A week or so ago, I posted a comment on another S.A. author’s article about Apple Inc (AAPL) stock. I asked the author if he believed the shares were expensive when trading at over 28x trailing earnings. Here’s the specific comment:
[Please excuse the grammatical error in the commentary. The second sentence should have read, “If you believe $350 is an approximate Fair Value, then the current P/E may not be too far off the mark.”]
I don’t believe the author responded to my question. However, a few other commenters did respond; some quite vigorously. Their upshot appeared to be: no one can value a stock, because it’s impossible to know the proper valuation multiple. Historical data doesn’t matter. It’s all guesswork.
Of course, I disagreed.
Let’s Talk About Apple, The Company
I believe Apple Inc is arguably the best consumer goods manufacturing, distribution, and retail marketing company on the planet. The business is well-managed, owns a tremendous franchise, has a fortress balance sheet, earnings, profits in cash, and senior leadership is shareholder-friendly. It’s everything I seek in a business and in a stock.
I’ve owned AAPL shares for over a decade; though over the years and only time-to-time, I’ve trimmed back and accumulated additional shares on valuation.
This article isn’t about questioning the viability or vigor of the Apple Inc business. It’s about the stock’s valuation.
Let’s Talk About Valuation
I contend there are two facets to successful investing: first, understanding/evaluating the business behind the stock; and second, understanding whether the stock itself is inexpensive or dear. Both exercises are important. Blow off either at your own peril.
Those who’ve read my S.A. articles know I place considerable emphasis upon valuation. Personally, I favor price-to-multiple valuation analysis.
Though discounted cash flow models have undisputed economic usefulness, I’m disinclined to utilize these for equity valuation. My issue with equity valuation DCF models is its results are often highly sensitive to the discount rate; and I find it very difficult to handicap just what discount rate to use. I also find applying an appropriate terminal growth rate to be a dicey proposition.
I like technical analysis (the charts and related studies), but use these as a confirmation or secondary valuation data point.
On the other hand, I’m not a fan of momentum investing (aka the “greater fool theory”) at all, nor do I believe in the Efficient Market Theory. I believe the EMT is nonsense.
A Process to Value Apple Stock
There are quite a number of price-to-multiple valuation data points from which to choose. For this exercise, I’m content to use P/E (ttm and forward-looking), P/Cash Flow, and the PEG ratio. These three valuation ratios lay out a reasonable case. Please add your comments at the end of this article if you think other methodologies are better-suited.
For most of the proceeding work, I’ve elected to utilize F.A.S.T. Graphs. It’s a flexible, reliable investment tool. As the old saying goes, “a picture tells a thousand words.”
Apple helps the P/E valuation process along by reporting “clean” earnings: meaning management doesn’t routinely include a bunch of puts and takes for one-off items. Clean earnings reports tend to simplify the evaluation by avoiding the often ambiguous task of determining which earnings “adjustments” are legit.
Let’s begin with a 20-year AAPL chart:
We see the long-term normalized average P/E has been ~25x. However, through the period, the annual earnings growth rate’s been almost 39%.
Meanwhile, the current ttm P/E is over 28x. This is the highest it’s been in over 10 years.
Apple Inc P/E Ratio – 6 / 2010 through 6 / 2020
Reverting to the F.A.S.T. Graph, what pops out is the 20-year EPS growth rate. Looking backward, it’s been sky-high. Simply by the ‘law of large numbers,” it’s very unlikely Apple can maintain a comparable go-forward growth rate.
Next, let’s look at the Street’s forward earnings projections:
Consensus S&P IQ analysts indicate EPS will grow 4% in FY 2020, then improve to 19% in 2021 (likely a post-recession rebound year), before moderating to 12% in FY 2022. These figures are highlighted above in yellow.
Looking at the analysts’ track record, we can determine S&P analysts have done a good job forecasting AAPL earnings a year or two out. Five times they’ve been on-the-mark. Four times the company beat expectations, and just once did Apple management fail to meet Street forecasts.
So, we can make a reasonable case that the Street forecasts are likely to be good, favoring an upside. Suggesting a “down” year in FY 2020 followed by a rebound year in FY 2021, the forward growth rate may be expected to come in at the low-to-mid-teens.
Now let’s look at Zacks.com, another equity resource website. Here’s what it lists about Apple Inc:
Zacks’ analysts indicate FY 2020 EPS will grow ~4%, then rise to 23% in FY 2021. This isn’t too far off the S&P IQ figures; just a bit better.
Let’s give the benefit of the doubt to Apple’s management, and project the annual EPS growth rate over the next few years will be in the mid-teens, say 15%. Hold that thought.
Now, let’s go back to F.A.S.T. Graphs.
Our 20-year chart logged nearly 39% EPS growth. Clearly, the past growth rate was far higher than any go-forward estimates. So let’s look at some other time periods and see if we can “match a curve.”
I offer an 11-year chart:
Ha! One may ask, “Didn’t you just ‘cherry pick’ an 11-year chart?”
No, not really.
First, we see the 11-year chart reflects a 14% annual EPS growth rate. That’s pretty close to go-forward Street expectations, and our bogey. Therefore, this chart was selected because it’s an attempt to “match the curve.” If I go back a year or two earlier, the annualized growth rate jumps up to 18% to 25%. Based upon current EPS estimates, that kind of growth rate seems unlikely. On the other hand, if we look at shorter term frames (less than 11 years), the EPS growth rate drops to the low-teens or less. That’s an important fact to be considered, but the current objective is to perform a cold-eyes review: determine the historical P/E during a period when the EPS growth rate was comparable to what we believe the forward growth rate will be.
