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Is Apple really as cheap as it looks?

"Apple is cheap" has long been a Wall Street cliché.

It's now become an increasingly desperate plea of shareholders unable to understand why the most profitable company in history seems valued by the stock market as if it's a mediocre business.

With a decline of nearly 5 percent, to just above $95 Wednesday following a mixed earnings report and sober guidance on the current quarter, Apple shares are off by more than 28 percent in the past six months, and are trading below their 2012 high on a split-adjusted basis.

At this level, the stock is indeed cheap by most standard measures. It trades near 10 times forecast earnings per share for the coming four quarters, compared to 15 times for the S&P 500. Stripping out Apple's massive $153 billion trove of net cash (that is, its cash holdings minus its debt), the business is valued around 7.5 times expected 2016 profits.

An Apple logo is reflected on a wet ground outside an Apple Store.
Bobby Yip | Reuters
An Apple logo is reflected on a wet ground outside an Apple Store.

In fact, Apple for years has appeared chronically cheap. The stock's forward P/E has been below the broad market multiple continuously since 2012, reaching a low just beneath 9 in April 2013.

It is perhaps the leading example of the distinction between a great company and a great stock. The depressed multiple has challenged Wall Street's typical assumptions of how leading companies should be valued.

Morgan Stanley analyst Katy Huberty has a $135 price target for Apple, roughly in line with the average sell-side target of $136.43, according to Factset. She arrives at this target by placing a multiple of 15 on her forecast of $9 per share in earnings for the current fiscal year, ending in September. It also computes to 12 times earnings, excluding Apple's net cash.

This is all quite plausible, and would get the stock up to a level slightly above where it traded last summer, when it peaked near $132.

More interesting, perhaps, is Huberty's hypothetical "bear case" for the stock, which could arise from further weakness in iPhone sales, an 8 percent drop in fiscal 2016 revenue, further margin erosion and a decline in earnings to about $8.25 a share. This adverse scenario gets her to a $91 stock price, or 11 times those lower earnings.

This is quite telling, the fact that the "bear case" results in a price target just 4 percent below where the stock trades right now.

How to explain what appears, to many Apple partisans, to be a punitively low value placed on this business?

Here are a few thoughts:

  • Apple's profit margins peaked in fiscal 2012. And based on current estimates for 2016, Apple's net income will have grown about 6.3 percent per year. Massive share buybacks have made per-share earnings much better, but the absolute earnings produced by company have been growing rather slowly.
  • The market has been stubbornly unwilling to give Apple "credit" for the enormous cash balance on its books. While a valuable cushion, and potential ammunition for future investment and acquisitions, it's hard to conceive of one or a few truly smart, low-risk moves Apple could make with this bankroll. Buybacks and dividends have helped rationalize the balance sheet, but are no magic for lifting the stock.
  • And any bold acquisition Apple might make would almost by definition amount to buying a company with inferior profitability to Apple itself. Good deals could still be had, of course, but investors seem to hold Apple to unreasonably high standards of corporate-culture purity and internally sourced innovation.
  • Investors seem unwilling to bet that every successive iteration of the iPhone will be a hit. The company with the largest market capitalization has tended to have long product cycles or a strong, durable stream of recurring revenue, whether Microsoft, General Electric, Exxon Mobil or AT&T. For Apple to grow, it must persuade a couple of hundred million people per year to spend a lot of money on a new smartphone. Apple has done an amazing job of doing just that in recent years, but Wall Street is clearly unconvinced it can pull this off in the long term.

This is, no doubt, why Apple is now highlighting the 1 billion-unit installed base of iPhones.

None of this challenges the idea that Apple shares are cheap. The argument must be over whether they are cheap for a reason or undeservedly cheap. With perhaps only 10 percent downside in the stock until it reaches its lowest valuation in more than a decade, it's hard to see there being a lot of downside from here, unless global consumer headwinds strengthen further.

But when everyone calls a stock "cheap" for years and the market fails to listen, it's time to find reasons besides valuation for the stock to work.