Stockwatch: is Apple overvalued – or on course for $3 trillion?

As the company smashes through the landmark $2 billion barrier, our analyst asks what’s next.

Nasdaq-listed Apple (NASDAQ:AAPL) continues to soar. It added another $200 billion (£152.5 billion) in only a week, to trade at $2.2 trillion, around $502 a share currently. 

This represents a trailing price to earnings (PE) multiple of around 38x, versus 12.5x at $71 exactly seven years ago, when I turned bullish on Apple due to its starting a major refreshment cycle of its products. 

The dividend yield was just shy of 3%, versus 0.7% today. Despite a somewhat parabolic chart – up 60% this year despite a 29% drop during March – the bulls reckon such a growth stock rating is justified because Apple is morphing from a chiefly hardware business to services. 

For example, it is well-placed to capitalise on the 30% revenue cut former chief executive Steve Jobs extracted from developers featuring in Apple’s App Store.   

Still some way to go re-balance revenue mix

The table from Apple’s fiscal third quarter results to end-June shows its legacy products – iPhone, Mac and iPad – constituting 67% of revenues, versus 33% for the relatively new categories of services, wearables and home & accessories. 

You can take a glass half full or half empty view of this. Perhaps the new categories have bags of potential while the iPhone’s resilience helps services grow and the Mac/iPad achieve impressive growth of 22% and 31% respectively. 

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 Or, perhaps nearly half of group revenue is exposed to highly competitive smartphone rivals, a mature market, while recent hardware sales may have benefited from a one-time shift towards more home working. With services at 15%, why should the stock command a PE in the thirties, even respecting a bullish forward view?

The near-term answer is: hordes of momentum traders having alighted on Apple – which in a narrow ratings’ comparison with other FAANG stocks (Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOGL)) looks as if it has some catching up to do. Institutional buyers will have to up their stakes as Apple increases its share of market indices. 

Longer term, the hope for Apple is that its services provide stickier revenues. Microsoft (NASDAQ:MSFT) has shown a good example of this with its Office software subscriptions, rather than relying on bringing out new hardware each year to impress customers each year to sustain revenues.

Source: Company REFS

At very least I think Apple’s rating discounts a great deal. Yes, iPhone sales are poised to benefit from 5G upgraded models, yet it is a big leap to assume the services and other new products intrinsically justify a PE in the thirties. 

It follows from a high liquidity-driven stock market currently, with institutions benefiting from cheap money and smaller traders their own leveraged accounts. Yes, Apple is a brand that will remain a global juggernaut and cash generator, whose stock will attract those with ‘buy the dips’ thinking.  

Political risks able to disrupt the stock’s momentum

Apple’s current valuation ignores a possible Biden administration which would make life tougher for big tech amid ‘antitrust’ (anti-competitive) concerns. It also overlooks the US/China relationship continuing to fester under another Trump term of office – China constituting 16% of group revenues, but, more vitally, being where all Apple hardware is made.  

Possibly behind the scenes, diplomats and business lobbyists have contained the fallout from Trump blocking sales of certain US semiconductors to Huawei.

If Trump is rational then indirectly hurting Apple does not make sense given its contribution to stock market valuation, his favourite barometer of the US economy. 

Yet he is also unpredictable and may feel emboldened in the event of a second term to go further, with the Chinese potentially responding in kind.  

Is there FAANG stock hysteria or overvaluation generally? 

If consensus forecasts are fair, the forward PE on the S&P 500 index is currently just over 20x. One economist has noted it has only previously been rated so highly in the two years before and after the 2000 internet bubble.

Apple is similarly at a valuation peak.  

The difficulty for such benchmarking is no historic comparison with the extent and velocity of monetary expansion under Covid-19 – with virtually all governments doing it globally. It is harder than ever to ‘fight the tape’ of asset values soaring – see how house prices appear to be joining the party once again. Some puppy prices are up from £2,000 to £2,500 in barely a month, another case of momentum in social psychology. 

Judging a stock like Apple is therefore now chiefly about crowd sentiment. It originated in monetary stimulus which persisted after the 2008 crisis, eased temporarily but has ratcheted up massively from end-March under Covid-19. Central banks are in ‘unlimited’ mode, governments  are doing ‘whatever it takes’ to bolster economies. It is unsure whether this ends in a bursting of asset bubbles or becomes the new normal, with inflation kept at bay or checking growth in debt.

I heard the boss of a major wealth manager say:

“Technology companies are doing well, benefiting from the change in work habits.”

Indisputably so, but does this justify the current extent of valuations?  

Admittedly growth stocks tend to perform well amid low interest rates. Authorities have cut to negligible or even negative rates – i.e. an equal and opposite effect for growth stock valuations being due. But that looks already to have happened plenty far enough. 

For a balanced view however: I quite disagree with bears who say:

“Look at the example of the Nifty Fifty 1960’s growth stocks – Polaroid perceived back then as a similarly safe play as Apple today – which de-rated savagely into the 1970s”.

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This comparison is muddled by oil price hikes after production peaked in the late 1960’s and OPEC capitalised on this with price rises. This led to stagflation, the chief cause for the Nifty Fifty’s capitulation. Yet Walmart (NYSE:WMT) achieved a near 30% compounded annualised stock return over 29 years, throughout the turbulence.  

I tend overall to wariness because any sense of mean reversion now seems cast aside, similarly as Fisher – a celebrated statistician and economist in his day – said just prior to the 1929 Wall Street Crash: “stocks have reached what looks like a permanently high plateau”.

Fiscal third quarter still hugely beat expectations 

Credit to management where it is due: 11% overall revenue growth to $59.7 billion versus consensus for only $51.5 billion – although Apple did avoid guidance when reporting its second quarter results. 

Diluted earnings per share also enjoyed a record 18% quarterly increase, helped by a persistent buyback policy since 2012, although this makes sense for a company with massive cash pots (and was part of my 2013 bull case).

Equity valuation is ultimately the net present value of expected cash returns, and Apple generated $16.3 billion cash flow, another quarterly record.  

A 22% operating margin for the world’s biggest company is superior, and potentially sustainable given Apple fans’ loyalty, unless problems arise with low-cost Chinese production. Yes there are cheaper Android phones and Windows-based computers, but many contented Apple users will not want to switch – hence a substantial customer base for services and other devices evolving.  

Source: Company REFS

Four-for-one stock split may also be a current driver

There is no rational reason why altering a stock’s ‘heavy’ image should prompt a wave of buying, but I have seen this happen repeatedly with stocks in vogue. 

People see a stock rebound after a split goes through – as if enough are stupid to think it fell for no reason, and buy – hence there is speculation beforehand, to seize maximum benefit. 

Apple is this week implementing a four-for-one split, i.e. three additional shares for every one held at the 24 August record date, with split-adjusted trading to begin on 31 August. 

Looking back to the last split – seven-for-one, six years ago – it coincided with a re-rating from about $65 to $130 over 18 months, but there were also underlying benefits of product refreshment I drew attention to.

Not an outright ‘sell’ but lock in gains

Possibly it is best to see how this stock split plays out, however I think Apple has benefited from enough general and specific hype to suggest holders ought to consider locking in gains, according to your risk tolerance. 

Yes Apple may become a $3 trillion company, say on a 10-year view, and a long-term pension fund would retain. The company also remains vigorously innovative and enjoys strong customer loyalty for the Apple eco-system of products and, increasingly, services. But the extent of speculation is creating market risk and political risks beckon. ‘Take profits’. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.