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Why is Apple's P/E so Low?

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Stocks with high Price to Earnings Ratios (P/Es) and low growth or margins get a lot of press, for example, Amazon.  It stock price defies explanation on a traditional valuation basis.  Yet it is extremely rare for a stock to have the opposite problem:  Accelerating growth and a P/E lower than the broader market.  This is Apple.

The ratio of price to earnings theoretically measures investors’ expectations of a company’s growth, such that expectations for future growth of earnings will propel the stock price resulting in a higher P/E ratio. Likewise, if expectations for future growth are not attractive, the P/E is low (ie Research in Motion with a P/E of 6.4x).   The S&P P/E is often used as the benchmark and companies growing faster than the S&P should, in theory, have higher P/Es than the overall market.

For that reason, investors often compare a stock’s P/E to its growth rate and buy the stock when the P/E looks undervalued.  For Value investors, the Rule of Thumb is to never pay a greater P/E for a stock than its growth rate.  Growth investors see past this rule and look for revenue and earnings momentum, and margin expansions.  They look for acceleration of these metrics and lose interest when the trends decelerate.

For both Value investors and Growth Investors, Apple is an attractive stock because its P/E is below its growth rate and because its revenues, earnings and margins continue to improve.  However, the stock remains undervalued as measured by its P/E at roughly 10x forward earnings (removing cash) compared to the S&P’s 13x forward earnings and it is frustrating investors.

Why is Apple’s P/E lower than the S&P while its growth prospects are so much greater?  Here are a couple possible explanations.

Institutional investors may be “maxed out” on how much Apple they can own.  Institutional investors recognized that Apple was a growth stock at a good price.  Yet traditional institutional investors, such as the large money managers like Fidelity, Vanguard or State Street, may be able to own just so much of one stock in each fund.   So, for example, each fund may be limited by its charter of owing maximum of 3-5% of any one particular stock.  Once they “fill their position” in Apple, they can’t buy anymore.

Look at Apple’s top three institutional owners.  Fidelity owns $30B in Apple stock (source: Nasdq.com), which represents roughly 5% of Apple’s market capitalization and roughly 5.68% of Fidelity’s assets under management. Similar statistics are true for the second largest owner, Vanguard, who owns $24B of Apple stock.  The third largest holder is State Street, which owns $21B of Apple stock and that ownership represents over 3% of its assets under management.  It stands to reason that these traditional money managers may be limited from buying any more Apple stock.

What gets more perverse is this:  If they are correct in their assessment of Apple and the stock price appreciates relative to other stocks, Apple will become an even bigger percentage of their portfolio (if other stocks in the portfolio do not appreciate in lock-step).  At that point, Apple will exceed the limit of any one stock in the portfolio and fund managers may have to pare their position.  The irony, thus, is as Apple does better, it could create downward pressure on the stock because fund managers may have to sell to remain within their stock allocation discipline.

Hedge funds generally are not subject to these rules, and they tend to have shorter holding periods.  But if they recognize the patterns of the institutional investors, they can trade around it and, in effect, keep the stock within a trading pattern.  It is plausible that between the traditional institutional funds and the hedge funds, Apple stock keeps getting bought and sold to remain within a range.  And, the stock has been prone to being stuck in trading patterns for periods of time.  As earnings expand and the price remains stuck in a range, by definition the P/E compresses (P remains constant; E goes up).

By the mid-2000s, most institutional investors understood Apple was a performing investment and most institutional investors who could buy the stock did.  Thus, if these investors all have stock allocation rules and are already in, where are new buyers for the stock?

