In intra-day trading Apple's stock price traded at a P/E ratio below 15. That threshold is now at a price of about $315/share. Excluding cash the P/E is under 12. On a forward basis, there is widespread agreement that Apple has the reward (yield) profile of a bond without the risk of inflation.
The history of the P/E ratio and the share price is shown in the following chart:
As the chart shows, Apple traded in a range of P/E between 35 and 45 until late 2008 and has been trading between a range of 15 and 25 since about spring 2009. It might seem that the price is rewarding growth, but it's not.
When adjusting for the growth the company has maintained, the company is at a similar P/E/tG (Price/Earnings/trailing Growth) to the depths of the recession.
At the trough shown above, the company was growing earnings at high 30% rates and sales in the teens. Today the company is growing earnings at 92% and sales at 83%. the following chart shows P/E ratio vs. growth.
From a historic perspective, Apple is as cheap as it was at the bottom of the recession. At the time there were many reasons given for why the company would suffer 'headwinds'. Most commonly cited was that the company was a maker of "luxury" products and luxury does not sell in a recession.
Today reasons being given for why the company will not prosper are far more nuanced. I won't re-iterate them but they deal with competition, platform issues, production issues, sympathy with companies that are failing, and saturation of markets.
The trouble is that these arguments are easier to refute than the luxury vs. economy argument. Exactly because the arguments are more precise, there is data that can be used to counter pessimism.
And yet, with or without data, markets sometimes decide that profits are not reliable indicators of value created or potential for value creation.
As I have tediously repeated in this blog, Apple's share price has been de-coupled from its earnings for many years. Consistent earnings growth above 70% is not seen as valuable. As the chart below shows, there is no correlation between EPS growth and value growth.
With the outlying quarter when 154% growth was matched by a negative 50% price change, the correlation does not look much better:
If we cannot correlate share price with growth then what is being valued? This has been a vexing problem because growth is the traditional, and logical, metric of valuation. Share prices, by definition (net present value of future cash flows) reflect future potential. That potential is more sensitive to growth than to anything else.
But I've been leaving one factor out of the share price definition. Share price is NPV of future cash flows plus current assets.
Since future cash flows are being thrown out of the equation, the company must be valued as a multiple of its cash. Does this relationship hold true?
In the chart below I show the weekly closing price of the shares and the corresponding value of the interpolated cash (and marketable securities) per share over the last two and a half years.
A strong correlation can be observed. The R squared value is a healthy 0.94. Of course this is not to imply causation. Correlation is not causation, but it is a hint.
Can predicting the cash per share be a strong indicator of future stock price? Perhaps. As long as this relationship holds, then having a reliable earnings model would still give us a solid predictor for the share price. Not because we can use EPS forward estimates multiplied by P/E but because we can estimate cash flows and the increase in retained earnings.
Of course, the market "is being irrational" because it values on the basis of the present only (not its future.) But who are we to argue? This valuation has held since October 2008.
As far as the market is concerned Apple's future is irrelevant. Its value is defined as a constant multiple of cash.
Apple's revenue for the first quarter was $24.7 billion, which at 83% was the largest quarterly revenue growth they ever experienced. Operating margin was an all-time high of almost $7.9 billion, representing 31.9% of revenue and yielding 95% EPS growth.
After earnings were announced the share price reached $350.7. This includes $70 in cash. Trailing twelve months' earnings were $20.97. That makes the Price/Earnings ratio 16.7. Excluding cash, P/E is 13.4. The average growth over the past four quarters was 77%.
The following chart shows the share price vs. earnings. The green line is price and the blue line is share price. I also added multiples of the earnings to show how the stock traded in certain multiple bands.
During the period of 2006 to 2008 the company shares traded roughly in a range of 35 to 45 P/E. Since late 2008 the company shares have traded in a range of 15 to 25 P/E.
Share prices normally reflect potential earnings growth and past growth is often a good indicator of near term continuing growth. This is why the P/E is usually a proxy for growth. The faster the growth, the higher the P/E. Or so one would think.
If we look at the P/E vs. earnings growth for Apple, the picture is not encouraging.
P/E and Growth don't seem at all correlated. In fact, if we drop two outliers it almost seems that P/E is insensitive to growth.
I took the data a step further and separated it into two clusters: pre-recession and post-recession.
The blue circles are Q1 '07 to Q2 '08 and the orange plus signs are Q3 '08 to Q1 '11. As the share price chart implies, there is a clustering of averages where during the 2007 and early 2008 period P/Es were in the 35 range while growth was in the 50s and P/Es below 20s with similar or higher growth ranges.
