Why is it so hard for individual investors to make winning decisions?
Part of the answer is psychology. It starts with a simple question. When is a stock "expensive?"
It often helps to have an example, so let us consider Apple (AAPL). The average investor thinks in one of the following ways:
- Recent move. Apple has more than doubled in the last year.
- Absolute price. Apple trades for $200/share. It is an expensive stock.
- The iPad. Apple's new product is a gamble. It depends on your opinion of the iPad.
I realize that many astute readers do not fall victim to these traps, but I beg your indulgence. One of the problems in writing a mainstream blog is the same problem I had when teaching at the University of Wisconsin. You do not want to teach to the guy in the back row, but neither can you teach to the median student. The challenge is to provide a little insight to everyone while not insulting the intelligence of anyone.
It is a challenge. And now back to the Apple example.
The Professional Approach
A professional trading the fundamentals does not care about how far and how fast the stock price has moved, as long as the story has improved even more rapidly. If earnings and earnings prospects have more than doubled, it does not matter that the stock price has doubled.
Absolute price is also irrelevant. What if the stock did a 10-1 split? All of the key metrics would be the same, but the psychology would be different. The P/E would be the same, as would growth ratios. Maybe a 5-1 split would be better. Companies often have a share price that resonates with investors, and Apple was popular in the 30's and 40's. As an astute investor, you should not care.
We also do not focus on the iPad. Valuation is about established products, earnings forecasts, and cash flows. New products are just the kicker.
Thinking About Apple
Here is the correct way to evaluate Apple. The company has about $43/share in cash and liquid securities. The recent earnings report was $3.67/share. The comparisons are tricky, since the company is now realizing all iPhone revenue as the sales are made instead of over the life of the phone. We knew this was coming and highlighted it in prior articles. Even when restating past earnings to reflect the change, the company shows a growth rate of 50% per year.
So let us be conservative in two different ways.
- We will not take the recent quarter and multiply by four. We will also not build in anything for the iPad. Just use $12/share in projected annual earnings.
- The earnings growth rate is 50%. A standard rule of thumb for the PEG ratio (price-to-earnings growth) is that anything under "1" is a buy.
Let us instead use a 20 multiple on our conservative earnings estimate -- giving us $240/share. Let us now add in the $43/share in cash and securities. This gives us $283/share.
Please note: This is not a "target", since the earnings may well be better in short order. This is my estimate of current fair value.
Why So Cheap?
Why is Apple so cheap? My answer is that many people fall victim to the traps outlined above.
If this were a $20 stock, it would soon be a $30 stock.
Meanwhile, you should not care. Every portfolio needs growth. Several of my recent articles have suggested that opportunities abound. I am writing about Apple, but you can do your own work on other technology stocks.
