Is Apple a Bubble?

In 1999, just after the Dow broke 10,000, the book Dow 36,000 predicted it would more than triple in just a few years.   That was two crashes ago and nearly 15 years later the Dow is barely 13,000.

Those foolish days would seem long gone, but just last week Forbes published an article which predicted that Apple shares will hit $1,650 by the end of 2015.  Just like Webvan and flipping houses, people are talking about Apple like it can only go up.

Further, Robert Shiller, who predicted the 2000 crash and then the 2008 then real estate crises, was quoted in The Economist saying, “You could play the bubble, because it might not be over yet, but I wouldn’t put money in Apple stock.”  With the rhetoric so eerily similar to previous crashes, it’s time to ask whether Apple is a bubble too.

What’s a Business Worth?

Valuing a company is straightforward in theory, albeit difficult in practice.  A business, just like any other asset, represents a stream of earnings.  The value of the business, then, is the net present value of that revenue stream, taking into account the risk an investor incurs and needs to be rewarded for.

So, to take a simple example, if you expect an investment to pay you $1000 per year, you would want that to be greater than a bank would pay you in an insured account. Investors have a shorthand for estimating equity returns called a P/E ratio which is the market price divided by the net earnings.

There is also a PEG ratio, which takes estimates of future earnings into account.  A PEG ratio of under 1.00 indicates a cheap stock and one over 1.00 indicates an expensive one. I’ll go over the actual values for Apple at the end of this post, but the basic point is that the assumptions about Apple’s prospects are implied by the price.

Therefore, to determine if Apple’s market price makes sense, we need to examine the business and then see if we think the assumptions the market is making hold water.  If those assumptions are reasonable, $600 a share is a fair price for Apple.  If not, it’s a bubble.

A New Age of Usability and Interoperability

First, let’s ask the question, why is Apple doing so well and why now?  Sure, they make great products, but lots of companies do and aren’t valued at over half a billion dollars. Clearly, there is something about this point in time which plays to Apple’s strengths.

Why is that?  I think the picture becomes clearer when you look at the four digital laws that I laid out in an earlier post:

Kryder’s Law:  Storage efficiency doubles 12 months.

Moore’s Law: Processing efficiency doubles every 18 months

Nielsen’s Law: Bandwidth efficiency doubles every 22 months.

Michio Kaku’s Caveman Law:  For technology to be successful, it needs to address basic human needs and desires.

These laws represent constraints on what we can do with technology and companies who can push those limits are rewarded handsomely.  Intel rose to stardom with memory chips and then in processors.  Cisco became wildly successful by innovating in bandwidth.  They both earned hefty profits when a marginal increase in performance translated into a large increase in consumer experience.

What’s interesting about this point in time is that, for now, the first three laws have effectively ceased to be constraints for consumers.  It’s been a long time since we had to delete e-mails with attachments to save disk space, any computer we buy will be able to run the programs that we want and, with 4G, bandwidth isn’t a major concern either.

It’s usability and interoperability that is at a premium today and that’s where Apple excels; not just with their individual products, but across the entire ecosystem they’ve created. We love Apple products not because of their technical performance, but because they’re fun and easy to use.

The Post-PC Era

Apple used to be a niche player in a PC world.  While their focus was on building products consumers loved, IBM’s PC architecture was designed with businesses in mind.  The result was that Apple got cut out of the enterprise market and the profits that came with massive investment in technology by businesses since the 90’s.

That’s beginning to change with the rise of Post-PC computing.  Smart phones and tablets are becoming de-rigueur in the workplace and Apple’s dominance in those devices is increasing Macs’ share of the corporate market as well.  Apple, all of the sudden, has become hip with CTO’s.

Moreover, with smartphone adoption still barely 50% and tablets merely around 20%, Apple has a lot of room to grow even with growing competition in the space.

The New Digital Battlefield

As I wrote in a previous post, the new digital battlefield will be largely fought in the new living room and in-store.  Connected TV’s, integrated with tablets and smartphones, are set to revolutionize home entertainment.  The same technology is being deployed in-store as well.  That, needless to say, is an absolutely enormous market.

In the living room, uncharacteristically, Apple finds itself running to catch up with Microsoft’s XBox live platform and Google TV.  Microsoft has over 60 million monthly paying subscribers and Google has snapped up important partnerships with manufacturers.  Meanwhile, Apple, if reports are to be believed, has stumbled in partner negotiations.

Nevertheless, it’s still too early to count Apple out.  They are supposed to be coming out with their new Apple TV later this year and it’s hard to imagine they won’t be a serious player.  If they get it even half right, the profits could be enormous (Microsoft’s Xbox division is already as big as Windows and growing 30% per year).

Irrational Exuberance?

I think everyone would agree that Apple is an amazing company with great prospects, but that’s not the question we’re asking here.  The real concern is whether Apple’s stock price implies unrealistic assumptions.  In other words, have investors let Apple’s success go to their head?

Let’s take a look:

Surprisingly, there doesn’t seem to be much froth is Apple’s stock price at all.  Their P/E ratio is very close to the general market, significantly below Google and nowhere near Amazon (which does look like a bubble stock).  When a 5 year horizon is taken into account, the PEG ratio stands at less than 1.00, indicating that it might be downright cheap.

In actuality, investors seem to be taking a “wait and see” approach to Apple’s future growth, giving them credit for what they’ve already achieved, but not much more.  Their value, as stratospheric as it is, seems to be a function of their earnings, not investor expectations.

Strangely enough, about the only thing Apple can’t seem to sell at a premium is their stock.

– Greg