Back to the valuation issue at hand.
The 11-year chart says the normalized average P/E was 15x. On its face, this makes sense for many mega-cap stocks: a mid-teen P/E corresponds to a mid-teen EPS growth rate.
Therefore, how can one justify a 28x P/E?
It’s difficult. We have to explain why “this time is different.”
Well, for one, we can look forward and utilize a FY 2021 estimate. Looking ahead a year (or even two years) is reasonable when performing a FVE for a solid growth company. For good measure, we can use Zack’s higher $15.25 EPS marker versus the 2021 S&P $14.73 EPS estimate. On a $360/share price, we obtain a 23.6x forward P/E. Still seems elevated.
What if we further fiddle with the numbers some more, and use a FY 2022 estimate (S&P $16.45 EPS), premising 19% growth in 2021, then another 12% on top of that in 2022?
We get a ~22x P/E. That’s more reasonable, but still far above the historical 15x record; and we have to bank upon forecast EPS growth for the remainder of this fiscal year, the next fiscal year, and even the one after that.
Using the record, one can make a decent case AAPL may command a sustained market multiple of ~18x. Indeed, 18x is well above the historical 15x average, but one can argue the premium is due to ultra-low interest rates, the quality of the company, its management, and overall financial strength. Furthermore, we can back out the balance sheet cash.
Even so, it’s challenging to defend a Fair Value greater than $319:
FY 2021 estimated EPS of $15.25 times a 18x P/E multiple, then add back $44 per share balance sheet cash, and we have a $319 FVE.
Even if we accept the Street estimated EPS out to the end of FY 2022, bump it up 5% for kicks, and add back current balance sheet cash, we only get a FVE $355. That’s a considerable amount of good news baked in. Not much room for error.
Nonetheless, at the time I wrote this article, shares have been bid to nearly $365 a piece.
Apple stock appears overvalued.
In 1989, the great Peter investor Lynch popularized the PEG ratio in his outstanding book, “One Up on Wall Street.” Given the plethora of data now available to investors, some argue its usefulness may have diminished a bit, but most believe it remains a good “rule of thumb” valuation metric.
To compute the PEG ratio, we take the current P/E, then divide it by the expected growth rate. Peter Lynch recommended using a 5-year projected growth rate. Many investors prefer to use a shorter projection: it’s difficult to predict growth rates out two years with accuracy, let alone five years.
A PEG <1.0 suggests an undervalued stock. A PEG between 1.0 and 1.5 indicates reasonable value for a reliable growth stock. Over 1.5 suggests the market is overvaluing the stock.
What’s Apple’s PEG3?
PEG3 = current ttm PE 28 divided by projected 3-year 15% growth rate = 1.9
A 1.9 PEG ratio is high. AAPL stock appears overvalued.
Apple is a cash machine. Let’s do one more valuation exercise using price-to-operating cash flow. By doing so, we can try to validate or question the previous data points. For brevity, I’ll just provide the “punch line” F.A.S.T. Graph and corresponding data:
A 10-year F.A.S.T. Graph fits the curve well. Over the period, AAPL stock grew operating cash flow by 10% a year. Looking forward through 2022, Street analysts expects a similar annualized OCF growth rate.
Through the same time frame, AAPL stock averaged an 11.3x P/CF multiple. The current P/CF multiple is 22x. Accepting the FY2022 forecast (two years’ out), P/CF drops to only 18x.
No dice. AAPL stock appears overvalued.
Summary and Conclusions
A major component of good investing is performing a defensible Fair Value Estimate. Just as in any other marketplace, the merchandise can become inexpensive (“on sale”) or dear (“overvalued”). Unquestionably, a Lexus is an outstanding motor vehicle. If one pays just $30K for a brand-new Lexus, it’s very likely a great bargain. If one pays $75K for the exact same vehicle make and model, the person likely “up-paid.” In either case, the car itself is an excellent automobile; that doesn’t change. The price paid determines whether the purchaser obtained value.
I believe stocks in general, and AAPL stock specifically, work in a similar fashion.
Based upon a brief price-to-earnings analysis, my Fair Value Estimate for Apple stock is ~$319.
We can grind the numbers by paying for two years’ EPS today, applying a 18x multiple, adding a 5% EPS kicker, then backing out balance sheet cash. That seems to be paying for a lot of “what ifs.” Even so, the Fair Value Estimate rises to only $355. Shares were bid at $364 today.
A PEG3 analysis indicates the shares are expensive.
A price-to-cash flow analysis yields an even lower FVE.
AAPL shares appear expensive.
Observations And A Challenge
Investing is about probabilities, rarely certainties. Could this analysis be wrong? Sure, it could be. It’s possible Apple shares will just keep rising higher and higher. But is that the mostly likely scenario?
Are there other valuation methodologies? Yes, there are. Can you offer an alternative FVE backed by data?
I challenge Apple stock investors to ask themselves:
Based upon the historical facts-at-hand, is there a higher probability AAPL stock will continue to rise above its historical, long-term valuation multiples, or is it more likely to revert to the mean? Alternatively, what is the likelihood Street forecasts calling out ~15% EPS growth will turn out to be woefully low?
Furthermore, if the stock now deserves sustained multiple expansion versus historical norms…why? And without clear answers to the foregoing, might there be alternative mega-cap tech investments with potentially better returns than AAPL?”
Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2020 investments.
Disclosure: I am/we are long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Originally published on Seeking Alpha