT), Microsoft (MSFT), Hewlett Packard (HPQ), Google (GOOG), or IBM (IBM), the central issue in the discussion is which of these companies have the highest expected return on equity. That is, for every dollar spent to purchase one of these institutions, which of them would yield the highest return per dollar spent? If someone were to purchase Apple at $375 billion outright, would he or she get a bigger return on that $375 billion or would he or she get a greater return by spending $315 billion to acquire Exxon Mobil? If one produces a higher return with Apple, then Apple is relatively more undervalued than Exxon and vice-versa.
This is precisely why there?s an artificial ceiling on market capitalization. For if Apple were to reach levels clearly suggesting a higher return on equity for Exxon Mobil (XOM) or any other similarly situated mega-cap name, it literally means that Apple is over valued relative to that name. At $400 a share, Apple would have a market capitalization of $376.4 compared to Exxon Mobil?s $315 billion cap, Wal-Mart?s $192.1 billion or Microsoft?s $221 billion market cap.
Yet, having a higher market cap in and of itself isn?t a problem so long as the analysis demonstrates that Apple will likely post a higher return on equity on its market capitalization. Moreover, cash and cash flow must be subtracted from market cap because hypothetical purchasers of the company would get that cash in the acquisition. Thus, net market capitalization becomes the basis for comparison.
This is exactly what investors who think Apple should have a 30 P/E on an expected $20 in earnings fail to realize. At $600 a share, Apple would have a market capitalization of $565 billion or more than Microsoft and Exxon Mobil put together. It is outrageously doubtful to suggest that Apple will somehow demonstrate a higher return on equity than Microsoft (MSFT) and Exxon Mobil (XOM) put together. I hope this demonstrates why it?s almost silly to believe that the market will give Apple a P/E ratio much higher than what it currently trades at in late 2011. Instead, Apple?s future stock price will largely be determined by its growth in earnings as it continues to undergo further P/E compression well into the future. I?ll be exploring the issue of comparative return on equity and comparative market capitalization in future articles to ascertain Apple?s true value. Stay tuned.
Andy Zaky is a graduate from the UCLA School of Law, an AppleInsider contributor and the founder and author of Bullish Cross -- an online publication that provides in-depth analysis of Apple's financial health.
That the day-to-day fluctuations in Apple?s stock price are more determined by the larger concerns of the broader market than they are with the company?s strong fundamentals. So keeping these concerns in mind, what investors want to know is: what is Apple worth and is the company currently undervalued? The short answer - Apple is definitely undervalued, and it should be trading at around $400 come 2012.
Traditional Valuation Metrics: Trailing & Forward P/E Ratios
The very first thing investors learn about fundamental analysis is that stocks are generally valued on a price-to-earnings ratio, and that a stock?s growth rate is what determines the multiple it receives in the analysis. For example, on a traditional trailing 12-month P/E valuation analysis where one multiplies Apple?s $15 in EPS by its 70% growth rate, Apple ?should be? worth about $1,050 a share on a trailing basis come this October.
Yet, as anyone who takes valuation seriously knows, stocks are seldom valued on their trailing P/E ratio. Instead, the market tends to value stocks based on their future expected earnings and long-term expected growth rate. In other words, key to the equation is what will Apple earn over the next 12-months, and what is expected out of the company in terms of growth over the next 5 years. Cash also plays a very important role in the analysis, but not in the way one would expect. We?ll get to cash in a moment.
So setting aside the issue of Apple?s enormous cash position, Wall Street analysts are generally modeling for Apple to earn $14.43 in EPS for fiscal 2010 and approximately $17.47 for fiscal 2011 ? that?s about 21% earnings growth. Moreover, when looking at what is expected out of the company over the next 5-years, analysts are modeling for about 18% earnings growth. Thus, based on these conservative variables, Apple should be currently trading at about 18 times next year?s earnings of $17.47 in EPS or about $314.46 a share. That?s about $54.46 above Friday?s close.
Looking at the future trailing P/E to beat Wall Street
Yet, simply analyzing Apple?s (AAPL) forward P/E ratio doesn?t really tell anyone what the company ought to be worth in the future. It only tells us whether the stock is currently undervalued, and what it ought to be trading at today. To get an idea of what the company will be trading at in the future, it is vital to ascertain not only what type of trailing P/E the market is likely to give Apple in late 2011 or early 2012, but what the company will actually report in earnings. This is precisely where investors can beat Wall Street at their own game, and sums up the value offered by independent analysts who consistently outperform Wall Street in forecasting Apple?s earnings.
