Replacing P/E in Valuing Apple Stock

by: Stephen Coleman July 31, 2008 | about stocks: AAPL    
Stephen Coleman

Stephen Coleman

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The price earnings multiple (P/E) is an increasingly useless metric when valuing Apple Inc.’s (AAPL) stock price. The reason why is that Apple now uses subscription accounting. Therefore, Apple recognizes the sales and earnings of certain products such as the iPhone, Apple TV, Apple Care and others over a twenty-four month time frame. By deferring its sales and earnings on significant products, Apple’s understates the health of its business.

The truth about Apple’s health can no longer be found in its earnings report. The truth resides on the balance sheet by calculating the change in cash. We define “cash” as the sum of cash and cash equivalents plus short-term investments. This is the same way that Apple itself reports cash.

The recent example of Apple earnings report (see conference call transcript) totally exposes how useless the price earnings multiple has become, as it relates to valuing Apple’s stock. Apple recently reported earnings of $4.6 billion for the twelve months ending June 30, 2008. Apple reported cash generated in the same twelve month period of $7.0 billion.

The variance between reported earnings and cash generated is $2.4 billion. I believe that Apple’s “True Earnings” are the $7.0 billion in cash that it generated in the past twelve months, fully 52% higher than its reported earnings of $4.6 billion over the same twelve month period. If you divide Apple’s “True Earnings” of $7.0 billion by Apple’s 886 million shares outstanding on June 30, 2008, you get Cash Generated Per Share of $7.90 versus the reported twelve month earnings per share of $5.19.

If we use the current stock price of $160 per share, the Cash Generation Multiple [CGM] is 20.3x which compares favorably to the price earnings multiple of 30.8x. I believe that Apple is selling at 20.3 times its true earnings of $7.0 billion.

Apple’s stock price is cheap, if you use CGM as your valuation metric. The CGM will be my valuation metric for Apple inc. going forward.

Disclosure: Author holds a long position in AAPL

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This article has 28 comments:

  •  
    Jul 31 08:44 AM
    stephen--the first sentence of your article says it all ---i so totally agree with you---and the last paragraph first sentence sums it up nicely---
    Reply | Link to Comment
  •  
    Jul 31 08:51 AM
    I only ever use P/E for ANY company as a crude "sanity check". PEG is more generally useful, IMO.
    Reply | Link to Comment
  •  
    Jul 31 09:19 AM
    Can you include a yoy comparison in cgm to explain apple growth?
    Reply | Link to Comment
  •  
    Jul 31 09:25 AM
    Shout it from the rooftops Steve...I've got Aug 160 calls!!
    Reply | Link to Comment
  •  
    Jul 31 09:35 AM
    I take my hat off to a very straightforward and concise explanation.

    Thank you.
    Reply | Link to Comment
  •  
    Jul 31 10:11 AM
    apple to $600! weren't people saying that a few months ago?
    Reply | Link to Comment
  •  
    Jul 31 10:22 AM
    Apple will grow quicker and bigger than any estimates. Almost everyone leaves out the Apps Store, which will soon rival itunes. the pend up demand for the iphone is STILL there...lots of us (myself included) are just waiting until our old phone contracts are up. and the world, including China, is coming. and so are the stores in all those countries. once people get into a store and play with the toys, they buy, not JUST because the toys are cool...but because they're wonderful to use.
    good article, thank you.
    Reply | Link to Comment
  •  
    Jul 31 10:44 AM
    Thanks....Great article.

    we need more of such discussion. I wonder if AAPL can provide us with pro-forma income statements not applying "subscription accounting". I have seen a company with LIFO accounting providing income statements based on FIFO so that investors can see more normalized financial performance. Or companies with international exposure provides figures assuming there was no currency fluctuation.

    Is it not allowed by SEC? They are not doing it because AAPL is not investor friendly? Plus creating such income statement model is quite simple for analysts. Only handful of analysts are looking at the growth in free cashflow.

    I know it may be an waste of time, but I am going to request AAPL IR to look into it.

    The problem is that only investors with accounting background, smart fund managers and analysts would look at AAPL's cashflow. Traders don't care....Quants will only look at AAPL's multiples. That is why AAPL's price is suffering.

    I saw S&P's analyst downgraded AAPL recently....he was still talking about EPS. I could not believe it. I partially blame AAPL's investor unfriendliness though.
    Reply | Link to Comment
  •  
    Jul 31 10:51 AM
    Wow... After 4Q09 its not going to matter any way. Both EGM and CGM will move the stock higher. From my estimates a forward looking CGM (4Q08) should value Apple at 20.3 x 10B= $203B. Apple earings and Cash are accellarating which indicates a growth stock. Cash growing 50%+ and earnings growing 30%+. Most growth stocks are valued based on 4 quarter forward looking estimates. If I were to do that, the cash looking forward would be 12 to 15 billion. Using a 20.3 multiple we're at 240 to 300 PPS.