As the following scorecard shows, the company's growth is exceptional. That does not seem to be something that is being valued by investors.
At last night's closing price Apple was trading at a P/E of 16.3. Excluding cash that ratio was at 13. On a conservative forward basis (my estimates) the stock is priced at less than 10 times next twelve months' earnings.
These figures show a remarkable pessimism that has persisted around Apple for years. It was slightly, but not much, worse during the great recession. It persisted whether the company was growing at 30% of, as now, 95%.
There are many hypotheses about why Apple's earnings and growth are considered worthless. They come and go with the whims of the age: recession, elitist, luxury branding, health issues, macro "headwinds", earthquakes, phantom competition.
Lately it's become fashionable to blame Android. That's a curious thing to me, because Android has been discussed at length here and it has been shown to be, for the time being, benign. Apple has not "lost sales" to Android as it has been selling all it can produce. In some ways it's been a boon as a co-belligerent against non-consumption.
The argument that the discount is in effect because of the future of Android has one first strike against it: the fact that the market does not often discount the distant future. Capital markets are notoriously incompetent in spotting disruptions and often reward those who are failing right up until the bitter end.
But let's take the "Android hypothesis" (i.e. that Android is causal to Apple's share price) seriously and analyze it. How could the impact be measured?
Since Apple is trading at a fraction of (a) historic multiple (b) multiple based on growth (c) comparable companies' multiples then we can assume that a "normal" valuation would be twice the current (i.e. a multiple of about 32). That would still be a discount to growth and history but it would begin to match some of the comparables. A doubling of the P/E would be a good start.
But a multiple of 32 would imply a doubling of market cap, which means that the Android hypothesis is causing the evaporation of about $300 billion in future profits. So it stands to reason that it's responsible for a $300 billion destruction of Apple shareholder value.
That's an interesting number since Google itself is only worth about $169 billion.
The measurement then presents a remedy: If Apple bought Google (it already has a third of its value in cash) and it shut down Android, it could create $300 billion in value. If could even throw away all of Google and still walk out with a profit.
Since reporting on the 18th, I've mostly finished going over the the fourth quarter Apple data. Here is a quick summary of the articles that covered the financial and product performance:
After introducing it last quarter, this is a chart that I'm trying to improve and use as a single snapshot of growth, product mix, profitability, cost structure and overall sales. The purist in me likes to see the chart clean but it can be a puzzle to some. So for the sake of explanation, this time I've added some annotations to the year-ago quarter.
The left half shows flows in the same quarter a year ago and the right side shows the flows in the fourth quarter just ended December 2010. You can see where sales came from, how much of each product's sales went to suppliers and how much was available to pay employees (and who got what). You can also see how much was paid in taxes and what was retained.
Please click on the figure (requires no scrolling when viewed on screens wider than 1464 pixels).
As shown in the Apple growth scorecard, the company's earnings growth is continuing at 75% with the top line increasing at the annual rate of 70%.
The $59 billion of cash on the balance sheet has reached the equivalent of $64 per share yielding an enterprise value of $263 per share based on closing price of January 21st.
The stock price has been rising but not outside a narrow P/E band. The following chart shows the stock price and the 15 P/E and 25 P/E bands that have bounded it for nearly three years.
As previously observed, this overall share appreciation is not accounting for the growth in earnings.
The trailing twelve months' earnings were $17.91 per share. Therefore the P/E ratio is now 18.2. Excluding cash, the P/E is at 14.7. However, that's based on 2010 levels of earnings. Those earnings are increasing very quickly.
To account for earnings and their growth, I developed the following chart which shows the P/E and P/E/trailing-Growth for the stock.
The P/E is fluctuating on either side of 20 but when considering trailing growth, comparable companies, the macroeconomic conditions and guidance the value of the company is reaching new lows.
P/E/tG nearing recession lows
Earnings were 75% higher in 2010 than the year before. So based on the growth, the rule-of-thumb ratio P/E/trailing Growth (P/E/tG) is 0.24. This ratio (where 1.0 is seen as "fair value") is the lowest since July 2009, during the first months of recession recovery. The trend for this ratio is down (see the burnt orange line in the chart above). It's not far from hitting the lowest point during the recession at 0.17.
Now I'd like to reminisce a bit about that point in time. The stock had bottomed at $78/share[1]. It was trading at barely 3x cash and a P/E of 11 but growing 3x that level (32% in the slowest recession quarter but averaging much higher).
So today we are at a similar point in valuation. The cash is at $64/share, shares are priced 5x that amount and the growth is 4x P/E[2]. Although analyst targets are less comical, there is still the sense of extreme despondency when looking at the valuation ratios.
