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Wall Street's Infinite Loop: How AAPL is valued

In the previous article discussing the growth scorecard, I left open the question of how Apple’s growth is reflected in its share price.

The approach to answering this question is to show how the share price correlates to that growth. The challenge for analysts has been that the company switched from subscription to current accounting for the iPhone (the largest component in its income statement). As they re-stated income and thus earnings, any historic review of P/E or other multiples of Earnings have to also be re-computed.

So this is what I’ve done:

The first chart shows Apple’s price per share (blue) vs. its trailing twelve months earnings (green) and multiples of those earnings (15x and 25x).

The chart shows how Apple was priced well above 25 P/E before October 2008 and has remained within the 15 to 25 multiple bands since the winter of 2008/2009. This seems fairly reasonable and the stock’s rise is a cause of celebration for many, but a cause for concern for some. Is this rise in price matching a rise in value?

To answer, we need a way to look at the valuation of Apple. One way is to plot the P/E ratio over time. That would show how the market perceives the value of the company (i.e. how many years’ worth of earnings is built into the price) The chart below does that.

I took the additional steps of plotting the P/E excluding cash from the price to show “P/E Ex cash” in the orange colored line and I also copied the Share price line from the first chart on this one for contrast.

What the P/E analysis shows is that as the stock rose, it’s P/E ratio fell. This means that the “valuation” of the company is quite a bit lower now than it was in 2006 and 2007. In fact, as a multiple of profitability, Apple’s stock is nearly half as valuable now as before the recession.

Since valuation is usually correlated with growth, (P/E is often compared in a ratio with Growth) we need to see whether the P/E in the chart above matches the actual growth of earnings. Fortunately we have just measured growth with the scorecard.  Here are the two charts together:

What this shows is that while earnings growth did slow down in the lead-up to recession (with the hugely anomalous 3G launch spiking growth to 155% in Q308 causing the year-later plunge to 11%), growth picked up again in the depths of recession and has moved back to pre-recession levels. The only difference is that the multiple assigned to the stock has remained near recession lows. This is visualized by the blue line being mostly above the red line pre-crash and usually under it post-crash.

To put a finer point on this, I plot the ratio of P/E and trailing growth (P/E/tG) in the brown line below:

It shows that as a measure of valuation with respect to growth, Apple is trending down. A P/E/tG ratio of 0.4 and closer to 0.2 if we exclude cash shows very weak confidence.

The only conclusion I can draw is that the market does not believe that Apple has significant growth opportunities. A P/E of 20 with consistent 70% growth is, to be blunt, damnation. For comparison, Amazon just reported 16% growth in earnings and was rewarded with a P/E of 68.

Amazon notwithstanding, is Apple an anomaly? Is the disconnect between earnings growth and the stock price unique to Apple or does it apply to most other equities? Is pessimism about Apple a symptom of pessimism in general? I will suggest a way to answer this in a future article.

  • http://www.mercuryintermedia.com Bill T.

    I suspect the market sees Apple as a gadget company, not one who is leading the way into the fourth major generation of computing – ultra-portable touch-screen computing – where computing becomes far more integral to our daily lives than ever before. The market may not understand it, but Apple's competitors cretainly seem to.

  • parv

    I think it’s because wall street thinks the 90s will be replayed and the law of large numbers. I think they are wrong on both accounts.

    • russell

      I think there is a lot of truth in your way of looking at this. i've heard/read several smart people in hi-tech say that when a company is going to be really hot, wall street underestimates for a longtime but catches up with uneven spikes overtime. Intel, Mr Softy, Dell, etc all went thru these periods early on in their growth phases.

      On the otherhand, Apple is a MegaCap at this time being well north of 200B in Mkt Cap. threshold. It won't be as dramatic as the above mentioned companies coming out of the gates as small/mid caps and blasting off, but i think apple could position itself to rewrite how well a large cap can perform. I thnk this from the perspective that this one if far more global in size/numbers than previous cylcles. The enterprise adopting apple is in no way factoring in the price at this time it appears. if they move as a herd and adopt, then the PE will expand. They can only be ignored for so long.

  • http://twitter.com/jtsd @jtsd

    Would there be any link to the fact AAPL is already well represented in many investment portfolios so demand for the stock is comparatively smaller?