If there is one thing that readers should take away from this article it?s that you should never fight Wall Street?s valuation metrics. Instead of relying on some alternative way to valuate the company to determine future price targets, embrace the market?s valuation but beat it on the earnings front. For while the market might continue to give Apple an 18 to 20 trailing p/e ratio well into the future despite Apple?s enormous cash holdings and robust 50-70% growth rate, the one thing that is not determined by the market is the earnings variable of the P/E ratio.
For example, let?s suppose that Apple continues to trade at a 19 to 20 trailing P/E come October 2011. Right now Wall Street analysts are modeling for Apple to earn roughly $17.50 in EPS. At that earnings level, Apple would be trading between $332 and $350 assuming a 19 or 20 multiple. Yet, nearly every independent analyst knows Apple will probably earn about $20 in EPS in 2011.
This is where investors can beat the street in forecasting a more realistic and achievable price target. Based on $20 in EPS for fiscal 2011, Apple should be trading between $380 and $400 in late 2011 early 2012 assuming a 20 multiple. This price-target beats the street by nearly $70 in share value, is based exclusively on the market?s current valuation of the stock, and presents a conservative, simple, and straight-forward analysis of Apple?s valuation.
Basing Price Targets on Wall Street Valuation Metrics not on P/E(x-cash)
Yet, if I ended the analysis right here, I would get no less than 40 messages in my inbox by disgruntled investors explaining to me that it?s irresponsible to valuate Apple on a retroactive trailing P/E basis without backing out Apple?s cash from the analysis.
For example, my 2011 model calls for Apple to generate roughly $18 billion in cash in addition to the $45.8 billion already stockpiled in the company?s coffers. That is a total $63.8 billion or 39.3% growth in cash over the coming year. If one were to back out this cash from Apple?s expected (2011) market capitalization of $376.4 billion, Apple would be trading at a trailing P/E(x-cash) of only 16.6.
Some would even go so far as to argue that Apple should be assigned a 25 P/E(x-cash) in order to conform with a more realistic 5-year growth rate; and that based on an expected $20 in earnings, it should thus be trading at $600 a share on a 30 multiple.
Yet, it?s very unrealistic to assume that the market will suddenly wise up to Apple?s (AAPL) enormous cash position and higher growth rate, and give it a 30 trailing p/e when Wall Street expects Apple to report a mere 18% earnings growth over the next 5 years. For while some might argue that its unreasonable to suggest that Apple will grow at such a meager pace, the market is not so easily convinced. Even if Apple demonstrates that it will far exceed the 18% growth expected over the next 5-years, it will do very little to alter the market?s foregone conclusion to the contrary.
There seems to be this underlying notion with investors that there will be some glorious day deep in the future when Wall Street eventually gives Apple a valuation that is perfect in every regard, and which contemplates the full potential and thrust of Apple?s business model. Theoretically, Apple should have traded at a 50 P/E over the past 5 years, but has only seen that valuation level for only a few moments.
Research in Motion (RIMM) is a fundamental powerhouse growing at astonishing rates, but the market continues to hold the belief that iPhone and Android are going to destroy the Blackberry despite repetitive evidence to the contrary. Research in motion has repeatedly demonstrated its ability to keep up with the competition in the smart phone industry, but the market refuses to give the stock a P/E ratio higher than 10. Altering the market?s perception is no easy task.
Furthermore, the historical record indicates that Apple will likely see an 18 to 22 P/E well into the future. Horace Dediu, a rising star among the independent analyst community, recently published a chart comparing Apple?s stock price, trailing P/E ratio and trailing P/E ratio (x-cash), which I find to be essential in determining the long-term direction and valuation of stock.
From a brief analysis of this chart, one should notice that while Apple has fully recovered and even made fresh all-times highs from the lows of the financial crisis, its P/E ratio has barely even moved. In fact, it has remained relatively flat over the past year and a half indicating apprehension on the part of Wall Street to give Apple a multiple significantly greater than that enjoyed by other similarly situated mega-cap stocks.