Guidance, Comparables and Macroeconomics
Unlike two years ago there aren't the same dark clouds on the macro horizon. The company is also not as cautious on its guidance (guiding 63% EPS growth must be a new record for a post-holiday quarter) and there is talk of bubble in valuation for comparable companies. Netflix, Amazon, and ARM have eye-watering valuations relative to growth.
A discount to the S&P 500
And to round out the tragic tale, Apple's P/E is, once again, at a discount to the S&P 500 P/E (14.7 vs. 16.57 respectively).
Given the new low in valuation contrasted with optimism on behalf of many (including management), on some forums there is discussion about Apple becoming the target for a take-over.
There is some perverse merit to this logic. With $64 in cash, $25/yr in earnings and 75% growth it's so cheap that if credit were available, it would make a tempting candidate. Private equity could take it private and use the gigantic cash flow to pay off debt (in about four years). In bygone days, this would have been an easy pitch.
Alas, the capital markets may not have liquidity for the size of the market cap Apple holds and I don't see any competitors able to get the leverage for an acquisition either. Or can they?
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Notes:
In early summer 2009 some analysts put 12 month targets for the stock at $70, so their predictions were within $6/share to today's book value.
A buyer of shares two years ago would only have to wait two years to have 80% of their investment sitting in retained earnings. An investor who read the data from Apple and knew that the iPhone existed could not fail but be amazed.
We expect revenue to be about $22 billion, compared to $13.5 billion in the March quarter last year. We expect gross margins to be about 38.5%, reflecting approximately $50 million related to stock-based compensation expense. We expect OpEx to be about $2.35 billion, including about $250 million related to stock-based compensation. We expect OI&E to be about $50 million, and we expect the tax rate to be about 25.5%. We are targeting EPS of about $4.90.
This is a particularly aggressive revenue growth forecast of 63% (note again that Apple's P/E has dropped to 18 and 14 ex cash and 10 on a forward basis) . Since Apple always guides very conservatively, the likely figures for the top and bottom lines are likely to be higher.
How much higher? Here are my estimates (growth in parentheses is year over year).
iPhone units: 18.4 million (110%)
Macs: 3.62 million (23%)
iPads: 6 million
iPods: 10.1 million (-7%)
Music (incl. app) rev. growth: 25%
Peripherals rev. growth: 23%
Software rev. growth: 23%
Total sales: $24.5 billion (82%)
GM: 38.8%
EPS: $5.89 (77%)
Looking a bit further ahead, earnings suggest the company is now trading at a forward P/E of about 9.5.
In the last quarter Apple's top line grew by 70% and the bottom line by 75%.
For a historical perspective, the following table shows year-on-year growth for products[1] and sales/earnings color coded with an arbitrary scoring range.
The major changes from the last quarter were the acceleration in software sales and the return to growth in iPod sales. iPod benefited from the continuing shift to iOS as the mix is now 50% touch in the portfolio.
Software growth reached a level not seen since 2008. It's not clear to me yet which products drove this increase.
Overall the growth is both wide and deep. I'm most impressed with the iPod as it was a surprise to hear such a high mix of touch.
The following chart shows the top and bottom lines plotted over time with color bands corresponding to the score system in the table above.
Note how earnings growth has been in the high or very high or exceptional range for all but one quarter over in the last four years[2].
Apple transcends the mythical "rule of large numbers"[3]. It's not only a mega-cap, but the second largest company in the world by market cap. Not only has this enormously valuable asset just grown in intrinsic value creation by 75% but it has maintained a growth of 70% for the last five quarters.
If that weren't enough, the average earnings growth has been 63% for the last sixteen quarters.
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Notes:
The iPad is not included since we don't have more than one year of sales and this is year-on-year not sequential growth.
The low growth for Q3 '09 was due to the corresponding spike the year before when the iPhone 3G was launched. That launch quarter in 2008 was a seminal turning point in the history of the phone industry when it became clear that the iPhone was not a passing fad. Steve Jobs famously participated in the conference call calling attention to the data which was obfuscated by subscription accounting. Alas, the news was lost in a sea of credit crunch panic.
I have an aversion to this rule as "large" is never defined except in relative terms. For example a $1 trillion market cap may be large because it's unprecedented, but it may be a trifle if the company is priced at book value.
In a recent but recurring lament I asked why Apple shareholders are not being rewarded for the company's growth. I pointed out that there is no fundamental reason why the company should receive such a low P/E multiple (about 18 ex-cash trailing and 10x forward while maintaining 70% earnings growth for over a year).
