Episode 8 | Decoding Apple's Valuation – with a Focus on Using the PE Ratio

In Episode 8 of "Market News with Rodney Lake," Rodney Lake, the Director of the GW Investment Institute, provides a comprehensive exploration of Apple's price vs. valuation a component of the GWII BMPB Investment Framework, with a focus on using price-to-earnings (PE) ratio. Comparing Apple’s PE of 35.5 with the S&P 500’s 23, he explains that its strong brand and financial performance may justify Apple’s premium. Lake advises that the PE ratio has limitations and should be considered alongside other factors for example earnings growth. He underscores the importance of understanding a company’s valuation in investment decisions, enlightening the audience about its significance and keeping them well-informed. Tune in to learn more and enhance your understanding of investment due diligence!

Transcript

Thank you for joining “Market News with Rodney Lake”. This is a regular show of the GW Investment Institute where we discuss timely market topics. I'm Rodney Lake. I serve as Vice Dean for Undergraduate Programs at George Washington University School of Business. Let's get started.

Welcome back to “Market News with Rodney Lake.” My name is Rodney Lake. I'm your host.

Today is episode eight. We are here in the Duquès Family Studio. Thanks again to the Duquès family. Today we're going to be talking about the business management, price valuation, and balance sheet framework. And today we're going to be focused on the valuation piece that P the price versus valuation. We're going to give the example of Apple. That's a larger position in our portfolios.

So we're going to use that, and likely you've heard of Apple. And you may have an iPhone as well and other Apple devices. So that's going to be the example. It's just a little bit of a refresher. Excuse me. BMPB; b equals business, M equals management, price valuation is the p, and the b is the balance sheet.

And we've gone over two of those components. Today we're tackling the third component, which is the price versus valuation. And that one can be a little bit mysterious. So a lot of times people think, well is this an art? Is this a science? How do we really determine what's the value of a company? Well, finding the price for a company is pretty easy.

You just go online. You. Okay. This is, Google Finance or pick any, you know, outlet that you would like. And there's the price. It'll tell you, if you have a brokerage account, you can find it there. You can find it in lots of places. The price is wherever the price is for that day, when you're looking.

But what's the valuation? What's the company actually worth? And you're trying to compare the valuation to the price. And what we try to do and what we try to teach for our analysts is what's the intrinsic value? How much do we think this company is actually worth? Well, in the, you know, historical this kind of cash flow set up, it is the present value the discounted future cash flows.

Well what does that mean. Well it's really about well what can this company produce in the future for its owners now. And how do we discount that value. Back to today. How do we figure out what's the current value for this company? when we know that they're going to grow into the future or we hope if we're buying it, they're going to grow into the future.

But in any case, the company is likely to be different in the future. So how do we account for that now? So we're going to do a couple of things today. And there's lots of room to talk about this. There'll be future episodes. it can get complicated. but your best to really try to simplify the valuation.

Don't overthink it. Don't over exact it. So, you know, Charlie Munger talks about if you're overly precise, you're just going to be precisely wrong. We're trying to be generally right at the investment it's due for all the stuff we do, including on the valuation. So a couple of things, to talk about, today will be that some of the metrics that we use and we're going to use Apple as the example.

So when we talk about Apple and again everybody's heard of Apple. Let let's just get started on the price. So we're it's about mid-July here when we're doing this episode. so this will be this episode, but we have to talk about, the price currently. So it's difficult not to date it. So what's the price today?

About $235 as of today per share. Well, what does that mean? Well, what's the value of the company. Well, per share is, is, you know, can be changed because a company can issue shares and it can decrease the number of shares. And Apple has actually done that over the last ten years in quite a bit. And I'll talk about that in a moment.

But okay, now we know the price. Well, to get to the what's called the market capitalization, what's the total value for all shares? What's for the company? We need to know how many shares there are. So there are about 15 billion shares outstanding for Apple. And by the way, Apple has decreased the number of shares over the last ten years by over 35%.

And there's some good articles out there, that, that talk about that. and that's one way. And when we talked about management, then that capital can be allocated by reducing the share count, buying shares back. And Apple has been doing that and has reduced the share count by a lot actually by almost, you know, over 35%, probably something like 37% over that ten year period.