Source: Asymco
The Market Capitalization & Return on Equity Problem
Instead of giving Apple the fairest possible valuation to determine the stock price, market participants are relying on Apple?s earnings to drive the stock higher. It is clear that the earnings part of Apple?s P/E ratio has been the determinative factor in the rise of Apple?s stock price over the past 18 months and not a fair valuation. While Apple will probably continue to grow in the 25% to 30% range over the next 5 years, the market is unlikely to give it a P/E any higher than 23 at the high end or 15 at the low end for any extended period of time.
Eventually, all large-cap stocks undergo an age of P/E compression in anticipation of the law of large numbers and lower long-term anticipated growth rates. Even large cap tech companies that continue to significantly outpace the growth of their valuation nevertheless experience major P/E compression. This acts as a ceiling to overall market capitalization and mitigates the problem of return on equity.
When discussing this issue with analysts, I hear the same repetitive concern about Apple?s market capitalization. That despite Apple?s growth rate, business potential, and staggering piles of cash, the fact that its market capitalization is about to surpass Exxon Mobil (XOM) to make Apple the largest company in the United States raises questions about its expected return on equity (eROE). And this is precisely where the issue of cash, expected cash flow and trailing P/E(x-cash) becomes front and center in the equation.
Whenever one debates whether Apple (AAPL) should have a larger market capitalization than Exxon Mobil (XOM), Wal-Mart (WMT), Microsoft (MSFT), Hewlett Packard (HPQ), Google (GOOG), or IBM (IBM), the central issue in the discussion is which of these companies have the highest expected return on equity. That is, for every dollar spent to purchase one of these institutions, which of them would yield the highest return per dollar spent? If someone were to purchase Apple at $375 billion outright, would he or she get a bigger return on that $375 billion or would he or she get a greater return by spending $315 billion to acquire Exxon Mobil? If one produces a higher return with Apple, then Apple is relatively more undervalued than Exxon and vice-versa.
This is precisely why there?s an artificial ceiling on market capitalization. For if Apple were to reach levels clearly suggesting a higher return on equity for Exxon Mobil (XOM) or any other similarly situated mega-cap name, it literally means that Apple is over valued relative to that name. At $400 a share, Apple would have a market capitalization of $376.4 compared to Exxon Mobil?s $315 billion cap, Wal-Mart?s $192.1 billion or Microsoft?s $221 billion market cap.
Yet, having a higher market cap in and of itself isn?t a problem so long as the analysis demonstrates that Apple will likely post a higher return on equity on its market capitalization. Moreover, cash and cash flow must be subtracted from market cap because hypothetical purchasers of the company would get that cash in the acquisition. Thus, net market capitalization becomes the basis for comparison.
This is exactly what investors who think Apple should have a 30 P/E on an expected $20 in earnings fail to realize. At $600 a share, Apple would have a market capitalization of $565 billion or more than Microsoft and Exxon Mobil put together. It is outrageously doubtful to suggest that Apple will somehow demonstrate a higher return on equity than Microsoft (MSFT) and Exxon Mobil (XOM) put together. I hope this demonstrates why it?s almost silly to believe that the market will give Apple a P/E ratio much higher than what it currently trades at in late 2011. Instead, Apple?s future stock price will largely be determined by its growth in earnings as it continues to undergo further P/E compression well into the future. I?ll be exploring the issue of comparative return on equity and comparative market capitalization in future articles to ascertain Apple?s true value. Stay tuned.
Andy Zaky is a graduate from the UCLA School of Law, an AppleInsider contributor and the founder and author of Bullish Cross -- an online publication that provides in-depth analysis of Apple's financial health.
Comments
Bravo to AI and Andy for this very insightful material.
Look. Cash is king. Every quarter that passes Apple adds to its hoard of cash. And I suspect it is adding cash at an exponential rate. But its stock is not keeping pace with this growth in cash.
Left unchecked, the line of the net worth of Apple's stock could conceivably touch the line of Apple's pile of cash and equivalent. And that IS inconceivable!
Ergo, the growth of Apple's cash hoard is like a magnet that will draw the stock price irresistably higher. Now, you might say that Apple will do something to decrease that pile. It might give a dividend. It might do a stock buyback. But the reality is that there's no real benefit to Apple the company in doing either of those things.
The third thing Apple could do is to invest that cash. And knowing Apple, those investments will be growing that "seed cash" to even higher values! Once again, Apple reaches the point where its value as a company in cash and cash equivalents exceeds the worth of its stock...but it won't! As this becomes clear that its net worth is closing in on its stock worth, the worth of Apple's stock will have to grow, will ye or nil ye.