There were many objections in the comments. Most of them dealt with recent reasons why doubts might have arisen among investors: Android hegemony or some perceived lack of competitiveness leading to margin compression or some macro hangover from the recession.
In this article I argue that none of these objections hold water. My argument hinges on the fact that there is a precise date when Apple ceased being seen as an exceptionally valuable company and that date precedes any of the causes being suggested.
The day of disillusionment was almost exactly three years ago: January 14th, 2008.
How to pin down the date of disillusionment
Consider the following chart.
The blue area represents either a premium (above 0) or a deficit (below 0) of Apple's P/E (ex-cash) relative to the S&P 500 P/E. This is a re-imaging of a chart, first introduced in June 2010 when I first pointed out that Apple was being discounted relative to the S&P 500.
By measuring P/E I am focusing not on the stock price, which has grown nicely, but the ratio of the price relative to earnings, which hasn't (see the next chart below). P/E is a fundamental measure of potential (its reciprocal is the stock's earnings yield.) It is usually highly correlated to the company's growth. If that P/E is uncorrelated to past growth, there is some significant discounting of future growth. It's the most significant (and simplest) measure of "faith" in a company.
By measuring the company's P/E relative to an index of other large companies (S&P 500 P/E) we can assess whether the company's potential is being valued as extraordinary or whether it's being valued as ordinary. In other words we are measuring whether a company is "special".
The chart shows that until January 14th, 2008 the company was valued at a significant earnings premium--a P/E consistently 50% higher than the norm.[1]
Following the collapse (about 40% drop in share price but 100% drop in P/E premium), there was a small recovery followed by a huge trough in valuation. During the recession quarters Q308 to Q309 S&P earnings fell to zero or below. As a result of S&P earnings collapse the S&P P/E shot up astronomically (as E approaches zero, P/E approaches infinity). Apple's earnings dropped as well but remained positive throughout that period bottoming at 37% growth(!) in Q408. As a consequence Apple's P/E fell as low as 11 while the market's went well above 100 (122.41 peak). The P/E deficit for Apple went 80%: Apple was valued as basically worthless (3x cash).
After the earnings recession, the S&P P/E recovered close to historic levels but Apple's P/E did not. It's in-line with the S&P but does not obtain the 50% premium preceding the recession.
So we can establish that the day that Apple's potential was discounted was nearly six months before the onset of recession.
What other discounting factors can we discard?
How about earnings growth itself? Did the collapse foretell an earnings collapse?
The chart above shows the P/E premium vs. earnings growth (in red). Although earnings growth began to slow soon after the 14th (earnings for CQ407 were not yet announced at that point), growth recovered six months later after the launch of the iPhone 3G[2]. Growth continued throughout 2009 and 2010 reaching new heights last year of 86%.
Still, the company received no premium to the S&P 500 P/E. Companies in the index averaged, at best, a quarter of Apple's growth in earnings.
What about Android? The first Android device did not ship until October 2008 (HTC Dream or T-Mobile G1). There were no appreciable Android volumes until 2009, one year after the drop in relative value and no talk of a threat until 18 months later.
The last objection to be put aside is that of margin compression.
This last chart shows how margins (in brown) behaved during the same time period. They went up. The only slight decline took place during the last few quarters, after the launch of the iPad, long after the collapse.
Regardless of the adjustments with product launches, Apple's GM is the envy of the world and is not at all correlated with the loss of faith in the company.
So What happened on January 14, 2008?
Having led you this far in the story, I'm afraid I'm going to let you down at the end: The cause for the loss of faith is a mystery to me.
There is only one noteworthy event that took place on that date: Macworld 2008 (January 14-18). During the keynote, Steve Jobs introduced the Macbook Air (and Time Capsule and Leopard and pre-announced the iPhone SDK which, six months later led to the app supernova). I remember that day and I remember that the stock began selling off exactly at the point when the Air was mentioned. It has never been the same since.
Obviously, correlation is not causation. The Macbook Air need not be the cause for the loss of faith in Apple as an investment. Or can it? I'm hoping someone can explain this because to me it makes no sense. The product was not a home run but it did not do badly either and its current incarnation seems to be a hit. Whatever sins the original Air may have had have surely been expurgated by now.
Regardless the cause, the bottom line is that, in the eyes of investors, Apple stopped being "special" that day. Its valuation dropped to in-line the S&P and, given its growth, well below what a large growth company should be worth. The company's shares went into the bargain bin and are still there today.
