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Apple's P/E compression illustrated

The reason we look at valuation is that it offers insight into how innovation is perceived. If a company is a successful innovator it usually creates vast wealth for its owners. However, the timing of that wealth creation depends greatly on its recognition by others. In other words, valuation lets you determine how recognizable innovation is. If your analysis tells you that a company is supremely innovative but nobody else recognizes this then you have an investable opportunity.

So with that in mind we like to compare industry and innovation analysis with what “the market” thinks about Apple.

The latest method we had in mind was to compare P/E (a measure of valuation) and Growth. We’ve shown before that they seem to be moving in different directions. That’s not been news for over a year. What we will try to do now is to see if there is discernible change in the relationship before and after the financial crisis.

The following chart is a simple representation of P/E (line chart with left scale) with Net Income growth super-imposed (bar chart with right scale.) We chose a time period of 22 quarters. 11 quarters after the crisis (i.e. quarters after the one ending in Sept. 2008) and 11 quarters before the crisis (quarter ending 12/20/05 through the one ending 6/30/08).

We then plotted a scatter of all these pairs (P/E vs. Net Income Growth).

 

The R-squared value simply shows that there is no correlation between these two variables, but this is not a surprise.

The next step would be to compare the pre-and post-crisis data sets. The idea being to see if, and to what degree, there was influence from conditions beyond the control of the company.

 

What seems to be happening is that the cluster of values did indeed move from the right (high P/E) to the left (low P/E) without much change in the growth.

We can get an even better feel for this by measuring the “center of gravity” of the clusters and plotting how they shifted.

This chart illustrates succinctly the phenomenon of “P/E compression” where P/E drops while growth continues.

In the case of Apple, average growth actually increased slightly between the two sampling periods (from 68% to 71%) while the average P/E dropped from 32.8 to 17.5.

What will follow over the next few weeks will be pair-wise comparisons of Apple and comparable companies along these metrics of P/E and Growth.

  • Canucker

    Blasphemous question: when a company is as successful as Apple, does P/E become less important as a comparative metric? In other words, do companies with high ratios (in this sector) represent greater volatility/risk? Perhaps Apple’s share price has matured? Who cares? Shareholders, obviously, but does Apple?

    • http://www.asymco.com Horace Dediu

      P/E is an artificial invention. It is not bound to any law about what a thing is worth. Prices can be completely disconnected from earnings and that’s not uncommon.

      It’s just a rule of thumb that can be sometimes useful in spotting perhaps mismatches between value and price.

      Given that, I don’t think it has anything to do with maturity. Obviously if a company is old and has very poor earnings it can still get a high P/E.

      • Canucker

        To clarify, I didn’t mean mature as in “old” company, more that investors have become comfortable in the company (i.e. understand risks and benefits). I agree P/E is an artificial construct but I also think too much weight is placed on this as it doesn’t capture a number of fundamentals. I appreciate your efforts in trying to understand the relatively low P/E at Apple but it is a surrogate indicator and suggests (to me) that investors have ascribed a fundamentally higher risk to Apple than is the norm due unpredictability and lack of understanding of why the company is able to grow at the rate it is. Once earnings growth begins to peter, perhaps the P/E will, paradoxically, rise?

      • WWOX

        I simplistically view it has more to do with the fact that the stock market post Lehman has become more risky. Those that have been in this stock from years before (thus with tremendous paper gains) are inclined more to take profit/ hold rather than buy more. When the risks of the market as a whole dissipate and with AAPL’s mojo still in tact, the stock will begin to exceed expectations.

      • MOD

        Apple’s “mojo” (tech prowess mated with consumer experience) is not something widely understood (or expected). The precedents here are Microsoft and Nokia. After 20 years of mediocrity, people cannot comprehend something better.

        This is hard enough for consumers (or IT departments) to understand, even harder for investors and market analysts who try to first understand and second measure what consumers can understand and measure, which often requires an understanding of what Apple’s business (mojo) does.

        So investors would have to:
        1) Understand and measure Apple’s business model.
        2) Understand and measure what consumers think of Apple’s business model.
        3) Understand (and measure) what other investors understand (and measure) about 1) and 2).

        It is rare to find investors who understand all 3.

      • Sacto Joe

        Which is cause and which is effect? Is the market riskier, or are investors more risk-averse? IMHO, it’s no riskier than its ever been. Indeed, with Apple one could argue that risk is much lower than it has been historically. So I’d phrase it a little differently: When the fear of risk as a whole dissipates, stocks as a whole will be more valued.

        But that still doesn’t explain why a stock like Apple, which has averaged better than 60% earnings growth since 2005 and has averaged 80% earnings growth for the last year and a half, has seen its P/E ratio drop by 25% since December of 2009. Could it be that it’s as simple as expectations for Apple earnings continually being far lower than reality, quarter after quarter? If so, then why are those expectations so low? Who’s guiding those expectations? And are those doing the guiding just incapable, or is there an anti-Apple bias being expressed? Or maybe a little of both?

      • Anonymous

        The market is certainly riskier because you see Europe facing a protracted sovereign debt crisis and practically every first world nation failing to implement correct macro-economic policies. The global economic situation is certainly the worst since the stagflation of the 70s, perhaps the worst since the great depression.

      • Sacto Joe

        I see Europe being forced to solve the innate problem of the Euro, yes. But the fundamentals of the bigger players are strong. And what does ” failing to implement correct macro-economic policies” even mean? Returning to the gold standard?

        There’s a smell of manufactured fear to a lot of this negative news. Until I see something a lot more substantive, I’m just not buying it.

      • Anonymous

        The US is also in a bad way due to a misguided move to deficit cutting, as is the UK and the core Euro block, correct macro policies in a depression would be a Keynesian expansion of government spending or tax cuts on low incomes.

        Obama’s Jobs bill would be a move in the right direction if he had any chance of actually passing it, the recent debt ceiling shenaningans however were disastrous.

        Returning to the gold standard would be a monetary policy not a fiscal policy, in addition to being insane.

      • russell

        I like how you define P/E here as ” a rule of thumb/ artificial invention” This is so true. As an investor in technology companies, i have more conviction in where i choose to allocate capital when i have a strong feel for a company in terms of: 1# its competitive position( pricing power, patent port., customer loyalty, critical mass, management, etc) in relation to competitors and #2 how sustainable that position(length of time) will be out into the future.

        The P/E can be a lagging indicator, early indicator or simply no indicator at all as to the the dynamics of the two points above, especially early in a tech cycle. The only comfort is knowing that if you are correct longterm, these factors are recognized for what they are in the market and price eventually reflects it.

      • russell

        I like how you define P/E here as ” a rule of thumb/ artificial invention” This is so true. As an investor in technology companies, i have more conviction in where i choose to allocate capital when i have a strong feel for a company in terms of: 1# its competitive position( pricing power, patent port., customer loyalty, critical mass, management, etc) in relation to competitors and #2 how sustainable that position(length of time) will be out into the future.

        The P/E can be a lagging indicator, early indicator or simply no indicator at all as to the the dynamics of the two points above, especially early in a tech cycle. The only comfort is knowing that if you are correct longterm, these factors are recognized for what they are in the market and price eventually reflects it.

      • russell

        I like how you define P/E here as ” a rule of thumb/ artificial invention” This is so true. As an investor in technology companies, i have more conviction in where i choose to allocate capital when i have a strong feel for a company in terms of: 1# its competitive position( pricing power, patent port., customer loyalty, critical mass, management, etc) in relation to competitors and #2 how sustainable that position(length of time) will be out into the future.

        The P/E can be a lagging indicator, early indicator or simply no indicator at all as to the the dynamics of the two points above, especially early in a tech cycle. The only comfort is knowing that if you are correct longterm, these factors are recognized for what they are in the market and price eventually reflects it.

      • Ian Ollmann

        It’s not artificial. The P/E is a representation of the performance of an investment. If your P/E is 15, then for an initial investment (P) you get back an return on investment (E/P) of about 6.6%. Stocks do not exist in a vacuum. They must compete for investment dollars with other stocks and other investments. If investors feel like the return on a stock is not enough, weighted for risk, they will shop for other investments and the price will surely fall. P/E is simply an estimate of annualized yield on your money, (assuming the investor can realize the profits from the company he owns) , weighted for risk.

        …but you knew all that.

        The simplest interpretation for the 2008 P/E compression is that the market’s tolerance for risk — or actual amount of risk itself or the perception of risk — changed. This is entirely predictable given Apple’s general unknowability due to secrecy and reliance on a parade of unpreannounced hit new products. Buffet wouldn’t invest in it for this reason, even though AAPL has outperformed BRK.

      • Ian Ollmann

        It’s not artificial. The P/E is a representation of the performance of an investment. If your P/E is 15, then for an initial investment (P) you get back an return on investment (E/P) of about 6.6%. Stocks do not exist in a vacuum. They must compete for investment dollars with other stocks and other investments. If investors feel like the return on a stock is not enough, weighted for risk, they will shop for other investments and the price will surely fall. P/E is simply an estimate of annualized yield on your money, (assuming the investor can realize the profits from the company he owns) , weighted for risk.

