Recently a friend of mine asked that I comment on an article's following statement: "The stock is really cheap for the kind of operating fundamentals they are putting up." The writer was referring the to stock of Apple corporation (AAPL), and most of us want to know how he came to this conclusion. Is it justified? Logical?
First we must understand what he means by operating fundamentals. These fundamentals are the tools (see Lesson 1 Tool Box) referring to price earnings ratio or p/e. There are many other operating fundamentals that have not been examined in this blog yet, but some we will explore in future blogs are cash on hand, debt, book value, and free cash flow.
Anyway, let's look at what we learned in lesson one: price to earning ratio (p/e). Apple is expected to earn $28.00 per share in 2011 and $32.00 per share in 2012. Based on trailing earnings (2011), Apple has as p/e ratio of 13.57 (stock price of $380.00 divided by $28.00 earning per share) and 11.875 based on forward earnings (2012). These ratios are considered very low for a company that grew 80% in 2011 and expected to grow greater than 20% over the next five years. If we take into account the $100.00 per share in cash on hand and subtract that from the current stock price, we would have p/e ratios of 10 and 8.75. If Apple actually beats the projections for earnings (which they have by 20% or more over the last six quarters), then these ratios would be insanely low by any measure historically. Therefore, we can conclude that using a price earnings ratio as a tool, Apple is a screaming buy at these levels!!!
Let's look at one other fundamental without exploring the details at how we arrive at the number. Free cash flow. Free cash flow is used as a tool because it examines in greater detail how a company is managing its profit or earnings. Earnings can sometimes be manipulated with the pencil strike of a creative accountant or chief financial officer. Manipulation does not neccesarily mean illegal, as there are general accepted accounting principles (gaap) which allow wide ranges of interpretation regarding inventories, asset value and liabilities. Free cash flow takes much of the guess work out of anaylyzing earnings and simply computes the amount of net cash (cash less expenditures) a company earns or puts aside during a quarter. Comparing free cash flow to earning per share (eps) can help us understand if the earnings number is real and not some accounting stretch to keep the investment community temporarily happy.
Interestingly, Apple is currently generating 38 billion dollars of free cash flow per year which is even greater than what they show as earnings per year. Based on this metric or tool, Apple is a magnificiently operated cash flow machine that knows how to take earnings and make them into the real thing: CASH!
I'm long Apple and suggest to all my readers that purchasing Apple under $400.00 will be a rewarding experience over the next two years.
Time for some NFL... yeah baby, finally the football season is on!
(Reminder: Check this blog's archives for other artcles.)
Steve M
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