And that's quite a lot. So we take the current price times the shares outstanding and we get the market cap. So if you've heard that Apple is a $3 trillion company, that's the market cap. So right now today it's about $3.5 trillion company a little bit more than that. well that sounds like a large number because it is an apples, one of the largest publicly traded companies in the world.

and so that $3 trillion valuation, you know, is it fair? Is it not fair? Well, that's for us as an analyst to figure that out. What do we think Apple is worth? Do we think Apple is worth more than that? Do we think Apple is worth exactly that? Okay. That's fair value approximately. Or do we think it's worth less.

So it's potentially overpriced. So we have to do our work. And just as an example, let's just say we don't have good reasons yet and we haven't done any work yet. But let's say that we think Apple is worth $4 trillion. and we'll figure out, you know, how, we did that maybe, later. But let's say for this example that we did the work, and we came up with a $4 trillion valuation because we think, the earnings are going to grow or we think the multiples going to increase.

And we'll talk about both of those things. Well, that means if we think it's a $4 trillion company, that's the valuation. That's our intrinsic value. And we got there because again we thought both earnings will grow and the multiples going to expand. Now that is an about 11% upside from today. So we compare that to the current price.

The current price is three and a half a trillion 4 trillion. That's approximately 11%. so that's 11% upside from where we are. So if we buy it now or if we already own shares, we hold it now, we can expect an about 11% upside from here. And that's on the price. And Apple pay some dividends. So we'll have to account for those two as well.

is that good? Is that bad? Well, you know, for the riskiness of Apple, many people might think that that's, that's an attractive, upside. depends when you think you're going to get that upside. So do you think that that upside is in one year and five years and five years, maybe 11% doesn't sound that good.

But if you're a target price, or your intrinsic price for Apple is, let's say one year out and you think it's $4 trillion, well, that's not necessarily a bad return, an 8 to 10% average return for the S&P 500 over the last 100 years. So 11% a little bit better than average. I think Apple is a way better than average company.

So maybe that is a good risk adjusted return for us, an investor for our portfolio. So if we own shares we're a hold. And if we're thinking about buying shares that that's what we can expect. Certainly you're not going to get the run, that you've had over the last 15 years with Apple, even the last five years.

But certainly that can be considered a good return in context of what you might get from your other parts of your equity portfolio. So, and considering what you might think that the risk is so, you know, you know, reducing the number of shares as we talked about is something that I just want to pause on here.

and that's really on the management side, they're doing this capital allocation, but it has a big impact on you. So if you're an existing shareholder, for example, which we are in our portfolio at the Investment Institute, what happens is because if we don't sell our shares and the number of shares, is reducing our percent that we own in the company is actually going up without us really doing anything.

We don't have to put any additional capital out. But that return of capital is coming back to us because the percentage that we own in the company, albeit small relative to the whole company, is increasing. so our value, is increasing. So that's fantastic news for us. it's super tax efficient if you're a taxable investor.

And it's a way for Apple to reward the shareholders that stick around in a very tax efficient way. Again, if you're if you're a taxable, investor and reminder disclaimer, this is not investment advice. So make sure you seek that if you if you need it and you're planning on doing things. But it's something to think about.

And when you see a company doing that, and we're using Apple as the example. So I just wanted to pause a little bit and talk about that, because if you see the share count decreasing over the last ten years for, for Apple, you think, well, is that good? Is that bad? Well, in this case, if you're an existing shareholder, we are.

Berkshire Hathaway, for example, is a very large shareholder of Apple. Their percentage in the company, if they don't sell any shares and if we don't sell shares, actually is going up without us putting out any additional capital. so that's really good, news for us. So let's just go over a couple of metrics here, that you might consider.

One of the things, and this is something, and we're really just going to lean on one metric called the price earnings ratio. And that's really just the price over the earnings. It's really very simple. Lots of people use this. And it's a very rudimentary but powerful way to try to understand what's the value of the company.

And this has been used, you know, for a long time. Well, all the way back to Ben Graham days when security analysis was being put in much more of a structured format, fundamental analysis was emerging. But this PE ratio dates way back to the early days of security analysis and fundamental analysis for companies, but it still works.

