3/1/13 – A Look at Market Valuations

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 1, 2013 11:19:34 AM

and tagged Economics Lessons

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I was thinking about market valuations this morning in light of some of the volatility we saw last month and some discussions we’ve had internally.

For illustrative purposes Apple is a good stock to look at for this kind of discussion. By some metrics Apple could still be considered inexpensive, but it’s uncertain whether it can continue to grow sales as fast as it has. How much of the valuation is based on the assumption of continued sales growth, and how will the stock price be affected if sales growth slows?

I think the question about top-line growth is a reasonable one. For example, heading to Florida with my son last week, we had a MacBook Air computer, an iPhone, and not one but two iPads. All this, for one man and a four-year-old, for one weekend. I’m not sure how much more Apple can sell me.

Of course, I may not be typical, and I know that Apple has other options to extend its top-line growth—Apple TV, for example. At some point, though, the company will run out of room. And then, sooner or later, the growth rate of total sales will slow.

On the other hand, Jim McAllister, Commonwealth’s manager of research and expert equity analyst, makes the point that top-line growth isn’t the only metric we should be looking at. Instead, earnings per share (EPS) should also be considered. Apple could increase its EPS immediately by about 40 percent by doing a massive stock buyback with its large cash holdings.

Another way to look at that is to back out the cash Apple holds from the stock price, which makes values even more reasonable—or even cheap.

To be clear, my comments are not intended to be a recommendation for or against investing in Apple stock, but are merely designed as a means to illustrate that the market as a whole appears to have a lot of similarities to Apple at this point. Valuations based on recent earnings appear reasonable, and by some metrics even cheap. Yet, recent earnings are at high levels of sales and historically high profit margins. There are questions as to whether and how much top-line growth can continue, and also questions as to whether current profit margins are sustainable. This casts some doubt on whether stocks in general can continue their recent strong performance.

What this account is missing, per Jim’s point on Apple, is the possibility for EPS to continue to increase faster than top-line growth. Even if total sales growth slows, or margins decrease, companies could easily reduce the number of shares outstanding with buybacks; even given flat earnings, this would automatically increase EPS. Considering the levels of cash that exists today on many corporate balance sheets, as well as increasing numbers of share buybacks, that seems to be a reasonable possibility.

The upshot here is that, while there are reasons to be concerned about the market, there are also good reasons to believe it can go even higher. No one knows for sure which way it will go, and as always, the market isn’t saying. As I’ve noted before, despite the lurking risks, the current trend appears to be for continued market growth, and possibly even new all-time highs. Looking at the market based on potential EPS growth, that doesn’t seem unreasonable.

I’m still not long Apple, though.

 

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