With non-cyclical mega-cap, P/E ratios actually mean something. It is very difficult for a stock to justify a P/E ratio north of 20x earnings once a business is worth over $250 billion. Earning high returns becomes quite difficult once tens of billions of dollars are involved. This is where the economic concept of “diminishing returns” originated. I think of this when I note that Apple delivered investor returns of almost 80% in 2019 even while profits barely inched upward.
From a P/E perspective, this is where Apple has averaged trading in the past ten years: 15 (2010), 14 (2011), 12 (2012), 12 (2013), 13 (2014), 12 (2015), 12 (2016), 14 (2017), 15 (2018), 16 (2019). From 2015 onward, Apple was a business that could fairly be characterized as an incredibly profitable business with $100+ billion in cash, enormous profits from iPhones driving over half of sales, and an electric array of high-profit margin goods and services that earned an incredible 21% profit margin across the product portfolio.
Since then, the valuation and the balance sheet has changed. Entering 2013, Apple was a business that was sitting on over $200 billion in cash and no debt. Like Berkshire, the mountain of greenbacks radiated power. The iPhone cost $199. And yet, the stock was trading at 12x earnings. The low valuation of the stock, the subsequent potential for deployment of that cash, along with the potential to hike the price of the iPhone, represented compelling value.
During that year, the price of the stock hovered between $58 and $100–the investors from that year through the present day either tripled or sextupled their funds depending upon the entry point. Also, the P/E for the investors is important to note as well. Apple earned $6 per share in profits in 2012. For those that paid $58, they get their hands on the stock at 10x earnings. For those that paid $100 for the stock, they paid almost 17x earnings.
Between 2012 and 2019, Apple doubled its profits per share from $6 to $12. Most of this was funded by share repurchases. The actual corporate profits for Apple increased from $41 billion to $55 billion during this time frame. In other words, Apple itself became 34% more profitable during the 2012-2019 stretch, but Apple repurchased obscene amounts of stock so that your actual ownership position of each share increased substantially such that the per share profitability doubled.
Specifically, Apple repurchased 2 billion shares of stock between 2012 and 2019, reducing the share count from 6.4 billion to 4.4 billion. It paid an average price of $105 for that stock. This means Apple spent $210 billion repurchasing its own shares over an eight-year period. During this time frame, Apple earned a total of $310 billion in profits. The company also moved to a “cash neutral” position during this time frame, as the $200 billion in cash and no debt was replaced with a balance sheet that now contains $100 billion in cash and $100 billion in debt.
On the business side, Apple tested the value of its brands and quintupled the price of its iPhone offerings during this period, taking the iPhone cost from the $199 offering to leading offerings that now cost around or over $1,000.
The investor community has rewarded Apple’s exercise of its pricing power, taking the price of the stock up to $318 per share against $12 per share in 2019 earnings. That is a P/E ratio of 26.5.
For prospective investors, it appears that the levers of value creation have been pulled (namely, realizing pricing power by hiking iPhone prices and going on a buyback spree by spending a $200 billion cash surplus) while the P/E ratio has also risen to its highest point since Apple has become a mega-cap company.
It would not be wise to expect that Apple would have a P/E ratio north of 20x earnings for the long term. Now that the stock is at 26.5x earnings, the efficacy of the buybacks is diminished. After all, just last year, Apple could spend $1 billion and repurchase 7.04 million shares of stock at a price of $148. Now, if it has $1 billion to spend on repurchases, it will only be able to repurchase 3.14 million shares with the same amount of cash.
Since Apple has become a billion-dollar spewing iPhone juggernaut, we have not seen this type of P/E ratio for the stock. We haven’t even seen a P/E ratio in the 20x range, let alone the 26.5x current range. The excess valuation is a real drag on my expectation for future performance of the stock. I think Apple will move profits from the $12 per share range currently to $20 per share five years from now.
That is 10.7% compounded annual growth rate. That would be fantastic earnings per share growth for a company that has a market cap of $1,400,000,000,000 at the start of the evaluation period. But while it grows earnings per share at that rate, I also expect the P/E ratio to compress from 26.5x earnings to 20x earnings. Essentially, I am predicting that future investors will capitalize each dollar of Apple’s profits at a 25% lower rate. The consequence is that the stock price only stands to rise from $318 to $400 for a compounding rate of 4.7% (maybe 6% counting dividends) due to the high valuation that exists right now.
To do better, you would need to bank on Apple selling iPhones for $2,000 or more in 2025 and launching new services and competing products that are lucrative in a manner somewhat similar to the iPhone. That is certainly possible, but it is a requirement to achieve compounding in excess of 6% (although an elevated P/E ratio could also accomplish this). I think Apple is a great company, but the analysis of the past and future has to compare the $200+ billion deployment, valuation changes, and iPhone pricing hikes against a more limited menu of options in the future. If you want a high probability of double-digit compounding with Apple, you can’t pay more than $250 per share at this time. That opportunity was available as recently as October. It will come again.