        …but you knew all that.

        The simplest interpretation for the 2008 P/E compression is that the market’s tolerance for risk — or actual amount of risk itself or the perception of risk — changed. This is entirely predictable given Apple’s general unknowability due to secrecy and reliance on a parade of unpreannounced hit new products. Buffet wouldn’t invest in it for this reason, even though AAPL has outperformed BRK.

      • http://www.asymco.com Horace Dediu

        The average U.S. equity P/E ratio from 1900 to 2005 is 14. (or 16, depending on whether the geometric mean or the arithmetic mean, respectively, is used to average). Apple is now at 14.99.

        That’s pretty average for all equities over a century.

        Are Apple’s returns average?

        http://en.wikipedia.org/wiki/P/E_ratio

      • Horace the Grump

        I have a major problem with this obsession of yours with P/E. It seems belie a fundamental misunderstanding of company valuation and corporate finance theory.

        it seems to me that you are looking for something that isn’t there.

      • MOD

        You never know until you look. And whether he finds something or not, the exercise will have been worth it.

        By the scientific method one has to study all possibilities, even if there is nothing there, since you don’t know there is nothing there, until you look.

        But if you know where to look be my guest to tell us.

      • http://www.asymco.com Horace Dediu

        As we mention in the first paragraph, the obsession is not with the valuation but with the sum (i.e. market) perception vis-a-vis our perception.

        I know enough about corporate finance theory to know that it’s not a theory worth knowing.

      • MOD

        Buffet does not invest in tech companies because he does not understand tech. He does not invest in his best friend Bill Gates’ Microsoft for the same reason, though he gave Gates’ foundation all of his money.

        Buffet only invests in companies where he sees a 20 year life. This is why he likes consumer brands like Coca Cola, Wendy’s, etc. They are not likely to disappear, due to people liking to eat and drink.

        No one can predict where technology will be in 20 years.

        With regard to the PE ratio, risk is not a component at all, I don’t see where you get that. The P is the market Price of the stock. It is possible that the market might impute risk into its prices, but one cannot ask the stock market questions and get answers. One can survey investors though.

        And from what I read what makes investors most afraid is the possibility that Apple will lose to Android (or HP or Microsoft/Nokia, or RIM, Amazon, Google, etc.) You could call this a risk, but most investors are just looking at market share and responding to consumers’ allocation of their dollars/yen/euros/etc.

        It is possible that they see big names like Microsoft, Amazon and think that if they get into the market, they will defeat Apple or take its market share. (Not understanding that there are plenty of consumers for everyone. The market is nowhere near to being satisfied until everyone in China and India and Brazil has a tablet, and that is 10-15 times the US market size due to the number of people there.)

        The third fear (possible risk) is a second recession/slowdown, which would affect consumer spending.

        Apple’s modus operandi of secrecy is well known to be a defensive move, since all of it products are widely copied (as soon as released). If anything, investors would want Apple to increase that secrecy. That all of Apple’s products are hits is well known.

        Given all this, I have no idea why Apple is such a bargain at its current PE ratio, (except for the above hypotheses). It could be that the market knows more, but I doubt it, with the nonsense I read in the Wall Street Journal. With Horace at the helm of this blog, I think we have the inside track here.

      • Anonymous

        > No one can predict where technology will be in 20 years.

        That is not really true. That is only 6 PC generations and 10 mobile generations. We can certainly make broad generalizations and expect them to be true:

        - computers get even more heavily integrated into our lives

        - people on average will own even more computers than today, and also use more computers that other people own as well (more local systems *and* more cloud systems) but ironically, when you look around a room it will look like fewer computers than today because they will be smaller and more subtle, more integrated into everyday tasks

        - the average computer user will be even less of a computer nerd than they are today, and the idea of taking a course in computers will sound like taking a course in pens today (what, you don’t assemble your own pen from a kit?)

        - computers will have to be even more reliable, even more secure, even more immune to viruses and botnets than they are today, because of the principle that people do not like to take shit from their iPod … once you are surrounded by 20 little computers that you rely on all the time, you can’t be nursemaiding them all the time … even today, only Gen X is stupid enough to put up with Windows … people who are younger or older than Gen X just expect tech to work, they don’t want to diagnose or play with the guts of it.

        So with regards to Apple stock, we can go down the above list and see that Apple is leading in this kind of modernization of computing.

        Also, we can expect some things that have *always* been true in computing to still be true 20 years from now:

        - the dominant industrial strength operating system will continue to be Unix (40 years right now)

        - the dominant native programming language will continue to be C (40 years right now)

        - the dominant Web programming language will continue to be HTML (21 years right now)

        - the dominant multimedia playback platform will continue to be ISO MPEG (19 years right now)

        - the dominant creative computing platform will continue to be the Mac or descended from the Mac, i.e. “iOS Pro” (27 years right now)

        - the Internet will be continue to get even bigger and faster (40 years right now)

        - Apple will continue to be the most innovative and profitable PC maker (34 years right now).

        Again, we go down this list and see that Apple has invested heavily over the past 10 years in Unix (OS X), C (Cocoa, Xcode, LLVM, App Store), HTML (WebKit, HTML5), MPEG (QuickTime, iTunes+iPod, iMovie, Final Cut, DVD), the Mac and creative computing (Mac OS X, Thunderbolt, FireWire, CoreAudio, CoreMIDI, CoreVideo, CoreImage, CoreText, CoreAnimation), the Internet (Wi-Fi, iTunes Store, Apple Store, App Store), and in making themselves healthy so that the company can continue to grow into the future.

        So all in all, it doesn’t take too long to see which of today’s tech companies are preparing for 2031.

        I mean, Microsoft still sells computers as kits, like in 1976, and you still have to know some MS-DOS to use them.

        Windows is not even a Unix and therefore does not even have a Web development stack.

        Windows does not have any creative computing infrastructure. To do pro audio work on Windows, first you have to install a 3rd party pro audio subsystem and get it to work right, a task that is beyond all songwriters, all musicians, and 95% of audio engineers. On the Mac, to setup a pro audio workstation, you take the Mac out of the box and push the power button and wait 12 seconds. Done. You already have 24-bit audio hardware, you already have a pro audio subsystem, you already have effects and instruments, you already have GarageBand. It is already working. And you can drop in any one of 5 or 6 pro apps in place of GarageBand and they just work. You can plug on one of thousands of audio devices and musical instruments and they just work. The contrast couldn’t be more stark.

      • MOD

        This is a great analysis. But Unix and C are common standards. It is possible that someone can use them as successfully as Apple. (I understand that Andorid is also based on Unix).

        The Apple brand is strong, but then so was Nokia’s.

        It is still considerably more secure that Coca Cola will be around in 20 years, than Apple (or MS, Nokia, etc).

        That is Buffet’s logic. I think Apple has more to bring to humanity than sugary drinks, that is why I would rather invest in high tech.

        But when I do so I like to look at the fundamentals like Buffet would, albeit with a shorter time frame (2-3 years).

      • MOD

        Also, Buffet is (or was) investing insurance premiums (the float) which he had to possibly (or eventually) repay to satisfy claims (due to hurricanes, fires, etc.).

        Thus he needed the most secure stock (companies) that he could find, else he would lose the premium money and would be unable to pay the claims.

      • Anonymous

        Hmm, some of your claims are a little extreme. For starters Apple hasn’t been the most profitable PC maker for 34 years, and that’s before we start ascribing some of their PC business profits to their OS.

        Also while it’s true that Unix is still dominant in industrial applications, and OS-X is at heart unix, the obvious corollary is not true – ie. OS-X is still very much on the outside of the enterprise market.

        Apple is in great shape in the consumer market, but that doesn’t give them a sure-fire twenty year franchise. Their technology stack seems solid, but that’s not enough – their OS was superior back in 1990 but before the decade was out they were on the ropes.

      • Davel

        I agree with your fundamental analysis that Apple leads in many categories your mention. I disagree with many of the examples.

        1) it used to be IBM dominated in computers. Then DEC was big, unix did not have a significant place in the server space till the 90′s.

        2) at one time COBOL and fortran were dominant languages. I will not say that c will be a dominant language 20 years from now. In fact it is not so today. Object oriented c is not c.

        I do not share your optimism about HTML or mpeg. To say apple will be a leading company 20 years from now is pure speculation. Steve jobs will be long gone from the scene. Someone, perhaps someone not with apple will be a leading visionary.

      • Anonymous

        > No one can predict where technology will be in 20 years.

        That is not really true. That is only 6 PC generations and 10 mobile generations. We can certainly make broad generalizations and expect them to be true:

        - computers get even more heavily integrated into our lives

        - people on average will own even more computers than today, and also use more computers that other people own as well (more local systems *and* more cloud systems) but ironically, when you look around a room it will look like fewer computers than today because they will be smaller and more subtle, more integrated into everyday tasks

        - the average computer user will be even less of a computer nerd than they are today, and the idea of taking a course in computers will sound like taking a course in pens today (what, you don’t assemble your own pen from a kit?)