The reason it's powerful is because it does work. But it has limitations like any other metric. And so when we look at Apple and we think, okay, well, what is the current valuation for Apple? Well, the current valuation, if we look forward and we're always trying to look forward, what's the current price and what's the next year's earnings is about 35 times, 35.5 to be a little bit more precise.

But we don't need to be so precise. Well, is that good or is that bad? Well, let's compare it to the S&P 500. The current expected, next year valuation for the S&P 500 is approximately 23 times, and this data is from FactSet and Bloomberg, by the way, for today's show. Well, you would say, well, that's a lot higher, 35 times versus 23 times.

Why are we paying so much for Apple? Well, you have to ask yourself then, is that valuation justified and how can I tell? Well, do you think that Apple is a better company? This gets back into other parts of the framework, or is it a better business than average? I would argue that it's a far better business than average for some of the reasons that you can think about—that it has a brand, it has a moat around its business, it has good profit margins.

It generates a lot of free cash flow. So those are all good things and are interrelated to this piece. But you have to think when you're when you have to consider when you're thinking about the valuation, are these things justified? Those are just some examples. And I would argue that it is justified. Should it be 35 versus 31 or 40?

Well, that's where the art comes in. That's where your conviction around what you think about the future for Apple has to come in. The higher the number, the higher conviction that you have to have around the growth of the company or the expansion in the multiple, the price that people are willing to pay. The only way you can grow the share or the market cap is really through multiple expansion.

So it trades at 35 times. It goes to 40 times on the same earnings or it grows earnings or both, right? So it has to do both earning expansions and/or multiple expansions rather and grow earnings. That's called the Davis double play. Sometimes that's fantastic if you have both of those things. And if you can get both of those right, you're going to make a lot of money.

In the case of Apple in our portfolios, that's exactly what has happened since we started buying shares more than 15 years ago. And both of our portfolios. And so that has been a terrific run for us. Now we're talking about a winner. It doesn't always happen that way, just to be clear. But that's something that has happened and it's been a very powerful return.

You know, for us, back to paying up for this. So you're paying up for Apple, and you're paying 35 times versus paying 23 times for an average company in the S&P 500, or just what we're saying, buying the whole index. Well, Warren Buffett has a saying about this. It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

And what does that mean? So I think, you know, for us, what it means is we would much rather pay up 35 times for a company like Apple, than let's say pay 23 times for the S&P. So, you know, what does that mean? You're taking on additional risk, let's say in the price because that multiple can contract closer to and let's say revert back more to the mean, which is the average of those 500 companies.

And obviously if earnings don't expand, then the valuation for the overall valuation is going down. But if you think that the multiple could remain higher, that people will continue to pay a premium for Apple, which I think is the case, is 35 times the right number, I don't necessarily know if that's exactly the right number, but my conjecture, and our conjecture at the Investment Institute, with our analysts, is that that premium will exist, at least for the foreseeable future.

Apple will demand a premium in the market, and people are going to be willing to pay up for Apple because it has a great brand, it has great management, it has really strong free cash flow. As a result of all those things. And that premium is, you know, should be awarded, is something that we consider appropriate.

How long should that premium last? Well, that's more difficult to know. You know, this is something. And as an analyst, when you look at the valuation, it is not a static setup. It's not something that you look at once and you don't think about again. This is something you visit really almost every day. If you're in the markets, you're thinking about, if the numbers don't change that much, you don't really have to do much.

But it's something that you should be consistently thinking about. When there are big moves in the company, you really need to re-underwrite your valuation for the company. So let's say the management changes. That has nothing to do with the underlying business necessarily on the metric side. But if you think the management has a significantly different direction, that might change the way you think about the premium, or the discount or whatever the company is.

In this case, Apple is trading at a premium. That might change your view on should we, you know, still have this premium, the company or we're more concerned or if they're saying, oh, we're launching new products. And so when you talk about, for example, the M1 chip, which has been out for a few years now, and Apple is on two successive series now, but really Apple replacing Intel and building its own chips and putting them into laptops, as an example, that was a fundamental shift in the business.

Now, you would say, how does that impact the valuation? Well, it means that they're controlling more of their business, so they're more vertically integrated than they were before. And I would think, and again, our conjecture, the investments too, that the premium should go higher because of that, because they're controlling more parts of the business, which means they can defend that territory as well.

