Over the weekend Barron’s made the case why Apple (AAPL) is worth $150, not the $109 it is currently trading at. You know the drill, it’s cheap, fortress balance sheet and “strong recurring revenue from Apple’s growing services business” could catalyze a 40% move at some point in the future. Without assigning a guesstimate as to when, I suspect Barron’s will eventually be right on this $150 call. The article goes on to highlight just how cheap AAPL’s “clean” GAAP (generally accepted accounting principals) earnings are relative to the S&P 500’s (SPX) on GAAP basis:
Apple tallies its earnings under generally accepted accounting principles, or GAAP, as all companies must. But unlike many, it doesn’t then direct investor attention to a cleaned-up measure of earnings that excludes restructuring costs, option awards to employees, legal settlements, and so on. Using GAAP numbers, the S&P 500 trades above 23 times trailing earnings. Write-offs have been unusually large of late because of a deep downturn in the energy sector, but even assuming a more typical pace of write-offs, the market would trade at about 20 times trailing GAAP earnings.
You know who doesn’t report GAAP earnings? Facebook (FB), a company with a $315 billion market capitalization, or 52% of AAPL’s with expected sales of $25.5 billion this year, or about 11% of AAPL’s expected $229 billion. FB, on an adjusted basis trades at 35x their expected 39% eps growth, not bad given the sales growth rate, but on an GAAP basis it trades 52x, and nearly 13x expected 2016 sales. In the history of the stock market there has only been one other time where a $300 plus billion market cap company has traded at such a healthy price to sales multiple, and that would be at the height of the dotcom bubble back in 2000 when Cisco (CSCO) and Microsoft (MSFT) were vying for the top spot in market cap terms, very near AAPL’s current $600 billion mark. In 2000, CSCO and MSFT posted what was then record revenues, combined about $41 million, and each stock traded about 36x. So FB, given its torrid sales growth could be viewed as cheap in year 2000 terms, but its also important to note that while both CSCO and MSFT saw sales grow year over year from 2000 to 2001, their share prices declined 90% and 66% respectively from their 2000 peaks to their eventual post bubble lows.
And then there is Alphabet (GOOGL), like FB, squeezing billions out of internet users search queries and ad serving. Comparing GOOGL to FB doesn’t really seem that fair, as their $514 billion market cap is about 7x their 2015 sales of $60 billion and about 7.2x expected 2016 sales of $71 billion, growing 18%!! GOOGL trades 22x their expected adjusted earnings of $34.50, but 28x on an adjusted basis.
So what’s the point of this little exercise? First I am glad Barron’s is highlighting the fact that while AAPL is considered a technology innovator, their sales largely come from hardware sales and their reported earnings have none of the smoke and mirrors that exist in high growth software/advertising models like FB and GOOGL. They also highlight the fact that if AAPL is to grow double digits again from such a large base, it will likely be from services, the sort of business models that investors have given a pass to what they can exclude from the results that they “steer” investors towards, on a comparative valuation (AAPL’s GAAP to FB/GOOGL’s adjusted) AAPL will be viewed as very cheap.
Lastly I have no idea if FB and GOOGL see a pause to their torrid sales growth, but as the companies mature, they will likely be pressured by investors to move towards GAAP reporting which could change the dialogue about their valuations at the exact wrong time.
Discussion below (from last week) on Adjusted vs GAAP earnings.
Adjusted Earnings vs GAAP
Last month the WSJ highlighted the differential in GAAP and reported earnings for the S&P 500 (S&P 500 Earnings: Far Worse Than Advertised). This after 2015 marked the slowest eps growth for the SPX (.4%) since 2009:
Look to results reported under generally accepted accounting principles and S&P earnings per share fell by 12.7%, according to S&P Dow Jones Indices. That is the sharpest decline since the financial crisis year of 2008. Plus, the reported earnings were 25% lower than the pro forma figures—the widest difference since 2008 when companies took a record amount of charges.
The difference shows up starkly when looking at price/earnings ratios. On a pro forma basis, the S&P trades at less than 17 times 2015 earnings. But that shoots up to over 21 times under GAAP.
Indeed, outside of 2008, the only other times the GAAP gap was as wide as last year was in 2001 and 2002. That was back when companies wrote off billions of dollars worth of dot-com bubble-era investments.
These sorts of concerns seem mundane during a Central Bank induced bull market in equities, but the concern has been catching some steam in the financial press since Barron’s asked the question How Much do Silicon Valley Firms Really Earn?:
The result is an inflated and distorted earnings figure — a number that doesn’t conform with generally accepted accounting principles, or GAAP, yet is widely embraced by analysts and investors in valuing tech companies. We estimate that a dozen leading companies this year will fail to expense $16 billion in stock compensation against their non-GAAP earnings.
It’s true that tech companies also report GAAP earnings, which require the expensing of stock compensation. However, many companies highlight the non-GAAP numbers that exclude stock compensation and other expenses, including the amortization of intangible assets. Stock compensation usually is the major factor that separates GAAP and non-GAAP earnings.
Ok that was a lot, but I think it is a really important topic for investors in high valuation stocks that report adjusted earnings. It doesn’t really matter in a bull market, but it will most definitely weigh on such stocks during market corrections like the one that we just had, and it will most certainly be a massive issue if for any reason stocks go into a protracted bear market like we had from 2000 to 2002.