    • Jeffi

      The value of a security is determined by it's expected free cash flows plus cash or minus debt. Every dollar Apple earns is worth the same as those earned by others. Therefore, even if Apple is over owned, those owners should be unwilling to sell Apple's at a discount to it's true value. The price that a new buyer will pay for apple is determined not only by what he's willing to pay, but also by the price that a seller is willing to take. In other words, low demand doesn't matter if it's correlated with low supply. Economics dictate that in the long run it's not a popularity contest.

  • Iphoned

    Why do cyclicals trade at very low PEs during th fastest phase of their “growth” cycles? Therein lord the answer to Apple’s correnly low PE.

    Not saying the wst is right, but not as irrational as it looks at first glance.

    • Jeffi

      That's logical except that Apple is not a cyclical. Apple's earnings having been going in one direction (up) for about 13 years. WST is not right. Capitalizing on short term mis-pricing is how one makes outsized long term returns.

  • timnash

    Although technically the recession is over in the USA, demand is depressed. Without a new stimulus package it will continue this way for some time and a double dip is still possible. So IMO, Wall Street will continue to value Apple with a recession P/E because they only pay 'lip service' to Apple being the innovator in its markets and don't believe this will lead to market dominance.

    • r.d

      wall street is just the salesman. people with 401K are the actual buyers.
      other players are retirement funds and hedge funds for rich people.
      Actual people playing the stock market is down so how is Apple going
      to get 25x, only if another bubble economy is formed.
      May be Apple should list in China and India then you can have
      your p/e of 50.

      • timnash

        Funds are the biggest drivers of AAPL and in my book the term Wall Street covers the professional investment business in the USA. If the economy recovers and funds recognise that Apple is one of the few really good investments, the P/E will increase.

    • Jeffi

      Apple's demand hasn't been depressed. Apple hasn't been in a recession. Apple's business has been booming for the last 5 years!

  • Danthemason

    For at least the last 5 years the market in innovation has been dominated by Apple. When does a phase become a trend, and how long for a trend to become the standard?

  • Chris

    Will iPad sales start to boom? Will Android overtake the iPhone and limit it to a niche like Windows did to the Mac? Can the Mac increase sales to business? How long will Steve remain CEO? I think investors still see some risk in AAPL. But there are many sunny day scenarios as well. Go Steve. P.S. reconsider the company's position on Java.

  • Joe_Winfield_IL

    AAPL went on a great run on the few weeks leading up to earnings. I think the "disappointing" iPad numbers were a good thing, as they caused many investors to take pause briefly and reflect on the run-up. There were likely lots of profit takers given the recent jump. However, for every seller there has been a buyer. The current trading range is also putting a floor under the stock, and when AAPL moves, it tends to do so dramatically. I'm glad to see that the stock is in a range with regards to P/E; it keeps away the talk of a bubble.

    People who don't follow the company daily as investors don't know what to make of the Jobs rant on the conference call. To me though, his points on iPad and competition signal that the earnings are poised to break out to yet another order of magnitude. He seemed really excited, and the earnings call is not the time and place for unfounded enthusiasm.

    @Horace, I would love to see a share price vs. forward looking P/E and forward looking P/E ex cash graph. I know that TTM is the industry standard, but I feel like in the case of a growth company like AAPL, forward looking measures might be a more valuable way to visualize stock. How does Apple stack up against Amazon, Netflix, VMWare, etc.? After all, stock purchases are supposed to be driven by expectations more than by historical results – especially for companies that don't produce income for their investors.

    • asymco

      Good point about the SJ participation on the conf. call. His performance was truly exciting. It's not often it happens, and the last time it occurred when the company reported 155% growth while the stock plunged by 80%. His point then was that iPhone was a huge factor in the future of the company. He was right. Now he plainly pointed out that the iPad is similarly poised.

      I have my own projections of growth but the standard way forward P/E/G is computed is with consensus from established sell-side analysts. As they have been very inaccurate in their projections in the past, I have a hard time trusting their consensus. Perhaps the "blogger analysts" should put forward an "unaffiliated consensus" to index against…

  • dave

    I think the PE of Apple has always been low compared to its actual profits/earnings.