        - computers will have to be even more reliable, even more secure, even more immune to viruses and botnets than they are today, because of the principle that people do not like to take shit from their iPod … once you are surrounded by 20 little computers that you rely on all the time, you can’t be nursemaiding them all the time … even today, only Gen X is stupid enough to put up with Windows … people who are younger or older than Gen X just expect tech to work, they don’t want to diagnose or play with the guts of it.

        So with regards to Apple stock, we can go down the above list and see that Apple is leading in this kind of modernization of computing.

        Also, we can expect some things that have *always* been true in computing to still be true 20 years from now:

        - the dominant industrial strength operating system will continue to be Unix (40 years right now)

        - the dominant native programming language will continue to be C (40 years right now)

        - the dominant Web programming language will continue to be HTML (21 years right now)

        - the dominant multimedia playback platform will continue to be ISO MPEG (19 years right now)

        - the dominant creative computing platform will continue to be the Mac or descended from the Mac, i.e. “iOS Pro” (27 years right now)

        - the Internet will be continue to get even bigger and faster (40 years right now)

        - Apple will continue to be the most innovative and profitable PC maker (34 years right now).

        Again, we go down this list and see that Apple has invested heavily over the past 10 years in Unix (OS X), C (Cocoa, Xcode, LLVM, App Store), HTML (WebKit, HTML5), MPEG (QuickTime, iTunes+iPod, iMovie, Final Cut, DVD), the Mac and creative computing (Mac OS X, Thunderbolt, FireWire, CoreAudio, CoreMIDI, CoreVideo, CoreImage, CoreText, CoreAnimation), the Internet (Wi-Fi, iTunes Store, Apple Store, App Store), and in making themselves healthy so that the company can continue to grow into the future.

        So all in all, it doesn’t take too long to see which of today’s tech companies are preparing for 2031.

        I mean, Microsoft still sells computers as kits, like in 1976, and you still have to know some MS-DOS to use them.

        Windows is not even a Unix and therefore does not even have a Web development stack.

        Windows does not have any creative computing infrastructure. To do pro audio work on Windows, first you have to install a 3rd party pro audio subsystem and get it to work right, a task that is beyond all songwriters, all musicians, and 95% of audio engineers. On the Mac, to setup a pro audio workstation, you take the Mac out of the box and push the power button and wait 12 seconds. Done. You already have 24-bit audio hardware, you already have a pro audio subsystem, you already have effects and instruments, you already have GarageBand. It is already working. And you can drop in any one of 5 or 6 pro apps in place of GarageBand and they just work. You can plug on one of thousands of audio devices and musical instruments and they just work. The contrast couldn’t be more stark.

      • Anonymous

        > No one can predict where technology will be in 20 years.

        That is not really true. That is only 6 PC generations and 10 mobile generations. We can certainly make broad generalizations and expect them to be true:

        - computers get even more heavily integrated into our lives

        - people on average will own even more computers than today, and also use more computers that other people own as well (more local systems *and* more cloud systems) but ironically, when you look around a room it will look like fewer computers than today because they will be smaller and more subtle, more integrated into everyday tasks

        - the average computer user will be even less of a computer nerd than they are today, and the idea of taking a course in computers will sound like taking a course in pens today (what, you don’t assemble your own pen from a kit?)

        - computers will have to be even more reliable, even more secure, even more immune to viruses and botnets than they are today, because of the principle that people do not like to take shit from their iPod … once you are surrounded by 20 little computers that you rely on all the time, you can’t be nursemaiding them all the time … even today, only Gen X is stupid enough to put up with Windows … people who are younger or older than Gen X just expect tech to work, they don’t want to diagnose or play with the guts of it.

        So with regards to Apple stock, we can go down the above list and see that Apple is leading in this kind of modernization of computing.

        Also, we can expect some things that have *always* been true in computing to still be true 20 years from now:

        - the dominant industrial strength operating system will continue to be Unix (40 years right now)

        - the dominant native programming language will continue to be C (40 years right now)

        - the dominant Web programming language will continue to be HTML (21 years right now)

        - the dominant multimedia playback platform will continue to be ISO MPEG (19 years right now)

        - the dominant creative computing platform will continue to be the Mac or descended from the Mac, i.e. “iOS Pro” (27 years right now)

        - the Internet will be continue to get even bigger and faster (40 years right now)

        - Apple will continue to be the most innovative and profitable PC maker (34 years right now).

        Again, we go down this list and see that Apple has invested heavily over the past 10 years in Unix (OS X), C (Cocoa, Xcode, LLVM, App Store), HTML (WebKit, HTML5), MPEG (QuickTime, iTunes+iPod, iMovie, Final Cut, DVD), the Mac and creative computing (Mac OS X, Thunderbolt, FireWire, CoreAudio, CoreMIDI, CoreVideo, CoreImage, CoreText, CoreAnimation), the Internet (Wi-Fi, iTunes Store, Apple Store, App Store), and in making themselves healthy so that the company can continue to grow into the future.

        So all in all, it doesn’t take too long to see which of today’s tech companies are preparing for 2031.

        I mean, Microsoft still sells computers as kits, like in 1976, and you still have to know some MS-DOS to use them.

        Windows is not even a Unix and therefore does not even have a Web development stack.

        Windows does not have any creative computing infrastructure. To do pro audio work on Windows, first you have to install a 3rd party pro audio subsystem and get it to work right, a task that is beyond all songwriters, all musicians, and 95% of audio engineers. On the Mac, to setup a pro audio workstation, you take the Mac out of the box and push the power button and wait 12 seconds. Done. You already have 24-bit audio hardware, you already have a pro audio subsystem, you already have effects and instruments, you already have GarageBand. It is already working. And you can drop in any one of 5 or 6 pro apps in place of GarageBand and they just work. You can plug on one of thousands of audio devices and musical instruments and they just work. The contrast couldn’t be more stark.

      • Davel

        Mcdonalds has a higher PE than apple. Why is that?

        Will it grow more than apple in the coming year? 2 years?

        Will it weather a potential world downturn better than apple?

      • Anonymous

        I would really like to see the figure redone with P/E replaced by (P – cash)/E.

        I know there are all kinds of issues with backing out the cash. Still, I think that it should be better representative of the PE concept. I really don’t think that those who use it think that cash and equivalents should be ignored.

        (Yes – your point is important that PE is a “rule of thumb”)

      • Chandra2

        “Obviously if a company is old and has very poor earnings it can still get a high P/E…”

        Horace, what are you getting at here? Can you clarify please?

      • Chandra2

        “Obviously if a company is old and has very poor earnings it can still get a high P/E…”

        Horace, what are you getting at here? Can you clarify please?

  • danthemason

    Its simple really, Apples money isn’t good enough for this market.

    • Ian Ollmann

      Yes, but this should favor the integrated money producer.

  • Jon T

    In the words of Buffett.. ‘there are innovators, imitators, and idiots’.

    With a little lateral thinking, Apple’s worth, growth, and future value, are all well appreciated by the first two categories, but not alack, by the last one.

    You can’t be more scientific about this than that.

  • Anonymous

    I’d like to see more analysis of the relationship between P/E and market cap. I don’t know how realistic I’m being, but I extrapolate from my personal financial situation to the entire world’s. I have two pots of money and one pot is named “Fear” and the other is “Greed”; the Greed pot is where my speculative money is. My extrapolation tells me there are a finite number of speculative dollars in the world. I then simplistically say that 10 is a standard P/E and anything above 10 represents speculative money. I look at Netflix with its P/E of 53 and its market cap of $11B, and I then estimate that there are 9 billion speculative dollars invested in Netflix (43/53 * $11B). Apple, in contrast, has a P/E of 15 and a market cap of $356B, which tells me there are 120B speculative dollars invested in Apple (5/15 * $356B). That tells me that speculative investors have an order of magnitude more faith in Apple than they do in Netflix, and that seems about right.

    As for me, 100% of my speculative money is in Apple and their apparently low P/E doesn’t bother me at all!

    • Danny

      I really agree with this..I opined a while back that every stock has a component of speculative money, and that my intuition is telling me the speculative component in AAPL is at an all-time low, which is the real culprit for it’s low PE. Not institutional holdings, or law of large numbers, etc. Maybe Horace can look into a way to measure this component.

    • Anonymous

      Chris

      I think it is not quite that simple. My guess is that part of the deal is that Apple has a greater gross revenue.

      Also, there is that cash I mentioned a while back. You should subtract that out since it is hardly speculative to buy stock in a company that has cash to cover your price!

  • ChampagneBob

    Apple could create a virtual explosion in its stock price with even a minimal buyback plan….. that would not change anything as far as Apple’s long-term plans but show stockholders that the company has interest in share price…. obviously an important point to insiders who hold large stock options going forward….

    • http://www.asymco.com Horace Dediu

      I sincerely hope that the company’s management never develops an interest in the share price.

      • Anonymous

        So well said. That would be like trying to drive by staring only at the speedometer and nothing else.