    I'm not trying to be contrarian here I just believe that Apple is unfairly undervalued at this time. Your CGM of 20.3 is based on backward looking CF. My contention is that forward looking cash flows are more appropriate. I estimate that Apple will have 45 to 50billion in cash by 4Q09-- 150% growth in 1.5 years. What company growing that fast uses multiples of 20x?
    Reply | Link to Comment
  •  
    Jul 31 10:58 AM
    You're only missing one thing in your formula - you have to back out the cash on the balance sheet before doing the calculation. Cash is worth cash, so net out the $23 per share cash and your multiple gets even cheaper.
    Reply | Link to Comment
  •  
    Jul 31 12:10 PM
    Auto:

    The year-over-year comparison follows. In the twelve months ending June 30, 2007, Apple generated $4,587,000,000 in cash. In the twelve months ending June 30, 2008, Apple generated $7,007,000,000 in cash. Apple Inc.'s year-over-year growth in cash was 52.76%. That result is far more true than the reported EPS growth of 31%.
    Reply | Link to Comment
  •  
    Jul 31 01:07 PM
    Why is everybody concerned about APPL's price suffering. It's an opportunity to buy more - rather than saying "X, Y, Z" doesn't get it.
    Reply | Link to Comment
  •  
    Jul 31 03:43 PM
    While it's nice to tell yourself that you see something about AAPL that the big investors don't get, it's unlikely that those managing large blocks of money haven't examined AAPL's cash flow. The information is readily available and up-front in any financial report. Everyone knows that cash matters because the concept is intuitive. So why exactly do you think that the stock market would collectively undervalue AAPL's cashflow?

    Everyone on this site and other internet sources already agrees that AAPL is a great buy. Doesn't that suggest that the share price is probably pretty fair? That AAPL will continue to grow but eventually level out or run into a problem? That the success of the iPhone will encourage other manufacturers to develop similar phones and compete with AAPL on pricing? Why should AAPL's share price grow faster than the market as a whole? It's a very well-followed company that most people love. Isn't it more likely that you would find an undervalued company by looking for an unknown in a boring industry that most investors don't know about?

    Frankly, I'm glad AAPL is sticking to conventional accounting and EPS reporting: CF information is there too if you want to read it, but we have standards for a reason. I try to stay away from companies that put big emphasis on "pro forma" or "EBITDA" or "earnings excluding items".
    Reply | Link to Comment
  •  
    Aug 01 02:55 AM
    Excellent analysis and comments!
    Reply | Link to Comment
  •  
    Aug 01 02:55 AM
    Excellent analysis and comments!
    Reply | Link to Comment
  •  
    Aug 01 04:57 AM
    the earnings are deferred for a reason and the reason is that in the future there's going to be some costs that affect those earnings. you can't just add the deferred earnings to the reported earnings and declare that to be apples' true earnings.
    Reply | Link to Comment
  •  
    Aug 01 04:57 PM
    While I won't say that I've done an extensive amount of homework on solely Apple, I will say that what I am seeing about Apple stock in particular is beginning to resemble the dot-com boom/bust. Everyone during that period of time was scrambling for different metrics to redefine the "new economy", which turned out to be a fad. Apple has had a meteoric rise paralleling dot-com darlings during their time. Buyer beware...
    Reply | Link to Comment
  •  
    Aug 01 06:25 PM
    Interesting hypothesis. Well written article, but you fail to explain, or alternatively argue, why the Street shouldn't adopt your valuation metric.

    AAPL is priced as a growth company, & therefore is given a certain P/E multiple over its reported or forward-looking earnings. If generated cash over the reported period yields an insight into "true" forward-looking earnings, rather than continually understated forward-looking "guidance," could not the Street still apply a P/E multiple, yet @ the same time lend credence to your valuation metric?
    Reply | Link to Comment
  •  
    Aug 03 12:03 PM
    if apple does not come out with another blockbuster product similar to iPhone they are fair priced....why??

    its a bear market p/es are contracting. and apple momentum will start to fade in 2009, and they may not have the same explosive growth they had in the last 2-3 years.

    when a company does not grow very fast....it gets value priced.

    i think msft and intc may be some examples....their earnings have grown but their share price has shrunk.
    Reply | Link to Comment
  •  
    Aug 03 01:54 PM
    Squawk:

    I want The Street to keep using the P/E. I want that useless metric, as it relates to Apple, to live long and falter. That way, I can buy Apple on the cheap for my clients. I am not seeking converts. I was just sharing my thoughts with a group of people who are quite discerning and, mostly, devoid of bluster.
    Reply | Link to Comment
  •  
    Aug 06 10:07 AM
    What about the 300 by year end ?
    Reply | Link to Comment
  •  
    Aug 13 06:37 PM
    Toni+:

    $300 by yearend was a layup. I believe that $600 is the real number.
    Reply | Link to Comment
  •  
    Aug 15 11:18 AM
    $345.00 by year end once people see the future of iMacs, MacBooks, MacBook Airs and iPod Touch for $99.00 Apple Stock will be $345.00 and $600+ near end of 2009!

    Long since 1997 @ $4.00 a shares... Bought some more at $119.00 a share a few months ago. Apple will be on fire soon. iPod Touch for $99.00 will be the huge sales for Apple which will be made up on both iTunes Store and Apps Store income. Apple to $650.00+ soon.

    See this link why?

    web.me.com/filmflamtv/...
    Reply | Link to Comment
  •  
    Sep 29 02:07 PM
    "I believe that $600 is the real number"

    September 29, 2008: Apple at 110$
    Reply | Link to Comment
  •  
    Oct 04 04:13 PM
    "The CGM will be my valuation metric for Apple inc. going forward."

    This is a problem if only 5-7 people in the world are using this method.

    Maybe they could sell their shares to each other at 200$ while the rest of the world is exchanging AAPL on the Nasdaq below 100$.
    Reply | Link to Comment
  •  
    Oct 07 04:42 PM
    Idiot Toni probably has lots of experience with spitting in mens' mouths.
    Reply | Link to Comment
  •  
    Oct 07 05:03 PM
    Idiot Toni is you. I'd try to explain it further for you, but drawing pictures with crayons doesn't work over the internet. Run along now, your boyfriend is probably getting hungry.
    Reply | Link to Comment
  •  
    Oct 07 06:10 PM
    Toni wrote: "Trailing PE is based on future guessed predictions."
    Reply | Link to Comment
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