Introduction: The Current Mispricing of Technology
At the risk of jumping on the everybody’s-writing-articles-on-Apple-bandwagon, this article is offered at the request of a loyal reader. Our objective is to put not only Apple’s valuation into perspective, but also what we believe to be the current undervaluation of technology stocks in general.
If looking at how the stock market has historically priced technology stocks doesn’t convince you that the market is not only not efficient, but in fact totally irrational much of the time-then nothing will. It was approximately 15 years ago that the market was telling us that technology stocks had almost unlimited value. Mr. Market was placing literally insanely high valuations on everything tech that made no economic or even mathematical sense. During this era, the simple Treasury bond was throwing off riskless interest that was many times greater than even the most optimistic expectations of what technology stocks earnings would be. To be clear, you could earn Treasury bond interest payments that were many times greater than the total earnings being generated by technology stocks.
Today, we find Mr. Market treating anything tech, in an exact opposite manner. In 2012, and as we head into 2013, technology is being priced at some of the lowest valuations it ever has. In fact, the valuations on technology are actually less than those on the average company as measured by the S&P 500 (S&P Indices:.INX). This is true notwithstanding the fact that technology has historical growth rates much greater than the average company, and continues to have forecast growth that is expected to be much greater than the average company. Mathematically, this is simply not rational. Logic would dictate that technology should command valuations that are much higher than the market, or at least equal to the market. It makes absolutely no sense that technology should be being priced below the average company.
The following table looks at 10 of the most prominent high profile technology stocks on the planet. The first three columns on the table are the most important supporting the thesis of this introduction. When you compare the current PE ratio on each technology stock in the table to its historical normal PE ratio since 1998, it is clear that technology is being priced at an abnormally low valuation. But perhaps even more importantly, the earnings yield available from these technology stalwarts is remarkably high, especially when contrasted to the current interest yields available from fixed income. Moreover, when you consider that technology is on the threshold of achieving exponential future growth, today’s low valuations seem even more absurd.
The only explanation that makes any sense to us is that investors’ exaggerated levels of fear, coupled with the unknown nature of this rapidly-evolving industry is generating pessimistic valuations. Therefore, the thesis of this article is to illustrate that not just the technology sector itself, but more specifically that Apple Inc. (NASDAQ:AAPL) is an absurdly undervalued strong business today. Moreover, based on the fundamentals underpinning Apple Inc. (NASDAQ:AAPL), we believe that this company should be rationally trading at a PE ratio somewhere between 20 to 25 times earnings.
This would be justified not only on its historical record, but more importantly based on reasonable projections of future growth. If expected growth does occur, then the fair value earnings justified price for Apple Inc. is approximately $900 to $1200 per share, and increasing every quarter. We arrive at these numbers by applying a PEG ratio (PE=Growth Rate) valuation to Apple Inc.’s current and near future earnings expectations. We will develop this in greater detail later in the article.
Apple Inc.: The 800-Pound Gorilla in Technology By The Numbers (Fundamentals)
From the time that Steve Jobs returned to Apple in 1996, the company has clearly been the technology profit growth superstar. Since the beginning of 1997, Apple has grown earnings at a compounded annual rate of 34.4% per annum. Even more remarkably, since the beginning of calendar year 2003, Apple has grown earnings at a compounded growth rate of 73% per annum. And, even more remarkably yet, since the great recession of calendar year 2008 (which incidentally Apple’s earnings growth was 36% that year, in contrast to the average stock as measured by the S&P 500 whose earnings fell by 40%), Apple’s average annual earnings per share growth rate has been 52% per annum.
The following three earnings and dividends only F.A.S.T. Graphs™ on Apple Inc. illustrate this remarkable record of consistent and strong earnings growth. This is an amazing accomplishment that would seem to us to justify an expanded PE ratio, rather than a contracted PE ratio, as the market is currently applying. The company has no debt, and as we will see later, generates prodigious amounts of free cash flow.
Powerful Historical Earnings Growth
Prodigious Cash Flow and Free Cash Flow Generation
Now that we’ve established Apple Inc. (NASDAQ:AAPL)’s amazing historical earnings achievements, let’s look at other fundamental metrics that relate to properly valuing a business. Our next graphic plot Apple’s operating cash flow and free cash flow generation since 2003. At the end of this fiscal year, Apple had over $117 billion of cash and investments with no debt.
This next graphic tells an interesting story about Apple’s cash flows. The graph plots Apple based on operating earnings, with free cash flow overlaid. The discerning reader will notice that Apple’s free cash flow dropped or flattened in fiscal 2011. However, they will also notice that Apple initiated a dividend as depicted by the light blue shaded area on the graph. It is the dividend that caused the drop in free cash flow, because our definition of free cash flow is as follows:
This concept is Operating Activities – Net Cash Flow minus Cash Dividends minus Capital Expenditures. This isdivided by Common Shares Outstanding – Company.
In other words, we calculate free cash flow after dividends and after capital expenditures. The point is that Apple generates prodigious amounts of free cash, which is indicative of a very strong and healthy business.
A Historically Low Price to Sales Ratio
When you look at Apple’s current price to sales ratio, you discover that it’s at the low range of its historical norms. This is in spite of the fact that Apple is setting record sales on its most recently launched product lines. On November 5, 2012, Apple announced that they had sold 3 million of their new iPad mini and Fourth Generation iPad in three days, doubling their previous first weekend sales milestone. Meanwhile, iPhone 5s sales have only been limited by not having enough supply to meet the demand. Nevertheless, there is no shortage of analysts and pundits wanting to dismiss Apple’s future growth, in spite of its recent successes. Somehow, new sales records are quote, unquote “disappointing the analysts and pundits.”
The PE Has Shrunk as Earnings Have Accelerated?
Based on everything that’s been written so far, the shrinking PE ratio on Apple shares since calendar year 2003 seems somehow bizarre. Record earnings, record cash flows, record sales and Mr. Market continues to devalue Apple’s business.