How Cheap Is Apple, Really?

 

 

Apple (Nasdaq: AAPL) is trading for 30 times trailing earnings. Some would argue that this makes the gadget guru an entirely unsuitable investment vehicle. Others like to point out the flaws of the P/E valuation metric, and blithely buy the stock anyway. Fellow Fool Tim Beyers argues that the company is cheaper than you think. Tim is a genius, but this time, I think he's wrong.

Let's have a closer look at Apple, and compare and contrast it to the competition:

Company	EV/FCF	LTM P/E	Forward P/E	PEG
Apple	12.4	29.6	25.1	1.7
International Business Machines (NYSE: IBM)	10.8	12.7	11.2	1.2
Microsoft (Nasdaq: MSFT)	12.3	15.2	12.9	1.5
Google (Nasdaq: GOOG)	18.6	32.5	19.1	1.2
Dell (Nasdaq: DELL)	10.1	14.6	12.1	1.6
Hewlett-Packard (NYSE: HPQ)	11.7	15.1	10.6	1.2
Garmin (Nasdaq: GRMN)	4.7	11.2	13.4	1.0

Data from Capital IQ (a division of Standard & Poor's) and Yahoo! Finance. Data current as of Aug. 26.

Price to earnings
All sorts of P/E ratios will make Apple look bad here. On a trailing basis, only Google looks more expensive -- but then again, who wants to base investment decisions on an accounting metric that is prone to manipulation and paints an incomplete picture? When you use forward estimates instead, in order to iron out some of the inconsistencies, Apple becomes the priciest stock of the whole bunch.

Of course, analysts have a tendency to underestimate Apple's growth -- the company has never missed an analyst consensus target since Thomson started tracking estimates for Apple. For that reason, I tend to knock a couple of points off whenever I'm thinking about Apple's forward P/E figures. But it'd take at least six bonus points to dive below Google's supposedly pricey valuation, and much more to reach the industry average. Yep, Apple looks expensive on a price-to-earnings basis, any way you wrangle the numbers. Let's move on.

The Fool Ratio
The same dynamics play into the price-to-earnings-to-growth ratio as well. Apple comes out looking expensive thanks to stingy forecasts and tricky earnings accounting. Google and IBM start to smell like roses, and Garmin might even be on sale at a discount.

As beloved as the PEG ratio has been in Fooldom -- heck we sometimes call it the Fool Ratio -- this metric has shortcomings of its own. Like the P/E, it's useful as a starting point before diving deeper, but it's not a silver bullet to cure valuation lunacy. Also, Apple's accounting for iPhone sales means that its revenue isn't fully realized in the quarter the phones are sold. Instead, the company recognizes revenue and cost of goods sold across each phone's estimated 24-month lifespan. So earnings simply don't tell the whole story here. Fair enough. Let's try a measure that backs out these accounting effects.

Break out the cash flows!
OK, now we're talking. If the proper value of a given company equals discounted future cash flows, it follows that any quick-and-dirty metric worth its salt should depend on the company's powers of cash generation. Also, we account for Apple's large cash hoard by using its enterprise value instead of its market cap.

From this angle, Apple is a superstar. Apple pulled in $10.3 billion of free cash flow over the last 12 months. That's about five times Dell's respectable cash bonanza, and nearly twice the cash mighty Google created. Heck, Apple even beats tech giant HP.

But Apple is also considerably more expensive than most of these high-tech peers. Looking over the cash flow metrics in the table above, Apple comes out looking fairly valued at best, and a bargain only if you put it next to Google. That's sort of like bringing an ugly friend along on a date, just to make yourself look better. In fact, if you're looking for an affordable gadget designer, Garmin might be your best bet. The company's lowly cash flow multiple likely results from poor growth projections as smartphones encroach upon its GPS-navigation turf.

It all boils down to growth
We've examined Apple from four different angles, and found its valuation relative to its peers lacking every time. Clearly, the market expects Apple's growth engine to remain far more revved-up than competitors'. So if you own this stock, you'd better have a firm conviction that the company will grow fast enough to leave analyst expectations eating dust for years to come.

Will the iPhone still be a hit in 2013? Can the Mac steal any more market share from Microsoft's PC hegemony? Is the iTunes-iPod symbiosis immune to new upstarts and counterattacks from a resurgent old-line music industry? For today's share price to make any sense, the answer to all of these questions must be a resounding "Heck yes!" I don't think it'd be good enough if one or two of those dream scenarios play out, and not even Babe Ruth expected a home run on every swing.

Could Apple succeed on every front? Sure. Will it? Highly doubtful. For one thing, Apple's absolutely crushing the high-end market for computers. NPD reports that it has more than a 90% market share on computers costing more than $1,000. To Apple's credit, this is an amazing statistic, but it also limits the growth of its computing business. 

In addition, we're starting to see the iPod sales slowing down as iPhones and other convergence devices with built-in MP3 players take their place. The rise of the iPhone has been impressive by all measures, but its ascent will most likely be paired with continued declines in iPod sales. Finally, Apple's forthcoming rumored tablet will probably be the hardest sell of its recent "game-changing" products. I wish Apple all the best in its efforts, but persuading consumers to buy what will probably amount to an eReader/oversized iPhone will be a much tougher job than storming the MP3 player market ever was.

If I owned any Apple stock, I'd sell today and lock in some profits -- because these prices can't last.