      • Anonymous

        Except Apple is going to have to start returning cash to investors at some point Horace, it may as well do it in a way that maximizes their benefit – however that ends up being.

      • Anonymous

        I agree completely.

        One of the things that has made Apple great is its ability to ignore stock price and analysts, and focus completely on their vision. You really get the feeling that management does not even read the analysts’ opinions. :)

        However, it does have a duty to its shareholders. This is part of being a corporation. At this stage of the game, I feel they really ought to begin returning some of their earnings to the shareholders either via buyback or dividends.

        A split would not be such a terrible idea. It would allow a lot more people join in.

      • MOD

        Steve Jobs has said that it needs to “keep its powder dry”, ie may need the cash for a war.

        Indeed, if the market is 10-15 times what it is now, it will need all the cash it has.

        Second, Apple almost went bankrupt some 10 years ago, and no one would lend it money or invest in it.

        I suspect that Jobs has developed a “depression” phobia resulting in consummate saving and self-reliance, because of that experience. Notably its debt is exactly $0.

        Personally, I think Jobs and Co. will use the cash wisely, to grow the company. I would give them 2-3 years and see what happens before telling them how to run the company.

        I would much rather they expand their manufacturing all over the world with that cash, to meet product demand, rather than give it to the shareholders.

      • MOD

        Steve Jobs has said that it needs to “keep its powder dry”, ie may need the cash for a war.

        Indeed, if the market is 10-15 times what it is now, it will need all the cash it has.

        Second, Apple almost went bankrupt some 10 years ago, and no one would lend it money or invest in it.

        I suspect that Jobs has developed a “depression” phobia resulting in consummate saving and self-reliance, because of that experience. Notably its debt is exactly $0.

        Personally, I think Jobs and Co. will use the cash wisely, to grow the company. I would give them 2-3 years and see what happens before telling them how to run the company.

        I would much rather they expand their manufacturing all over the world with that cash, to meet product demand, rather than give it to the shareholders.

      • MOD

        Steve Jobs has said that it needs to “keep its powder dry”, ie may need the cash for a war.

        Indeed, if the market is 10-15 times what it is now, it will need all the cash it has.

        Second, Apple almost went bankrupt some 10 years ago, and no one would lend it money or invest in it.

        I suspect that Jobs has developed a “depression” phobia resulting in consummate saving and self-reliance, because of that experience. Notably its debt is exactly $0.

        Personally, I think Jobs and Co. will use the cash wisely, to grow the company. I would give them 2-3 years and see what happens before telling them how to run the company.

        I would much rather they expand their manufacturing all over the world with that cash, to meet product demand, rather than give it to the shareholders.

      • Anonymous

        Their net cash pile at 75billion is larger than Microsoft’s was at its peak. At current rates it will exceed 100billion next year.

        There is simply no way on earth that they need that much for component purchasing or building manufacturing capacity. Any merger which required more than a fraction of it would be a terrible idea, since it would entail them buying a big firm that was growing slower than they were.

        They might be able to go 3 years without any return of cash, but at that point we’d expect to see them with way over $150Billion and a resultingly poor P/E ratio due to the dilution of the enterprise with so much low RoI cash and fixed income.

        There is no credible need for such huge prospective cash levels. Indeed the fact that they’ve not had any debt since their cash hit 10Bn rather indicates that their need for working capital is far lower. If they need huge amounts of cash as a hedge then they should have issued long maturity debt to boost gross cash, but they never have.

        Most likely the main reason that we’ve not seen any cash returned to investors thus far is not because Apple needs all 75billion, or because Jobs has a fear of failure but simply because too much of it is currently overseas due to tax constraints.

      • John H. Frantz

        I wonder if Cook will have this more pragmatic view on the cash hoard. With his newly acquired shares he is becoming firmly fastened in the same boat as other shareholders. A buyback would serve him well.

      • Anonymous

        I think it’s significant that Apple is one of the backers of the idea of a repatriation holiday. There are only two reasons for them to care, because they want to buy a huge firm which is listed in the US for cash or because they want to return cash to their own investors. Huge mergers have never been Steve Jobs’ style so I don’t really think that he is any less pragmatic about this than Cook.

        As to whether the money is returned as a buyback or a dividend – my personal preference would be a mixture of the two. A buyback alone is good for insiders at the expense of investors, a dividend alone is the opposite. Ideally money should be returned in a way which is sterilized so as not to favour either.

      • Anonymous

        I think it’s significant that Apple is one of the backers of the idea of a repatriation holiday. There are only two reasons for them to care, because they want to buy a huge firm which is listed in the US for cash or because they want to return cash to their own investors. Huge mergers have never been Steve Jobs’ style so I don’t really think that he is any less pragmatic about this than Cook.

        As to whether the money is returned as a buyback or a dividend – my personal preference would be a mixture of the two. A buyback alone is good for insiders at the expense of investors, a dividend alone is the opposite. Ideally money should be returned in a way which is sterilized so as not to favour either.

      • MOD

        How does $1 billion for each of the 40 commentators on this blog sound?

      • Anonymous

        I think it’s significant that Apple is one of the backers of the idea of a repatriation holiday. There are only two reasons for them to care, because they want to buy a huge firm which is listed in the US for cash or because they want to return cash to their own investors. Huge mergers have never been Steve Jobs’ style so I don’t really think that he is any less pragmatic about this than Cook.

        As to whether the money is returned as a buyback or a dividend – my personal preference would be a mixture of the two. A buyback alone is good for insiders at the expense of investors, a dividend alone is the opposite. Ideally money should be returned in a way which is sterilized so as not to favour either.

      • Chandra2

        All reasons you mention are true

      • http://www.asymco.com Horace Dediu

        Two thirds of Apple’s cash is held outside the US where. That’s about $50 billion now. That money is more-or-less frozen there due to tax treatment.

      • Anonymous

        Is there a solid source for that number Horace, or is it just a rough estimate based on the distribution of their revenues?

      • http://www.asymco.com Horace Dediu

        That figure came from Oppenheimer in an analyst face-to-face presentation less than two weeks ago. I don’t know how widely it was publicized outside that audience and I have no link other than private communication from an attendee.

    • Anonymous

      Except for the fact that stock buybacks very commonly do not end up impacting stock price commensurately. With a stock like apple that has historically behaved very irrationally whether due to gaming or whatever, a stock buyback would amount to simply having a giant cash bonfire.

    • Anonymous

      No. Apple is the only one who has an even better investment than Apple stock: making Apple products. It costs Apple $300 to make an iPad, and within weeks they sell it for $500 and they have a 40% return. If a company is investing in their own stock, that means they don’t have that kind of product internally to invest in, which means the stock is probably not a good investment.

      The cash hoard is there for one reason: to make it impossible for Apple to go out of business. Apple is the sun in the Apple ecosystem. If it is possible for the sun to go out, that ecosystem is much, much less valuable. The cash hoard enables Apple users, developers, employees, investors, suppliers, contractors, and so on to invest themselves fully in the Apple ecosystem with no fear of it going away. Go ahead and take 3 years to learn Objective-C, Apple will wait. Go ahead and buy 20,000 iPads for your business and go ahead and develop core business apps in Xcode for those iPads.

      Apple could shutter all stores and stop all manufacturing and run on cash for 10 years. All they have to do is keep pushing their technology forward and it is impossible for them to go out of business.

      Microsoft achieved this same kind of ecosystem confidence in the 1980′s by leveraging IBM’s monopoly to gain their own monopoly, then leveraging that to gain other monopolies, and all the while, using illegal business practices to “cut off the air supply” to any company that so much as hinted that it might one day threaten one of Microsoft’s monopolies. Of course, this system ultimately ate itself as Microsoft devoured its own ecosystem. And Microsoft has not pushed their technology forward. For example, they did not have NT on ARM up their sleeve like Apple had Mac OS X on Intel up their sleeve when the game called for it. So Microsoft may yet kill themselves. No amount of forcing can make a Windows PC maker ship a Windows 7 ARM tablet. Microsoft made that gambit impossible with their lack of stewardship of their own technology.

      • Chandra2

        I agree with your commentary on the technology related aspects. But…

        “…If a company is investing in their own stock, that means they don’t have that kind of product internally to invest in, which means the stock is probably not a good investment….”

        I hear this from other sources as well. Why are we taking such a black or white approach. I go to work, spending 5 bucks on operational expenses ( gas, clothes etc. ) with 20 bucks amortized capex ( education, skills etc. ) and say I earn 100 bucks a day. That is a huge return. I only spend $25 of the difference thus have $50 to invest. How I choose to spend that $50 is no reflection on my skills or my ability to grow my future earnings. If I do not like sharing that $50 with a few others, what is wrong in buying them out so I do not have to share that $50 with them in the future.

      • MOD

        Warren Buffet would agree with you. I would strongly suggest you read any of his writings. He advise all companies to invest in themselves, ie purchase back their own stock, but only if such stock is undervalued., and secondly if they have cash to spare that they cannot invest in better alternatives.