And that's why, if it keeps on doing what it's doing, Apple will hit $1,000 a share within the next five years.
This is an absolutely outstanding series of articles -- all of which easily explain the arcane world of AAPL stock valuation much better than anything I've read from the usual analyst suspects.
Bravo to AI and Andy for this very insightful material.
I like Andy's stuff, but in fairness to the "usual suspects," unless you are a customer of theirs, you never see anything but a summary of their analysis and not the reasoning behind it. They all use similar methods.
I might tend to agree with you if Apple were acting like a typical behemoth company. Instead, it's acting like a start-up.
Look. Cash is king. Every quarter that passes Apple adds to its hoard of cash. And I suspect it is adding cash at an exponential rate. But its stock is not keeping pace with this growth in cash.
Left unchecked, the line of the net worth of Apple's stock could conceivably touch the line of Apple's pile of cash and equivalent. And that IS inconceivable!
Ergo, the growth of Apple's cash hoard is like a magnet that will draw the stock price irresistably higher. Now, you might say that Apple will do something to decrease that pile. It might give a dividend. It might do a stock buyback. But the reality is that there's no real benefit to Apple the company in doing either of those things.
The third thing Apple could do is to invest that cash. And knowing Apple, those investments will be growing that "seed cash" to even higher values! Once again, Apple reaches the point where its value as a company in cash and cash equivalents exceeds the worth of its stock...but it won't! As this becomes clear that its net worth is closing in on its stock worth, the worth of Apple's stock will have to grow, will ye or nil ye.
And that's why, if it keeps on doing what it's doing, Apple will hit $1,000 a share within the next five years.
The cash adds value to the company's stock only in the instance of figuring takeover value. Is anyone going to try to take Apple over? Not in your life. Cash in really only otherwise of use if it is capitalized. Apple is way beyond the point (IMO) where they can capitalize even a small fraction of the cash they have already hoarded, let alone the $15b they are adding at the current rate of accumulation. The bottom line is, profits drive stock valuation. Nobody but an arbitrager buys stocks for the company's cash on hand because unless you buy the entire company or they declare a dividend you see not penny of it.
Apple is a unique company, I think we all agree to that, thats why were here. Steve Jobs and his unique vision has been a huge influence (to understate things) in forming and steering Apple to it's present position. He appears completely unconcerned with market trends, short term profits, what his investors and pretty much everyone else thinks. And his vision has been proven, time and time again. It's not an act.
The dudes been (is?) a buddhist, applies buddhist principles to business, he's tripped on acid and publicly stated it was one of the most important experiences of his life. He's been around since the beginning of personal computers and singlehandedly had a huge effect on the evolution of the PCs. Who else tells people what they want or will want, and then is proven right, over and over again. Thats vision like nobody else has.
When Bill Gates, the world's youngest self made billionaire, the individual responsible for the company which has been arguably the most influencial in shaping the history of the PC is on stage with Steve Jobs, he looks at him like a wide eyed puppy.
The point is (besides shameless Steve jobs worshiping), what would Apple be without Jobs? Thats not an unthinkable scenario. Pancreatic cancers a nasty beast. It's conceivable, some would say likely, the he could be on his last legs. Each big project he introduces could be his last. What happens to Apple then? We all know what happened last time he left. People without vision took the reins and drove it straight into the ground.
How do you factor that into your forward P/Es?
Rob
Apple is gorilla with a dominant proprietary architecture and value added chain. The iPhone is truly revolutionary along with the iPad. However, once the stock goes flat from persistent PE compression, the only the company will be able to reward stockholders is via stock dividends. It also may be a time to sell.
What about the elephant in the room, and why I haven't invested more in AAPL (although it has treated me very nicely). Steve Jobs' pancreatic cancer, subsequent liver transplant, and the poor track record of Apple to share information on his health with investors.
[...]
The point is (besides shameless Steve jobs worshiping), what would Apple be without Jobs? Thats not an unthinkable scenario. Pancreatic cancers a nasty beast. It's conceivable, some would say likely, the he could be on his last legs. Each big project he introduces could be his last. What happens to Apple then? We all know what happened last time he left. People without vision took the reins and drove it straight into the ground.