    Part of the answer is probably the stock price. Apple has high visibility, but the 300 price drives mom and pop investors away.

    As stated above, AAPL is in most institutional portfolios.

  • Chris

    I very much appreciate this site's focus on P/E, especially historical P/E, since I see it as fundamental to understanding AAPL. I don't know how typical my situation is, but to the extent it is it helps explain the tendency for AAPL's P/E not to get too high again. I happen to be roughly the same age as Steve Jobs. I recognized his genius in the late 1990's and therefore put a large percentage of my 401K in AAPL. As a result, I plan to retire in a few months, and I also watch AAPL's P and E like a hawk. I've already started selling, but only very slowly. However, if that P/E starts climbing up towards 50 again, you can rest assured I'll be selling faster and faster.

  • Kevin

    I believe one reason that AAPL’s P/E ratio hasn’t recovered from the recession is the increased concern over Jobs’ health (including Apple’s continued lack of transparency on this issue due to privacy) and its perceived dependence on Jobs for vision, strategy, and innovation. Some believe AAPL will fall 50% if he were to leave; maybe that is already reflected in the stock price.

  • Iphoned

    I know why. It must be th white iPhone. (pls keep that a secret.)

  • Hamourabi

    The quarterly year over year growth is a very unstable indicator of growth. I suggest to use instead 4 time the 4 quarters moving average of the quarterly growth.

  • Sam Penrose

    You sort of dance around the idea that maybe stock market valuation is not attributable to a rational model. My explanation for the declining P/E is simple: the faster Apple grows, the more it highlights the abitrary nature of any valuation. Consider: AAPL is worth roughly as much as XOM. Is there anyone in the world who honestly believes that fabulous consumer electronics are worth more than huge amounts of oil?

    • Joe_Winfield_IL

      I sure do. XOM doesn't exactly have autocratic control of its assets. Oil is a commodity, and as such Exxon has little pricing power. Many of the oilfields are in politically unstable countries, not to mention that oil is subject to heavy regulation, changing government royalties, OPEC production decisions, increasingly strict fuel economy standards, trade agreements, political standoffs, alternative energy legislation, etc.

      Exxon is an impressively large and successful company with massive profits. But they will struggle to achieve significant share growth due to antitrust concerns in the west and nationalized oil companies everywhere else. Without a realistic expectation of growth beyond the commodity market, they are relegated to their current status as a blue chip income investment.

      Apple is unburdened by all of these things, and they have a mountain of existing cash with no debt obligations. Their market share in the two largest segments (PCs and phones) is very small, and both markets are growing and forecast to continue growing over a long run. The gadgets don't need to be worth more than the oil – they simply need to generate more profit for the individual company.

      • Joe_Winfield_IL

        Oh, and I've never heard of a giant iPod spill in the Gulf of Mexico, or the Amazon delta, or the Black Sea. People may wake up and decide they don't like Apple's products, but it won't involve tens of billions of dollars of reserve for remediation and litigation.

  • Russell

    @Horace
    Does the P/S ratio get consideration when looking at valuation? I see this ratio correlating best to market share gains/ hypergrowth markets. I realize Apple is a Mega cap(.>200bln) but the market is vast and its early in the cycle. Is it too large( capitalization) at this point to consider this ratio for any valuation purposes?

    I've heard/read that P/E is the a better after- the- fact measure once the dust has settled and all that was up for grabs has been settled. P/S ratios assume the P/E will follow. Regardless of the measure used (sales or earnings) apple appears to be undervalued at this time. Its even more so if you consider it from the sales perspective. As Geoffrey Moore said in the 90's, maybe the ratio one needs at this point is a price- to- vision.

    Great charts. They give me clarity.

    Russell

    • asymco

      I showed sales growth in the previous article next to profit growth. I'm not thrilled to use sales, as sales without margin are without value. By definition a company is worth the net present value of all future cash flows and sales without margin has little or no bearing on that.

  • neilw

    Excellent post. If nothing else, it shows pretty clearly that w/regard to actual company performance, the share price is reasonable, even cheap.