        He says that oftentimes their own company is a management’s best investment. This is often the case because management knows its company better than anyone else.

        With Apple however, within 10 years they disrupted the music industry, and now the cellphone industry. What is next, the PC industry, the movie business, the TV industry? I would think they need the cash for this. I don’t know too many banks that would lend to you if you came in with such a business plan.

        And I like the comment about ecosystem. Apple’s cash gives them security and is making it safe to purchase their product or develop software for them etc.

  • James Lambert

    Hey, This stuff is really interesting. I wonder if you get markedly different results switching from P/E to something like enterprise value / EBITDA. I appreciate that your interest is in Apple’s share price but a comparison between various valuation and earnings measures might be illuminating. It may tell us how out of whack Apples share price really is in comparison to its competitors. If at all.

    Another small point. I’m sure my old Physics professors would want to know why your graphs have best fit lines. As you point out there’s practically no correlation so the gradient isn’t terribly informative.

    Keep up the good work

    James

    • http://www.asymco.com Horace Dediu

      Yes, the fit lines are useless. I had them in the charts but forgot to delete them before publishing.

  • http://deviceconvergence.wordpress.com Nalini Kumar Muppala

    a note on narrative mode: the article begins with first person plural and a few paragraphs later turns into first person singular.

  • Anonymous

    It is interesting how the P/E seems to have taken a “permanent” hit after the financial crisis. At the same time, I believe the market is continuing to apply the mythical law of large numbers to Apple, essentially ignoring the growth rate altogether. Factor #2 is the continued belief that either Apple will stumble or competitors will suddenly get the formula right, and the growth rate will fall off a cliff. Both of these are completely emotional considerations, unsupported by much real evidence.

    The market continues to be flummoxed by such a large company growing so quickly.

    • Anonymous

      Investors don’t understand how digital scales yet. You can have one genius do one unique and amazing thing, and then you can duplicate his work a billion times for almost no cost. If you are shipping an iPad anyway, putting better software on it does not increase manufacturing or shipping costs but it can radically improve your sell-through.

  • http://wmilliken.livejournal.com/ Walter Milliken

    I wonder how the P/E correlates to the proportion of institutional assets Apple stock represents. Getting this number would take some digging, you’d probably have to pick some representative institutional investors and figure out their Apple holdings from the reports. But this might speak to a variant of the “market cap too large” argument. You’d probably need to do this with some other semi-similar companies to see if Apple is acting differently.

    • Z Kariv

      Assuming that Institutional invester percieved Apple as “too big”, hance damping its price–Why should they still keep it in its protfolios?

      • http://wmilliken.livejournal.com/ Walter Milliken

        Sorry, bad phrasing on my part — I was trying to say they saw too large a share of their own holdings being in Apple, rather than being directly intimidated by its overall market cap. The two things are related, since they’re both due to Apple’s rapid price growth over the last few years.

        Thus there’s no reason for them to sell Apple, but they’re perhaps unlikely to buy it, except possibly on price weakness. That would cut out a large portion of the market for the shares. NASDAQ data says Apple is about 70% owned by institutions.

        For the non-institutional investors, the share price may be the deterrent. This might be a slight argument in favor of a stock split, but it’s not clear that small investors would have that much impact, given they’re only 30% of the market for the stock.

        There’s also the potential that the institutional investors would sell if the price rose significantly, acting as a buffer on the stock price. That does match the pattern the stock’s been in for a while. It would be interesting to see if the occasional price jumps to new levels are driven primarily by institutional or non-institutional buying; I’m not sure if there’s a way to derive that data, however.

      • Dajhilton

        You ask why should institutional investors continue to keep Apple in their portfolios? Because if they did not they would not be able to answer this simple question which would be asked at board meeting: “Do you mean to tell us that this institution has failed to invest in (1) America’s largest corporation; (2) while it is experiencing 50% year-on-year growth in stock price? What investment could be more obvious, even to the average man on the street, let alone to investment ‘experts’?”

    • Anonymous

      Isn’t it more to do with those investors thinking that their own holdings of Apple are big enough, rather than thinking Apple is too big? They are betting on Apple growth if they own the stock, but perhaps they do not want to bet more than 20% of their fund on one high tech company?

      Investors don’t understand that Microsoft and Google and other tech companies all have empty cupboards. They probably think that what Steve Jobs did in 2007 and 2010 with iPhone and iPad can be done by any high tech company at any time “if they get lucky.” You have to know a little bit about software to understand that Apple is a decade ahead of everybody. Microsoft has not even done a modern operating system core yet, and Linux does not have a modern display layer. (It has like 100 antique ones, but that is no good. That is why Android is so slow and will continue to be for years to come.)

      • Anonymous

        The problem could be one of concentration, ie. that the number of institutions holding Apple is relatively small compared to those holding MS. That higher concentration would make it hard for those investors already holding Apple buying more while maintaining a diversified portfolio.

      • http://wmilliken.livejournal.com/ Walter Milliken

        I was under the impression that Apple was pretty widely held across institutional investors these days.

      • Anonymous

        Hmm, I know that in the UK there’s a movement for insurers and pension funds to attempt to balance up the cashflows from assets with their liabilities – which has led to a preference for dividend bearing stocks in many cases.

        Many institutional investors are endowments and foundations that are very conservative, who may have a preference for Blue Chips.

        Then if you think of Mutual Funds, Apple may be outside the purview of many due to their investment parameters.

        Finally there’s an odd effect because though Apple is the most valuable tech firm, Jobs is far from the richest tech mogul. The amount of Apple stock thus tied up by the founders is unusually low, leading to a significantly larger free float.

        Apple is undoubtedly more widely held than it used to be, but it may still not be enough.

      • http://seekingalpha.com/article/285685-aapl-s-cash-on-hand-why-shareholders-should-stop-whining theuglytruth

        Over 60% is held by institutions

      • http://wmilliken.livejournal.com/ Walter Milliken

        That’s essentially what I was thinking, yes, a concentration argument relative to their own portfolios, rather than the actual market cap, though they’re likely linked. That’s why I called it a “market cap too large” variant, though that was probably a bad choice of terminology — what I get for being in a hurry to finish the post.

  • gbonzo

    I am a big fan of Asymco, but there are now several entries that seem to imply a mindset that there should be a stronger connection between P/E and historical growth, or that there should be a stronger connection between historical P/E and current P/E. I am little bit at odds with these.

    There should be a strong connection between P/E and future growth, which is always an estimate. Changes in P/E reflect changes in market estimates of future growth.

    We can say that the market was right when it gave Apple a high P/E in the past. Apple proved to be worth that high P/E. Points to market for that one.

    Now we should be discussing and estimating the future growth of Apple. I still fail to see why historical P/E numbers and historical growth figures are so very important. I also doubt that the financial crisis has much to do with it.

    Respectfully, gbonzo

    • Anonymous

      if you believe:
      - apple will eventually command 20%+ of the overall cellphone market at similar per unit ASP to now,
      - and if you believe that apple has a strong potential to “ipodify” the PC market with the iPad (e.g. 70% market share of 300 million units a year) with similar per unit ASP to now,
      - and if you believe that apple still has potential to enter lots of new markets, then…

      Yes, apple today deserves a P/E of 30+ easy.

      However those assumptions above are all open for debate of course.

      • Chandra2

        In the phrase “If you believe”, the “you” is the market as a whole. It is that much harder to come to a conclusion on the P/E. On top of that, no one knows what will happen in the future with any degree of certainty.

        The P/E of today is a reflection of the market estimate of the future of the company.
        But all future courses of actions have a probability curve, some are more certain than the other. As the time line moves from present to future, the probabilities change and the market adjusts.

        I look at one thing. Do the changes in P/E correlates very strongly with near term events. If it does, then one possible conclusion is that the probability curve of the farther out years are too dispersed and skewed towards uncertainty ( conservative, low risk taking ) than certainty ( risk taking).

        It seems to be like this:

        Great near term news -> P/E goes up -> Probability curve is skewed towards certainty and optimism
        Great near term news -> P/E goes down dramatically – > Probability curve is skewed towards certainty and pessimism
        Great near terms news -> P/E is more or less steady with small up and down movements -> Probability curve is too dispersed to be of any use and the market is skewed towards conservatism than risk taking

    • http://twitter.com/disc1979 Dirk Schmidt

      The future cash flows should define the value of a stock. There is not debate about it. We are looking at relations and patterns to find explanations why Apple’s share price may not reflect its intrinsic value. We limit our analysis to public data as we want it to be “peer-reviewable”.

      • gbonzo

        There are recent analyst opinions like this: “Apple to ship 86.4 million iPhones in 2011″. This refers to calendar year 2011.

        Let’s split it like this: Q1 (known) 18.65m, Q2 (known) 20.34m, Q3 (estimate) 23.05m , Q4 (estimate) 24.36m. By these numbers, the iPhone unit growth has quickly slowed from 100% in the past to 50% measured from CY10 Q4 to CY11 Q4.