How do you factor that into your forward P/Es?
Rob
Enderle???
I've been waiting a long time on these boards to say this, but to write a whole article on the premise that Value is equal to EPS (trailing or forward) times P/E (trailing or forward, respectively) is a tautology. In other words, obvious and useless.
Let me explain. Pick your favorite metric of relevance 'X' (where X could be FCF, Earnings, EBITDA, EBIT, # Employees, Eyeballs, Sales, whatever...), and it is a tautology to that Price = XPS*[P/XPS] - since XPS and XPS cancel out, and Price = P. As I said, it tells us nothing. Of course, everybody on Wall Street loves 'EPS' because that is what our accounting mavens have deemed relevant, notwithstanding the fact that it has become a massaged and managed number to the point of irrelevancy for a lot companies (although perhaps not necessarily Apple). So let's stick with that.
The important question is, what does the P/E ratio mean? (The logic for what I am about to say is quite straightforward and requires some high school algebra, which I won't bore you with; if you want to know, PM me - it may be another 24 hours until you hear back, since I am traveling). For an all-equity firm such as Apple, the Forward P/E is simply equal to 1/[rE - g], where rE is the 'expected annual return demanded by equityholders' and g is the 'expected long run growth rate in earnings per share.' It can be thought of as the rE-adjusted-growth-rate (If Trailing P/E is used instead, the formula becomes P/E = [1+g]/[rE - g]).
Incidentally, the price per share is thus P = EPS1/[rE - g]
Bottom line? You can say nothing whatsoever about P/E ratios unless you are willing and able to say something about rE and g. If you are not able to - or cannot - say something about those two fundamentals, you are simply sticking your head in the sand. The P/E does not happen magically, nor is it pulled out of thin air: It comes from the company achieving certain long-run growth rates in EPS relative to its cost of equity. (Aside: The Forward P/E of the US stock market during the past hundred years has been about 14).
Let's look at Apple. In what follows, leave its ~$45B in cash aside (this amounts to about $50 per share).
Now, a reasonable estimate for Apple's rE is something in the region of 12% - 14% (Warning, jargon: this is from applying the Capital Asset Pricing Model, given Apple's beta of about 1.5, assuming a market risk premium of 5% - 6%, and a 30-year T-bond yield of ~4%).
If we think $400 per share is what Apple should be worth (and assuming EPS1 = $18 and rE = 14%), the non-cash value of Apple would be $350. This implies a Forward P/E of about 20. The arithmetic then says that Apple would need to grow its EPS at about 9% per year from here to forever. Is that possible? Perhaps. But it is tough. Consider that nominal US GDP has grown at about 5% in the past couple of decade. It is achievable if the market believes that Apple can grow at supranormal rates for the next few years, and then revert to a long-run (nominal) GDP growth rate. Everything depends on how Apple achieves its growth in the next few years (and then hoping that it can go sideways, matching the broader economic growth rate from then on).
The point I am making is that, 'Apple = $400' is a bet on two huge unknowns, namely rE and g. To suggest that it is primarily about making a bet on next year's earnings is oversimplifying the issue. For instance, Apple may deliver $20 in EPS next year, but if the market believes that Apple has become riskier (thus increasing its rE) or it begins to doubt Apple's growth engine (e.g., because of Jobs' departure or some other factor), then the stock could not only not get anywhere near $400, it could fall relative to where it is now.
This is exactly what investors who think Apple should have a 30 P/E on an expected $20 in earnings fail to realize. At $600 a share, Apple would have a market capitalization of $565 billion or more than Microsoft and Exxon Mobil put together. It is outrageously doubtful to suggest that Apple will somehow demonstrate a higher return on equity than Microsoft (MSFT) and Exxon Mobil (XOM) put together. I hope this demonstrates why it?s almost silly to believe that the market will give Apple a P/E ratio much higher than what it currently trades at in late 2011.
Sure. About 2011 or 2012. But give us 5 to 10 years.... if Microsoft's decline (as a business) keeps getting steeper, if the other competitors keep failing to recreate Apple's experience, if the oil industry has reached its peak... it is bound to happen.
Practically all analysts actions are backward looking. Sure they try to 'project' future earnings but they base it on past performance and intrinsically assume that the current landscape continues unchanged. But there are certain events that analysts do not include in their forecasts because such events cannot be modeled using traditional statistical methods that have been developed for predicting recurring events, i.e. the weather, repeated throws of dice, etc. And it is precisely these types of (non-Gaussian) events that really move stock prices.
