Seeing Value in Apple: Would a Stock Split Help?

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:

1. Recent move.  Apple has more than doubled in the last year.
2. Absolute price.  Apple trades for $200/share.  It is an expensive stock.
3. 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.

1. 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.
2. 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.

Comments

[Apple share price]

The Stock Split would allow many more people to become AAPL Shareholders. It would also take the joy out of Shorting this stock which is the favorite yo-yo of the Hedgefunds. I would love to have four shares at $50.50 per share for every one of my $202.00 shares.

[stock trading newsletter]

I have a feeling that Apple like the 'exclusivity' of their stock like they do in their products.

[james]

Nice clear overview on my wife's favorite stock as she has a double. However, we all recognize that AAPL is flat in price over two years. But what a fun trip that was!

james

[sfgirl]

Thanks for the insight.

[Mike C]

Excellent points, especially the one about absolute price. I would often get this question from clients when I bought Berkshire Hathaway.

Just curious, what would be your sell catalysts on AAPL? What would need to happen either fundamentally or technically to shift your stance on the stock? I am interested to get some insight on your sell discipline as I think this part of the process is probably the least discussed and yet the most important.

FWIW, from 2006 to 2007 I built a position in Chesapeake Energy in the late 20s/early 30s. I rode that stock up to the July 2008 high of 74 all the way down to the November 2008 low of 10 back up the current 25-26. I was convinced it was ridiculously undervalued from Oct 08-Dec 08 when it was between 10-13 but the position size was already too big to justify increasing without ignoring risk management. Still, I consider not selling any during the May 2008 through September 2008 timeframe a failure because I violated some of my sell rules.

What are some of your sell rules or sell process?

[Pete Borini]

Always amazing how these splits (or even potential splits) bring out the buyers. I like the conservative assessment here.

[Paul Nunes]

well written Jeff! A very concise explanation which everyone can benefit from.