    However, I believe that those calling Apple shares overpriced or even bubble-inflated are not looking at it this way at all. Rather, they see three things, none supported by facts:
    1) Large numbers: Apple is almost $300 billion, it can't possible have that much more growth in front of it (numbers suggest otherwise).
    2) Y2K hangover: whenever a tech company goes up this much, it must be a bubble. Never mind that the nature of Apple's stock ascension has absolutely nothing in common with the internet or telecom bubble stocks of the late 90's.
    3) Apple's whole business is a bubble: never mind how much they've sold and grown; one day everyone's going to wake up and realize that all Apple products are just a fad, all style and no function, and they're going to dump them and move onto the next thing. As a user of many Apple products I find this genuinely laughable, but this attitude seems to be extremely common, at least around the internet (does it infect the actual investing public to a great degree? I don't know).

    So haters are still gonna hate. For the rest of us, it's nice to see some objective analysis.

  • dms

    My theories:

    1. The market sees smartphones ultimately becoming commodities, like PCs, and Apple maxing out at niche marketshare, like in the PC industry. Even though iPhones sales are booming, they may perceive that there isn't as significant a first-mover advantage anymore.

    2. Wall Street does not understand the iPad at all. The tablet market is a complete blind spot for them. No one, outside of Apple and a few visionaries, see how potentially disruptive the tablet computing is. Even if they realize the disruptive impact of the iPad, they may not have a clue as to how to quantify the impact.

    3. Things that Apple excel at (hardware design, user interfaces, branding, marketing, impact on pop culture) are things that the numbers guys do not get at all. They get specs, components prices, marketshare, distribution points, etc. etc. which is fine for valuating companies like Dell, Intel, and maybe Amazon. But I don't think most analysts get Apple's "special sauce" and hence undervalues the impact of this special sauce in the consumer market.

    My 2 cents

    • Iphoned

      I think the wall street and the analysts understand all this as well as anybody posting on this board. Perhaps better. It seems the wall street understands the risks also, not just the most positive possibilities. They are just being more prudently conservative with valuations than some of the more enthusiastic Apple investor fans.

      • Joe_Winfield_IL

        I agree with @dms on item 3 – the analysts may understand the appeal of Apple products and integration, but it is very difficult to put a future value on this "special sauce." While it is proprietary, it is not the same as a drug patent, for example. As such, they discount the part that makes Apple special to its customers.

        However, I don't think the stock has a problem. Wall St. understanding aside, the market cap is more than 3x what it was early last year. Considering that this is not a small company, that is quite a run. The only stocks that have run this far are either early life-cycle businesses or companies back from the brink of bankruptcy. Apple is one of very few large caps to have achieve major organic (non acquisitive) top and bottom line growth over the past couple of years. This past growth is fully recognized in today's price, and the professional analysts all have 6 and 12 month price targets above today's price – in some cases well above. I expect the stock to take a breather and trade in a cycle for a bit longer, then take its next big leap.

  • Chandra

    >The only conclusion I can draw is that the market does not believe that Apple has significant growth opportunities.
    > A P/E of 20 with consistent 70% growth is, to be blunt, damnation.

    > is Apple an anomaly? Is the disconnect between earnings growth and the stock price unique to Apple or does it
    >apply to most other equities? Is pessimism about Apple a symptom of pessimism in general?

    I do not think it is an anomaly. One way to look at this is as follows ( back of the envelope calculation ): Zero or meager growth P/E is around 12. When will Apple reach that stage. Let us say in the next 5-6 years. Today's P/E is 20 can be theoretically justified with the following growth rates for the next 6 years : 20-25% for the next 4 years and 10-15% for the next 2 years and then who knows. Let us assume it will reach that zero/meager growth state then. Such a story deserves only a P/E of around 20. Apple's revenues will reach $185 billion with a EPS of around $42. To achieve this, they have to selll in the outer most year around 160 Million iPhones and 70 million iPads per year. At this rate we will be targeting close to 3/4 a billion iOS devices. At that time, the P/E will shrink to 12 for a share price of 504.

    So today's price with a P/E of 20 really projects a price of 504 in 5 to 6 years. That is not bad but it is not explosive as some people tend to assume. And all the positive expectations about Apple have to come to fruition for this to happen.

    Chandra