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[1] I should point out that the P/E ratio is based on post 2009 re-stated earnings. The restatement changed the P/E as the "E" changed. This was based on the abolition of subscription accounting for the iPhone. Although it may seem unfair to hold the market to this standard, restatement did not actually change cash flows which were transparent and visible to all, even to amateurs such as myself and the other unaffiliated analysts that published throughout this period. Earnings may be an opinion but cash flow is a fact. Valuation on the basis of cash flow should have yielded the same results as shown above.
[2] That quarter showed a y/y growth of 150% while the stock was in freefall. In fact, it was during that earnings day that Steve Jobs came on the conference call and pointed out the astronomic iPhone cash flow to an audience of analysts more concerned about their own jobs.
The following graph shows a five−year comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 Composite Index, the S&P Computer Hardware Index, and the Dow Jones U.S. Technology Index. The graph assumes $100 was invested in each of the [securities].
In other words, if you had invested $100 in the S&P 500 in September 2005, you would have $103 now. If you invested $100 in Apple in September 2005, you would have $529 now.
Apple investors should rejoice!
However, in terms of reward for earnings, consider the following graph:
The red line represents the S&P 500 P/E ratio and the green and orange lines represent Apple's P/E ratios depending on whether you include cash in the price.
The reward to investors Apple does not seem so appealing anymore.
Although Apple received a premium valuation to the S&P prior to October 2008, it has traded at a discount or in-line with the S&P since then.
Another way of putting it is that the P/E ratio for large companies has returned to pre-recession levels. The P/E ratio for Apple has not.
For a final point, a comparison of earnings growth (which should correlate to the P/Es) above shows that while the S&P is given a similar valuation to Apple, growth has been decidedly less spectacular.
Apple's average growth over the period shown was 63% (shown as the orange line) while the S&P has grown at an average of -33%. Nevertheless the market has chosen to reward the two assets with the same multiples valuing their future growth in earnings roughly the same.
At least they are equivalent. For much of 2009 and early 2010, Apple was considered to have a far less promising future than the average large American company.
In the previous article discussing the growth scorecard, I left open the question of how Apple's growth is reflected in its share price.
The approach to answering this question is to show how the share price correlates to that growth. The challenge for analysts has been that the company switched from subscription to current accounting for the iPhone (the largest component in its income statement). As they re-stated income and thus earnings, any historic review of P/E or other multiples of Earnings have to also be re-computed.
So this is what I've done:
The first chart shows Apple's price per share (blue) vs. its trailing twelve months earnings (green) and multiples of those earnings (15x and 25x).
The chart shows how Apple was priced well above 25 P/E before October 2008 and has remained within the 15 to 25 multiple bands since the winter of 2008/2009. This seems fairly reasonable and the stock's rise is a cause of celebration for many, but a cause for concern for some. Is this rise in price matching a rise in value?
To answer, we need a way to look at the valuation of Apple. One way is to plot the P/E ratio over time. That would show how the market perceives the value of the company (i.e. how many years' worth of earnings is built into the price) The chart below does that.
I took the additional steps of plotting the P/E excluding cash from the price to show "P/E Ex cash" in the orange colored line and I also copied the Share price line from the first chart on this one for contrast.
What the P/E analysis shows is that as the stock rose, it's P/E ratio fell. This means that the "valuation" of the company is quite a bit lower now than it was in 2006 and 2007. In fact, as a multiple of profitability, Apple's stock is nearly half as valuable now as before the recession.
Since valuation is usually correlated with growth, (P/E is often compared in a ratio with Growth) we need to see whether the P/E in the chart above matches the actual growth of earnings. Fortunately we have just measured growth with the scorecard. Here are the two charts together:
What this shows is that while earnings growth did slow down in the lead-up to recession (with the hugely anomalous 3G launch spiking growth to 155% in Q308 causing the year-later plunge to 11%), growth picked up again in the depths of recession and has moved back to pre-recession levels. The only difference is that the multiple assigned to the stock has remained near recession lows. This is visualized by the blue line being mostly above the red line pre-crash and usually under it post-crash.
To put a finer point on this, I plot the ratio of P/E and trailing growth (P/E/tG) in the brown line below:
It shows that as a measure of valuation with respect to growth, Apple is trending down. A P/E/tG ratio of 0.4 and closer to 0.2 if we exclude cash shows very weak confidence.
The only conclusion I can draw is that the market does not believe that Apple has significant growth opportunities. A P/E of 20 with consistent 70% growth is, to be blunt, damnation. For comparison, Amazon just reported 16% growth in earnings and was rewarded with a P/E of 68.
Amazon notwithstanding, is Apple an anomaly? Is the disconnect between earnings growth and the stock price unique to Apple or does it apply to most other equities? Is pessimism about Apple a symptom of pessimism in general? I will suggest a way to answer this in a future article.