        What is the smartphone market growth in that scenario? Is Apple growing less than the smartphone market which would mean Apple losing smartphone market share? If Apple is losing share does it mean margin pressure? If Apple has margin pressure, the iPhone profit growth could be lower than 50%.

        All these question appear on a very near future, just a few quarters. What about in a year or two, are we in a situation where the profit growth slows dramatically, as the market seems to estimate? Many would argue that iPhone margins are excellent, but not sustainable in the long term. Analyst Per Lindberg said that about Nokia for a long time. He got fired, because he seemed to be consistently wrong, but in the end he was right.

        I don’t say that I agree with the 86.4 million figure that started this gloomier thinking, but I certainly have some doubts about margins in the longer term. I also fear the Android juggernaut.

    • http://twitter.com/disc1979 Dirk Schmidt

      The future cash flows should define the value of a stock. There is not debate about it. We are looking at relations and patterns to find explanations why Apple’s share price may not reflect its intrinsic value. We limit our analysis to public data as we want it to be “peer-reviewable”.

    • Anonymous

      Good points, gbonzo. Allow a consideration of uncertainty in evaluating P/Es.

      A high-risk startup, or a firm at risk of a competitor knocking out its legs, might face a 50/50 chance of making $10 or losing $9/share over the next year. If its assets are only $2, the loss scenario puts them out of business, and investors lose their full investment. But the success scenario pays out handsomely, enough to justify the attempt. Equity is like a call option on earnings; the more volatile earnings are around the expected, the greater the option value. Alternatively, you as an investor own the earnings but have a put option (go out of business).

      There’s no put option value on Apple’s earnings. They make go up a little or a lot but even in a crisis the company will not go out of business. The consensus earnings growth deserves a lower P/E because many of the competitors’ higher multiples are based, ironically, on the optionality of their shakier finances.

      • Chandra2

        >Equity is like a call option on earnings; the more volatile earnings are around
        >the expected, the greater the option value.

        Walt, it does sound counter intuitive. But it is making me think. The counter-intuitive implication being “Had Apple’s earnings had more volatility/risk around the mean, the price of apple stock will be higher for the same mean earnings and hence higher P/E”. Why is that?

        What I am confused a bit is, the VIX index is based on the implied volatility of the S&P 500 index and we always hear that a higher VIX represents fear and panic in the market. Higher VIX is usually associated with bearish sentiment and lower S&P prices.

        May be I am missing something. There can be volatility with an upward trend of the mean and volatility with a downward trend of the mean. It makes sense for the price to be higher than a low volatile stock in the first case ( upward trend in earnings ).

      • Anonymous

        Yeah, I thought about an alert for counter-intuition.

        But rather than worry about thinking of Apple as MORE volatile (uncertain outlook for earnings), think of the fact that some competitors have more volatile future earning streams. Think, in fact, about pre-IPO private equity. VC types are thrilled if 1/5 of their deals make it big and they lose money on 2/3, because they’re looking at 1000% upside but only 100% downside.

        Or so their spiel goes. Even a portfolio of 10 deals makes for a very uncertain outcome. “Expected” earnings for the whole portfolio might be very low, but investment return still being high.

        I don’t use this type of analysis in my work so keep your ears open for others who claim more expertise.

      • Chandra2

        Walt: After reading your ‘call options on earnings’ idea, I read up on volatility and options pricing. There is Statistical Volatility ( past volatility measured in standard deviation ) and implied volatility. They simply define away implied volatility as the difference in price between the theoretical price ( which includes SV) and the supply-demand determined market price for the option. They make a claims that if an instrument has high SV, the IV component will be non zero. That is, market price is higher than the theoretical price. The explanation is that several different volatilities with the same mean are possible and since people can make money in options when there is volatility, the demand for call options increases and hence the increase in premium. So from a call option buyer point of view, if you expect volatility to be higher in the future, you buy the call option and it is a bullish strategy.

        But why do people consider higher VIX ( the embodiment of implied volatility ) as an indication of bearish sentiment? These two contradict each other.

        Just as an aside, the financial media quotes VIX all the time. They say VIX is higher and so the market is volatile. Is it not the case, the market is volatile and hence the VIX is higher?

        Second aside, why is volatility always given a negative connotation. Can’t you have volatility with an upward sloping mean?

      • MOD

        The VIX is calculated and disseminated in real-time by the Chicago Board Options Exchange. It is a weighted blend of prices for a range of options on the S&P 500 index.
        http://en.wikipedia.org/wiki/VIX

        Volatility is not necessarily bearish. Most commentators do not know what they are talking about. Whether the market has a big jump or a big dive, the VIX will increase by exactly the same amount.

        (Although it is more likely that the market will have a larger drop than a jump, since people panic in a herd mentality when facing a predator, but do not get greedy simultaneously. They see other people get greedy and make money first, then they follow, after it is shown to them that it is safe.)

        But commentators (and people in general) will search for a cause of the big dive and fix on the VIX. When the market jumps few look for a reason, but the VIX will also be high.

      • Anonymous

        Implied volatility is symmetric because of the nature of the model used, and because the share price is supposed to contain all information currently available – ie. if there was a preponderance of negative potential then the stock price would move until their wasn’t.

        That doesn’t change the fact however that higher volatility implies higher risk and thus causes investors to demand from an asset a higher return, ie. a lower price.

        So while high volatility doesn’t imply a downward motion is more likely than an upward one, an increase in volatility does imply a decrease in asset price.

      • MOD

        The strike price is the price at which you have the option (why its called an option) to call the stock (to buy it) or to put the stock (to sell it at), by the expiration date.

        A strike price of 0 means that you make any and all money above the market price of 0. The question is how much much you paid for that 0 strike price option. If you recoup more than you paid for it, then you make a profit, else a loss.

      • Anonymous

        More volatile asset classes should correlate with higher returns, that’s not counter intuitive at all. It’s orthodox that investors should require a risk premium.

        The mistake is in thinking that higher return should mean higher value. The entire point is that the return increases because the value decreased.

        So if I offer two investments, that yield the same average return at par but one has high volatility and the other has low, we would expect the price of the former to drop until it had a suitably higher return to compensate for the volatility induced risk.

      • Chandra2

        That is how I understood it. But Walt made the remark “The consensus earnings growth deserves a lower P/E because many of the competitors’ higher multiples are based, ironically, on the optionality of their shakier finances. ” And the point about treating equity as a call option on earnings and higher volatility in earnings demanding a higher premium and hence higher price. That is the contradiction I am still trying to resolve in my mind.

      • MOD

        It is like gambling. Most people investing in small companies making little revenue are gambling it will strike it rich with an invention or product or software. So they are not worried about the small revenue (E-Earnings) which give it a high PE.

        (Like if you had $1, and one shot at wealth, you would put it on a 32-1 number at the roulette, rather than a 2-1 spot.)

        Thus treating equity (common stock) like a call option (a speculation that it will be worth much more in the future).

        Indeed, if it had a low PE they would not consider it a speculative investment (rather a stolid investment), thus would not gamble on it, thus ignore it.

        Value investors would pick it up instead, but only if it was a safe company. A high tech company (like Apple, or even Microsoft) with a low PE is a strange fish to most. It is no longer a speculative company, so speculators ignore it, but it is not as solid as a soap or food company, since high-tech can change quickly, and thus safe investors like pension funds would avoid it.

      • Anonymous

        Oh I see, well then I would argue that the idea of treating Equity as a call option on earnings is flawed in two ways.

        First off there is the problem that option pricing uses an arbitrage model, whereby the option price is determined by constructing a risk free portfolio of asset and option. Since you can’t actually trade the underlying cash flows the option pricing model has no theoretic basis when applied to equity itself.

        If we gloss over that theoretical problem there are two practical ones. We don’t know the value of the underlying cashflows, is a major problem, but we also don’t actually know the volatility. This is because vol isn’t constant across all strikes (the so called smile or vol surface) and the strike price of equity-as-an-option is 0. This means that we can’t just use the at-the-money volatility, because we’re not at the money – we’re as deep in the money as we possibly can be. Our available smile data isn’t going to cut it.

        So the ‘equity as an option’ argument means that we’re now trying to value a derivative on an underlying which we have no market value for, using a volatility that we have no market value for based on a model that we have no theoretical basis for using.

      • Chandra2

        Eduardo, Thanks for that. Can you clarify why “the strike price of equity-as-an-option is 0″. In this model, the underlying is the discounted earnings flow ( with all its uncertainties ) and the strike prices are the various future changes in that discounted value, is it not?

      • Anonymous

        The strike on a call option is what you have to pay to acquire the underlying – but once you buy an equity you own the rights to the future cashflows (kinda, sorta, ish) – there’s no additional payment to be made.

      • MOD

        The strike price is the price at which you have the option (why its called an option) to call the stock (to buy it) or to put the stock (to sell it at), by the expiration date.

        A strike price of 0 means that you make any and all money above the market price of 0. The question is how much much you paid for that 0 strike price option. If you recoup more than you paid for it, then you make a profit, else a loss.

      • Anonymous

        We’re not talking about an actual equity option here though.