What am I talking about? Innovation. Completely new products and markets. It is logically impossible to build a statistical model for the likelihood that Apple will develop the iPhone (and the flow of revenues and profits that it generates) before the iPhone is invented. Likewise for the iPad. And for whatever device Apple will introduce in the next 5 years. These are all unique events, they are not generated from a fixed setting (the earth's atmosphere, or two dice thrown a specific way repeatedly). Each time a new product is successfully introduced, the landscape changes and your old assumptions must be discarded. And so what do analysts do about these non-recurring events? They ignore them. [I won't claim authorship of this notion, google Nassim Taleb and Black Swans.]
I have invested a considerable amount in AAPL. I hardly look at the numbers. The question I ask is "Do I have faith that this company has the ability to keep on coming up with fantastic new products that open up new markets and guarantee exponential growth in profits for the foreseaable future?" I don't have that kind of faith in RIMM, certainly not MSFT. As long as I have that faith in AAPL, I will keep buying and holding it. As soon as I lose faith in it, I'm unloading on the next trading day.
As for the pancreatic cancer talk floating around.. while I hope Steve Jobs lives to see 150, when the inevitable does occur (retire or worse), I plan on selling a kidney to be able to buy up as much AAPL as I can after it crashes. There is no stopping Apple.. Two points: 1) Apple plans their products 5-10 years in advance, their genius and foresight borders on clairvoyance, I'm not worried about a dry spell in great products. 2) Apple has a highly engrained culture of creativity and intelligence, they realize that this is their most important asset, which is why they hired an "educational expert" a while back to make sure these values are maintained (can anybody help with the name?).
Looking forward to the next installment!
p.s. Andy.. any chance you'll let us know when you're going to pull the trigger on some AAPL? Doesn't hurt to ask
Enderle???
Flattered, but no
Rob
Now, a reasonable estimate for Apple's rE is something in the region of 12% - 14% (Warning, jargon: this is from applying the Capital Asset Pricing Model, given Apple's beta of about 1.5, assuming a market risk premium of 5% - 6%, and a 30-year T-bond yield of ~4%).
Danger! Danger! Be warned! The Capital Asset Pricing Model, the CAPM is CRAP. It will tell you what Asset A should be priced relative to Asset B but it doesn't have anything to say about what the absolute levels should be. And the problem, as anyone may have gleaned from recent stock market experience, is not mistakes in predicting the relative price of assets, it's the complete and utter failure in predicting the collapse in the absolute price levels of securities.
Look at the statement above, "assuming a specific market risk premium and a specific T-bond yield". It's a statement about relative prices! Does the quality of Apple's products not figure at all into its valuation? How about the effectiveness of its management? How about the mysterious ability to consistently come up with wildly successful new products? If you disregard factors such as these in your analysis, then you are in essence assuming that all companies are the same when it comes to these factors. That's not a smart thing to do.
Look at the statement above, "assuming a specific market risk premium and a specific T-bond yield". It's a statement about relative prices! Does the quality of Apple's products not figure at all into its valuation? How about the effectiveness of its management? How about the mysterious ability to consistently come up with wildly successful new products? If you disregard factors such as these in your analysis, then you are in essence assuming that all companies are the same when it comes to these factors. That's not a smart thing to do.
If this is just another way of saying that not all companies are created equal, then I agree with you. But it's also instructive to consider that the last 13 years or so of brilliant management at Apple was preceded by just as many years of poor management. The lesson is, things can change, and not always for the better. All the fancy metrics aside, are investors not right to ask themselves how much longer Apple's amazing run of successful new products can last? Very few companies have managed this long a string of successes. History suggests that we should look for signs of a turn.
Economics and related discipline are pseudo science at best.
I'm curious about Mr Zaky's predictions for Apple stock in 2000.
But I think I know the answer already, I cannot recall one positive 'analyst' from that time.
J.
Buy what you know. and what you believe in.
When the iPhone launched I knew it was a game changer.
So when I had chance (and a significant chunk of change to) I bought at $82.
I'm not selling yet as I continue to see AAPL innovating and breaking new ground and believe they have vast areas of potential growth in the marketplace.
In fact at the next stock market crash I'll probably buy more.