I believe Apple recognized this conundrum when it announced a dividend in March 2012.  The dividend addressed two concerns:  a large cash balance and, potentially, the stock’s trading range.  As a result, funds that were mandated to invest solely in dividend-paying stocks could then invest in Apple.  If you look at the Apple stock chart, Apple appeared stuck in a range (of roughly $330-$415) prior to this announcement and has subsequently popped up to a new trading range (of roughly $530-$640) since the announcement.  This could be coincidence, or it could be the explanation.  Consider this:  by opening up the stock to dividend funds, Apple brought in a fresh set of demand.  Once that demand was filled, as described in the previous paragraph, the stock gets stuck in a range again.  And, as earnings expand but fresh demand for the stock is limited, P is stuck, E goes up, and the P/E multiple, again, compresses.

If these structural constraints are true, Apple could “open up” another investor market.  Retail investors like us could buy the stock.  Retail investors tend to be longer-term investors, buying and holding a stock, particularly one with which they can identify.  But retail investors view Apple’s stock as “expensive” because it carries now a $600+ price tag.    Retail investors often get hung up with “expensive” because of the price level, not thinking about valuation.  Apple is one of the least expensive stocks on the market in terms of valuation, trading at a discount to the overall market.  Consider a stock that costs $600 and delivers $50 earnings per share is no different than owning 10 shares of a $60 stock delivering $5 earnings per share.  If this is explained to an experienced retail investor, the response often still is “yes, of course, $600 is too much to pay for a share of stock.”  Apple needs to split its stock to bring in retail investors, open up the market for another set of investors to hold the stock and let their biggest fans enjoy the company growth.  Read Why Apple Should Split Its Stock.

Some suggest that Apple may be just too big to grow anymore, but I disagree with the logic.  Apple’s market capitalization exceeds $500B.  Previously oil companies propelled by oil prices rose to these levels and Microsoft and Cisco in the dot.com era.   Microsoft and Cisco are probably most analogous because they were expected to continue to develop new products to sell into new markets.   However, Microsoft and Cisco achieved that market capitalization because the P/Es were so high.  Cisco's P/E increased from 68x in October 1998 to 200x in April 2000 (Source: Ycharts).  Microsoft's P/E ranged from 56x to 81x from October 1998 to December 1999.  In contrast, while Apple has the largest market capitalization, it has a remarkably low forward P/E of 10x, or 14.9x on the same current basis as the aforementioned Cisco and Microsoft.  Apple has reached this market capitalization despite its P/E.

In general cases when a company's stock is undervalued, investment bankers would suggest splitting up the company in order to “unlock value” but, in Apple’s case, the value is in the “wholeness” of the company and its ecosystem.  The best opportunities for Apple to begin trading in line with its growth prospects would come through global growth, formation of new funds or a new class of investment vehicles or splitting the stock to encourage broader retail ownership.   Global growth is obvious:  more money in the system is new money to buy the stock and, as overall stock market appreciates, Apple stock appreciation would not exceed its allocation limits in portfolios.  The financial community has always been innovative when an undervalued asset exist or where value can be unlocked, and this suggests to  me that either the structural constraints, if true, will be relieved or new funds will come online to take advantage of the opportunity.  A new investor base would bring in more demand for Apple stock and increase the stock price.  And, should Apple split its stock 10:1,  retail investors could feel comfortable buying the stock at more palatable price levels.

Apple's P/E  is not in line with its growth rate and the stock price feels stalled at these levels.  If the stock traded at P/Es commensurate to the overall market, the price would be $780 today, and higher if it traded on its expected growth.  In my view, Apple could split the stock to open up demand to a bigger investor pool, the retail investor. Today, the vast retail market is reluctant to dole out $600 for one share of stock.  The price tag is a challenge although it is a good buy.  For a $600 share, investors get to earn a forecasted $46 in high-quality earnings, have roughly 20% of that share price in cash, and can anticipate future growth from expected new products this year (the iPad Mini and the iPhone 5) and next (the new Apple television-like device).  As more retail investors become more savvy (and they are, after the recent market downturn and loss of trust in financial advisors) and understand valuation (thank you Jim Cramer for demystifying stocks), perhaps value can be unlocked without a stock split.  But a stock-split would definitely help smaller investors get over the price tag.