        The suggestion has been made that equity itself is an option on the cashflows and I’m pointing out that if you try to model it as such then it is an option with strike of 0.

        It’s also has no expiry, but that’s less problematic – at least for an american option.

      • Anonymous

        We’re not talking about an actual equity option here though.

        The suggestion has been made that equity itself is an option on the cashflows and I’m pointing out that if you try to model it as such then it is an option with strike of 0.

        It’s also has no expiry, but that’s less problematic – at least for an american option.

      • MOD

        Equity is more than an option. It is an outright claim on the the cash flows (revenues).

        Granted there is no expiration, but there is still a purchase price on the equity. And there is a selling price. The difference is the trading (or investment) profit.

      • Chandra2

        Sorry to belabor this, but I want to understand. If the cashflow is say $10 a share, isn’t that the ‘in the money strike price’ with the infinite expiry option price being the stock price?

      • Anonymous

        No :)

      • Anonymous

        Ok, I think I’ve figured out what model is confusing you – and it’s based on modelling an equity as an option on liquidation value, with a strike given by the liabilities.

        Let me first give an example of that model in a case where it works pretty well.

        Suppose we have a closed end investment fund, which has 1 year to orderly liquidation, a pot of $100mil in assets and a bond of $100mil in liabilities ( due upon liquidation). We’ll also assume a zero risk free rate for simplicity. The fund has 1 million shares.

        So this firm has a NPV of zero, and we can model it as a call option with a strike of $100 (the liability) and an underlying of $100 – (the assets). ie. this is at the money.
        The model is potentially useful because it allows us to quantify the relationship between the equity price and the vol of the underlying, and to model how the equity price will drop as we approach expiry.

        Everything makes sense here, increased vol means increased equity price, as we approach expiry the premium due to vol will diminish smoothly till we’re left with just the pay-off, which is Assets-Liabilities or 0 whichever is greater.

        An interim example where this model might have been somewhat applicable though on shakier ground would be Barclays Bank when it hit it’s stock price nadir of 44p. At that point there was significant fear that market conditions would force the firm into liquidation or nationalization – however it seemed that if it could survive the short term problems it had a viable business.

        Apple however is not a good fit for this model in any way, and I hope that’s clear from get go, and your confusion over the affect of vol on the share price is a good example of why.

        First off it’s clear that if we try to use this model Apple is massively in the money. The strike may not be quite 0 but it’s certainly very close because Apple has no debt and only small liabilities due to warranties etc. Vol only has a very small impact on the premium of an option that is deep in the money, so we might expect an undetectably weak correlation between vol and shareprice.

        However the main component of the underlying is the enterprise value of Apple’s actual business, and that has a much stronger inverse correlation with vol – which will dominate.

        TL/DR – while you can model equity as a call option, and while it can be useful in some cases Apple isn’t one of those cases.

        (I’m posting here because of the stupid way discus narrows deep threads to a tiny column!)

      • Chandra2

        Thanks Eduardo for the clear explanation. I think I get it. I am also trying to get an intuitive understanding. On that count, I understand what you say about the relationship between deep in the money option price and the vol etc. I need to reflect and understand why liability represents the strike ( my own lack of background is the reason for not understanding this but I will there ). More importantly, I need to understand how to characterize the volatility as negative and risk when the mean is trending up, like the way Apple has been doing over the past two years. It has been trading around a band ( representing some volatility ) but the whole band is upward trending.

      • MOD

        He used liabilities as a strike price but he also gave you the equal amount in assets are free money to buy the option. This is because assets-liabilities= 0 and you cannot have a 0 priced option, because it cannot go below 0 (for the sake of the comparison), whereas if it is $100 it can go to $99.

        Volatility is not necessarily bad. It is what the market does when responding to various world events, or even to what other stocks in similar industries are doing. People have a herd mentality. If Google or Microsoft fall, they sell Apple too (idiots).

    • http://www.asymco.com Horace Dediu

      Of course an equity is priced only with regard to the future value. The P/E implies optimism (or pessimism). What I point out is that there was a great deal of optimism when the company’s future was very cloudy and unsure but a lot of pessimism now that its future is quite predictable.

      The financial crisis is interesting because the shift between optimism and pessimism happened rather suddenly, independently of fundamentals, and can therefore be seen as causal. We can also observe the same shift in other companies.

  • Josephanddonna

    On a rough average, it looks like Apple has been growing its net income at a rate of 60-70% per anum since 2005. Even assuming a 50% growth rate shows an explosion in earnings on its way. If we assume EPS this fiscsal year of $30, then in five years it will approximate $227. Even assuming P/E drops to 10, that equates to a stock price in 5 years of $2,270/share. One year later, it would increase 50% to over $3,500 /share.

    I contend that the only reason the P/E ratio for Apple is dropping is because its earnings are exploding far faster than people realize. I also contend that this makes Apple a screaming buy now, and more so with each passing quarter.

  • Chandra2

    The various psychological reasons attributed to why the ‘value’ of Apple is different from the current price, I am curious about one thing. Everyday Apple trades 10-15 million shares a day. Are those people, as a group, not aware of all the points being discussed here? Those buyers and sellers are the ones that keeping the price away from value. ( let us leave out the certain % of the daily volume that is generated by pure traders who does not care about value ).

    • Anonymous

      I can only suggest that you turn your question onto yourself, by which I mean this, why don’t you own more apple stock than you do?

      You have most likely some cash in a current account that you use for day to day living, some savings in a savings account for rainy days and perhaps some equities, a pension pot maybe, a home, who knows what else.

      You could sell/leverage the house, sell all your other equities and buy Apple, then buy more on margin. But you (most likely) won’t and you won’t for a bunch of good reasons that I won’t even try to enumerate.

      Two things would raise the price, either an increase in population of people looking to buy at current prices and higher or a decrease in the population of people willing to sell at current prices and lower. So when you answer for yourself why you’re not in the former group, you get a better idea for the micro-economics at play.

      • Chandra2

        Eduardo: Not sure exactly where you are going with it, but here is my own microeconomic answer. I do not add to my Apple position for diversification reasons. Now, if I chance upon a lot of money, then I will definitely consider putting it in Apple, so the % of Apple holdings in my whole portfolio does not change. So there seem to be a few more reasons than just increase in head count of people on either side of the trade.

        In any case, I do understand what you are saying. It is the nervousness about the future that make even believers sell, especially when they have made quite a bit of profit. That is true even though they may not put that money in a better place, on a risk adjusted basis, but they feel better that it is in a safer place.

        What I am thinking is, all the reasons postulated in this thread are mere ‘Models/Artifacts/Explanatory Devices’. The people who actually make these buy and sell decisions on a day to day basis do not deeply think about these factors in their decision making process. But there is a wide spread belief ( that includes me ) that somehow the combined buy and sell activity which is not necessarily generated out of any deep rational philosophising, is somehow model-able using rationales that were not part of the supply/demand generation of the orders on a daily basis.

      • Anonymous

        I’m just saying that each investor makes the decision on a day to day basis. You, like I suspect most people who believe the Apple story are put off from buying more because as you say primarily because of diversification – which is to say you wish to manage your risk.

        Given the tremendous growth we’ve seen from Apple, people who invested in them back in the day whether directly or via funds are suddenly looking at an outsize portion of their savings being in a single firm. As a result they (or said funds) don’t buy more, and indeed will be driven in many cases to sell either to fund their lifestyle, to meet obligations or to actively diversify.

        As you seem to be saying, P/E is just a model which we use to examine stock prices. In some ways that model also directly affects stock prices because some people are trading from the model, but ultimately stock prices are driven by the micro-economics.

        In the case of Apple I think that we have to abandon many of the models that work for other stocks, because the micro-economics are so different. The combination of tremendous growth in market cap and tremendous size of market cap are unprecedented.

        Why does this affect the validity of the usual models? Because they depend upon the idea that the population of investors are buying and selling based on their idea of the value of the stock. But if the investor population is unusually concentrated, and considerations such as risk are the driving factors then this completely breaks down.

      • Chandra2

        Alright, yes. Couple of points.

        >Because they depend upon the idea that the population of
        >investors are buying and selling based on their idea of the
        > value of the stock.

        I wonder what % of daily volume of any stock for that matter is based on considerations of value. Is it significant at all?

        Asking, because ‘value’ itself is a model and hence artificial and why should reality fall in line with this model? Why do we all believe it should? We all seem to retrofit data into such a model and when model does not work ( it rarely does ), we try to modify the model or try to theorize why the ‘price’ is not right. But we all have this unshaken belief that the model called ‘value’ has to be right. I think we need to question that assumption for any stock, let alone Apple. ( I am not saying we should abandon all these theoretical studies, they serve a useful purpose in terms of compactly codifying the past )

        >But if the investor population is unusually concentrated

        Are you saying that this unusual concentration is something unique to Apple. That is something to think about. Please elaborate as to why you think it is unusually concentrated.