When you outsource to Intel in the past, that's what they did. You're much more reliant on Intel providing those updates for you. Whereas now Apple can rapidly iterate and you can see that the M1, M2, and 3 chips have come out much more quickly than updates came out from Intel because Apple controls that process and they have more control in that process.

And they have demonstrated their willingness to be innovative. And that has made a big difference. And the output for the company. And so very likely you should get a higher valuation for that. These are things that, those are only a few examples. You have to really think about the company in total, and you really have to revisit these things as I mentioned, any time that there's a significant change, but you should always be thinking about the valuation in your companies, even if your company doesn't change in this case, Apple, maybe the market's changing.

Maybe the market multiple is changing. So it goes from 23 times for the S&P and it goes down to 15. Well, what happened? Why is that happening and how does it affect the relative pricing? And is it deserved for your company? In the case of Apple, that premium exists now and has existed for a while, but not always actually.

Apple, you know, long ago traded at a discount to the S&P 500 in some cases. Those were, you know, in hindsight, obvious fantastic buying opportunities. But you had to have a thesis on that. You know what people missed, let's say long ago, was that Apple shifted from, let's say, hardware-only business where, you know, you're really worried about replacement cycle because they thought about the iPhone to hardware, software, and services business where that's a higher profit margin business, that's high recurring revenue business.

And so Apple started to get re-rated as a company, which means that people said, well, it's not just a hardware company. It's not just at risk where there's replacements replacement cycle. It is to a degree, but because it’s more vertically integrated hardware software and it's offering more services. You think about the App Store and news and everything else that people purchase through Apple and now Apple TV.

Those are all recurring revenue businesses, and you can put a much higher margin on those because the cost for delivery is far lower than a phone, for example. Apple in the market gets this premium because even for the commodity, more commoditized parts of the business, which is the hardware piece, you know, they're able to charge a premium to their competitors, let's say an Android phone.

So they're the premium price point. So you're getting a higher profitability associated with what are the unit economics on every phone you add in these other pieces that they've been able to grow over the years. So if you look at the growth in revenue for Apple, it's come from the services business. It's come from, you know, the App Store.

So those things are high profit margins. And when you're growing those things faster, it's fantastic for the business. It's fantastic for the shareholders. and, and people are going to pay up for that, multiple, pay up. And, and the result is a higher multiple. So the 35 times, again, I'm not sure that that's the appropriate number.

you know, from one day to the next. Is it should it be exactly that number? It's always hard to tell. You can use this frame. You can use this type of analysis for almost all companies. Now it gets a little bit more difficult in financials because for example, PE doesn't necessarily mean. And there you have to use price tangible book.

But I'm mentioning this because for different companies you certainly have to think about different metrics. For a company that's an established company, the price earnings multiple is a very appropriate, measure to get started with. Just to be clear, as I mentioned, there are limitations for this. it's not perfect. It's very imprecise. It's imperfect. In fact. But it is a great place to start to start thinking about the company and you compare it to its peers.

you compare it to the S&P 500 to, you know, make sure you compare it to its industry. Make sure you compare it to the S&P 500 and try to think about, you know, how the company is positioned. If the company is a financials company, particularly banking company, you're typically going to use a metric called price. The tangible book.

And we can talk about that in future episodes. but if a company doesn't really have revenue or earnings, then the PE is really not useful. particularly earnings, and especially if they don't have revenue. So if it's an early stage company, the p e multiple is really not going to be useful for you. So you have to think about price to sales, and some other metrics that might make sense.

Those things are harder to to really gauge because if a company's so early stage, it's much more difficult to to think about, okay, well, what's the path in the next three and five years? And there's a lot of opportunity in those companies if you can understand them and understand them much better than others. However, there are limitations. and you can have very divergent outcomes, in that.

Well, that's a wrap. for today, I hope that this piece has been helpful for you. as you think about companies. Again, Apple, being the example here. But plug in any company that's an established company and you can use these metrics, for yourself. Reminder, this is not investment advice. So make sure you're doing your own work.

That's a wrap for episode eight. We look forward to seeing you back on episode nine. Thank you.

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