      • MOD

        Average AAPL daily trading volume is 19,864,100 (shares) = 19.8M

        Shares outstanding are: 927.09M

        So 19.8/927.09 = 2.1% of total AAPL shares trade per day

        That is not that much, consider that many of these shares are bought and sold several times per day, the same shares, in fast trading strategies, and add up to 2.1%.

        As far a long term holders, it depends of the definition of “long term.” Most fund managers only look about 6 months to 1 year ahead. (Look at the analysts’ projections, they are made for them). Pension funds or endowments perhaps look 5 years ahead.

        But with such a liquid stock then can bail out easily if they change their mind about its outlook.

        Then there are intermediate funds, that look toward then next earnings release or next product announcement. This probably means a few days to a few weeks horizon for them.

      • Anonymous

        I don’t have any hard evidence for an unusual investor population, just vague hand-wavey stuff, it’s just a hypothesis at this point.

        Apple is both unprecedentedly large for a public company and grew unprecedentedly quickly for its size, so there’s the idea that rapid growth freezes in early concentration. It’s the largest firm to never return cash to investors. If we consider firms that grew as fast it has an unusually small percentage of shares in the hands of founders and thus a large free-float. Oh and Apple continues to not be in the DJIA, so their stock isn’t being held by as many passive index trackers as other firms of similar size.

        If this really is an issue then we could see a counter-intuitive situation where even as growth slows in future P/E holds up – because the investor base growth finally starts to outstrip growth in the underlying enterprise.

    • http://twitter.com/disc1979 Dirk Schmidt

      Trading allows a share price to move up- or downwards. It is good that people trade Apple or any stock for that matter.

    • Anonymous

      “Don’t get mad; get even.” If Apple is trading cheap, it’s a golden opportunity for you.

      Of course, you might be wrong; maybe you’re not seeing something that others do. So you try on sites such as this one. Meanwhile, you diversify.

      As a minor expert in diversification, I can say one needs only a smidgeon of quality information that one knows is better than the consensus, in order to justify a huge emphasis into your best ideas. As an even more minor expert in human psychology, I know that most everybody overrates their insights and the others are too depressed to act on ‘em. Caveat lector.

      I personally think the pursuit of finding a fair value for Apple is a MUCH less interesting question than how we can take the sort of success Apple has had, into our own work. Kinda a Gresham’s Law problem.

  • MOD

    From WSJ
    Stocks: Playing Offense—Carefully
    By BEN LEVISOHN

    In this topsy-turvy market, it is little wonder why investors are exercising so much caution. But some carefully chosen risks could pay off, say strategists and money managers.

    There isn’t any doubt that investors have plenty to worry about. Europe is struggling to find a solution to its debt woes, the U.S. economy is teetering on the edge of a recession, and even emerging markets are growing more slowly than expected.
    STOCKS
    STOCKS
    Bloomberg News

    Microsoft is now a ‘deep value’ stock, according to at least one analysis.

    As a result, the Chicago Board Options Exchange Volatility Index, known as the “fear gauge,” has remained above 30 for 27 consecutive days, the longest such streak since the financial crisis. And defensive stocks—often-stodgy companies with stable businesses, such as food producers and telecommunications firms—have fared much better than the overall market.

    The average defensive stock in the Standard & Poor’s 500-stock index has gained 1.1% during the past six months, compared with an 11.6% loss for the S&P 500 overall. There are 134 companies in the S&P’s four defensive sectors—utilities, telecommunications, consumer staples and health care.

    That doesn’t mean it is time to sell defensive stocks, which can add much-needed ballast to a portfolio. But valuations are beginning to suggest that adding some riskier stocks could pay off, some strategists say.

    During the past six months, the S&P 500′s price/earnings ratio based on earnings forecasts for the next 12 months has plunged to 10.9 from 13.4, while the P/E of consumer-staples stocks has fallen only to 13.5 from 13.8. Riskier cyclical stocks—those that are more exposed to the economy’s fluctuations—have plunged. The forward P/E of energy shares dropped to 9.1 from 13. The ratio of consumer-staples to energy valuations is now nearly 1.5, the highest since December 2008.

    This isn’t merely a U.S. phenomenon; the gap between cyclical and defensive stocks has widened globally as well. Consumer staples in the MSCI World Index have a forward P/E of 13.7, while energy stocks have a forward P/E of 8.9. (The overall MSCI World Index has a forward P/E of 10.2.)

    The upshot: Value is turning to riskier, economically sensitive stocks. “Unless you think we’re headed toward a catastrophe, your stock portfolio shouldn’t be defensive,” says Aaron Gurwitz, chief investment officer at Barclays Wealth. “You should be comfortable with some risk.”

    Cyclical stocks could indeed fall more if the U.S. slips into recession, as some economists are predicting. But even that wouldn’t necessarily be the death knell that many expect, says Jonathan Golub, chief U.S. equity strategist at UBS AG.

    Since the end of World War II, there have been 14 periods when the S&P 500 has dropped 17% or more, including from April 29 to Aug. 8. Nine of those stretches were followed by a recession, but only five had top-to-bottom declines of more than 22%, and two were accompanied by drops of less than 15%.

    In other words, even if the U.S. economy enters a recession, much of the stock-market damage may be done already.

    “Investors have been hiding in defensive stocks as a way to get through this period,” Mr. Golub says. “That leaves other stocks attractively valued.”

    He says material and technology stocks look particularly inexpensive. They are trading at forward P/E multiples of 10.6 and 10.9, respectively.

    Investors shouldn’t abandon all caution, however. Andrew Lapthorne, head of quantitative strategy at Société Générale SA in London, recommends striking a balance between defensive stocks and risky ones. To do so, he runs two screens: One looks for “deep value” stocks—typically cyclical companies that are trading cheaply and should do well if the market bounces back. The second looks for quality stocks. Right now, 60% of the opportunities are in deep-value stocks, Mr. Lapthorne says.

    “I have no idea what the macro cycle will do,” he says. “But there’s more opportunity in deep value.”

    Mr. Lapthorne’s defensive screen begins with something known as Piotroski’s F-score, a model that uses nine measures of profitability, leverage and operating efficiency to find quality companies. He then chooses the companies that have a dividend yield of at least 3% and strong balance sheets. Companies that pass this screen include DTE Energy Co., Abbott Laboratories and Consolidated Edison Inc., he says.

    The deep-value screen uses a modified version of legendary investor Benjamin Graham’s 10 value criteria. It first looks for underpriced companies, such as those that have an earnings yield—a stock’s earnings per share divided by its price—at least twice that of a typical triple-A bond, and a dividend yield at least two-thirds the triple-A bond, a sign that they are undervalued.

    Then the screen tries to weed out the riskiest of the bunch by looking for companies with less debt than their tangible book value and total debt lower than twice net current assets, among others.

    Companies that meet all 10 criteria are few and far between: Only three companies in the FTSE Global 500-stock index have made the cut since 1992. That is why Mr. Lapthorne uses a less-stringent version of the screen that includes companies that pass at least six of the tests, with at least two from each set of criteria. Stocks that measure up include Forest Laboratories Inc. and Microsoft Corp., he says.

    “Because of the selloff, you’re getting a greater number of stocks coming into the deep-value screen,” Mr. Lapthorne says. “As soon as you see start seeing Microsoft in there, it’s time to take advantage of the big declines.”

  • davel

    I was thinking of a post recently where someone pointed out the fact that boomers are nearing retirement and this could be a major reason for compression of PE. If you were a boomer and your portfolio took a hit in 2008, how comfortable would you be of risk?

    Also consider the flash crashes and various reports of non-normal market activity. What would you do with your money? Even with Apple’s earnings since most funds have Apple would you invest money not in funds into the stock?

    I bring this up because I wonder if the PE ratio of the market as a whole has declined and/or if the PE for growth segments has declined in the past few years.

  • gctwnl

    I wonder how the accounting rules change has influenced this. Apple used to have to report income from iPhone over a stretch of years, now they can do it in one go (when sold). Is it pre/post crisis or is it pre/post accounting change?

    • http://www.asymco.com Horace Dediu

      What all analysis should be based on is current statements of accounts. As Apple changed accounting they re-stated their accounts. They re-issued historic accounts and asked everyone to discard any old accounts as they are no longer valid.

      We’re applying those re-stated accounts. So the answer to your question is: it is pre- and post-crisis and post accounting change.

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  • MOD

    “Sorry to belabor this, but I want to understand. If the cashflow is say $10 a share, isn’t that the ‘in the money strike price’ with the infinite expiry option price being the stock price?”

    If the cash flow (thus net profit) is $10, then your equity is the whole $10. You are entitled to the entire $10, (assuming assets>=liabilities).

    With an equity/option comparison:

    The strike price is $0.
    The market price is $10 (after the $10 profit realization)
    The option price is at least $10 (in the money means above the strike price, which is $0), since you can exercise it (call the stock, then immediately sell the stock for $10).

    Since the option is infinite in time length, people will impute it some possible future growth, because the company could grow.
    But it will rarely be less than $10, because once you sell the assets and pay the liabilities of the company, you will have $10 left.

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  • demodave

    To think that Horace wrote this article back on September 9, 2011. Amazing.