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Thursday, November 10, 2011 -- As we explained in Chapter 2, anyone who can forecast Apple's future earnings and future trailing P/E ratio can forecast Apple's stock price. In fact, Apple's stock price is nothing more than multiplying Apple's trailing 12-months (TTIM) of earnings per share (EPS) by its price-to-earnings ratio (P/E Ratio). If you know both variables, then you know Apple's stock price. For example, if Apple trades at a 12.5 P/E ratio in October 2012 and the stock reports $44.00 in earnings per share on a trailing 12-month basis, then it necessarily follows that Apple trades at $550 a share. That is a mathematical fact.
More on the Limitations of Financial Analysts
While most analysts do spend a tremendous amount of time forecasting Apple's earnings, you'll notice that not a lot of analysts give a basis or a well reasoned argument for why they believe the stock will trade at the multiple they assume in their analysis. I find this to be rather shocking as getting Apple's P/E ratio right is far more important than getting the earnings number right. A forecast that misses Apple's fiscal year EPS by $1-$2 has far less of an impact than a forecast that under or over-estimating Apple's P/E ratio by a factor of 1 or 2.
Here's why. Suppose Analyst A holds a 1-year price target of $572 a share based on his forecast that Apple will trade at a 13 P/E ratio on $44.00 in earnings. The analyst believes that Apple will trade precisely at $572.00 the day after it reports its fiscal Q4 2012 earnings. Now suppose that Analyst A missed on his earnings expectations by $2.00 but got the trailing P/E ratio number right on the dot. If this were the case, the stock would trade at $546.00 a share or just $26.00 or 4.55% under his price target. That's no big deal at all. He pretty much nailed it.
Now suppose Analyst B perfectly forecasts Apple's EPS number of $42.00 a share but completely over-estimates what type of a P/E ratio Apple would trade at. For example, suppose instead of believing that Apple's P/E ratio would contract, that he believed in the notion that Apple would see P/E expansion. Instead of forecasting a 13 P/E ratio, Analyst B believes that Apple will trade at a 15 P/E ratio and thus holds a price target of $630.00 a share. Notice that $42.00 x 15 = $630 while $44 x 13 = $572.00.
By over-estimating the P/E ratio by a factor of 2, Analyst B completely missed his price target. Even though Analyst A missed on earnings, he got the price-target almost exactly right. And that's because he was able to understand what the market would be willing to give Apple in terms of a valuation in 2012.
If Apple reports $44.00 in earnings per share in fiscal 2012, then for every 1-point an analyst misses on their P/E ratio expectations amounts to a $44.00 difference between the price target and the actual market price. Every 1-point amounts to $44.00 in price per share. Now imagine Apple reports $87.01 in fiscal Q4 2015. That means for every point a forecast misses on Apple's P/E ratio amounts to $87.01 in the price per share. It's going to require a very high level of accuracy and understanding to gain a handle over where Apple will trade in 2015.
Now we spent the entirety of Chapter 4 laying out the difference between financial analysts and market analysts. We explained how each group has its limitations. While financial analysts couldn't really tell you much about how the market actually functions, they do have a much better grasp of where things are headed in the long-term because they have an excellent understanding of the financial situation. They know the earnings picture, the valuation and thus have a generally better understanding of where Apple will be 1-year, 2-years or 5-years from now than do market analysts. With one massive caveat.
Because financial analysts don't have a good understanding of how the market functions, they are extremely limited in being able to accurately forecast Apple's future trailing P/E ratio. You see, to be able to come up with an accurate forecast and a good sense of what type of a multiple Apple is going to trade at over the next few years, you have to fall within the Venn Diagram of being both a market analyst and a financial analyst. You will need to know and understand the financials, and how the market will react to those numbers. How the market will react to Apple's financials is precisely where financial analysts suck at being able to forecast price targets for Apple. There are certain things that analysts simply cannot wrap their minds around.
For example, in the summer of 2010, many Wall Street and Independent analysts adamantly argued that Apple would see P/E expansion in 2011. As a result of the flash crash, the European debt crisis and the summer correction, Apple saw some P/E contraction between the months of April and July -- some people saw this contraction as temporary nature.
Until fiscal Q2 2010, Apple was seeing rapid P/E expansion which then started to briefly trend down. Many people argued that we would see P/E expansion in the seasonally favorable second-half of the year, and that fiscal Q4 2010 and fiscal Q1 2011 would be met with massive expansion.
A lot of Apple investors, analysts and independents could not believe that Apple was trading in the 25 P/E ratio area. Many argued that we would see Apple's P/E get back up to the 30-level we saw in fiscal Q1 2010 and many people made really poor bets accordingly. A lot of independent analysts came up with some outlandishly high price targets.
Yet, as you can see from this chart below, Apple's P/E ratio has completely contracted and continues to contract even as we head into 2012. This is precisely what we predict would occur in an article we published in August 2010 when Apple was trading at $235 a share entitled "Valuing Apple at $400 per share." At the time, a $400 price-target was on the high end of Wall Street which held low to mid $300 price target on Apple. This was also at the very low end of independents.
But in this article, we explained very clearly that Apple would continue to see major P/E contraction well into the 2011 fiscal year. This idea of an era of P/E contraction was a largely unpopular idea back in 2010. Yet, as you can see from this chart below, we were right to say that Apple would see steep P/E contraction going forward. In fact, Apple's P/E ratio has continuously contracted without pause in fiscal 2011, and continues to contract even as we head into 2012.
This brings us to some very important principles that should always be very closely observed when forecasting future price target and when devising investment strategies based on the forecasting model. In the sections below, we will give a broad overview of the key elements that we believe are central to accurately forecasting Apple's future trailing P/E ratio. But we're going to begin by laying out probably the most important principle when it comes to forecasting and modeling.
Reasonable Conservatism: Modeling, Forecasting & Investing for the Floor
If you were in a geometry course, the first axiom you learn is the closest distance between any two points is a straight line. Between any straight line, there are infinitely many points and infinitely many planes.
At Bullish Cross, the first principle to forecasting and modeling is that you always forecast, model and invest based on the floor and not the ceiling. What is meant by this is you want to invest based on where you think the floor will be a year from now. You devise your investment strategies using reasonable conservatism of where that floor happens to be. Here's what reasonable conservatism is.
Wall Street expects Apple to earn $34.49 in fiscal 2012 and $38.56 in fiscal 2013. That is not reasonable conservatism. That is f'ing stupid. You might as well just draw an estimate for $10.00. That estimate for $34.49 doesn't help anybody. Heading into 2011, Wall Street analysts were modeling for $17.00 in earnings. Apple reported $27.68. A reasonably conservative estimate would call for $26 on the low end and $29 on the high end.
Reasonable conservatism is the practice of coming up with estimates that Apple is very likely to achieve and then basing your price targets, and investment strategies on the low end of that reality. For example, Apple will probably earn between $42.00 and $46.00 in earnings next year. So what you want to be doing is thinking what is the lowest valuation that Apple would trade at and be sure to invest in a way that will keep you at least at break-even if that were to come to pass.
For example, in 2012 I think the low end will be a 10 P/E ratio if the sentiment gets dramatically bad. We're talking horrendous sentiment. Far far worse than anything today. If Apple reports $44.00 in earnings next year which seems more and more likely, then that would result in a price target of $440 a share. The principle of using reasonable conservatism says that you should be no lower than break-even if that were to come to pass. So then you look at your investment strategy for 2013 and then determine what would happen if Apple were to trade at $440.00 a share in October 2012. Would you be at break-even? If that answer is yes, then the strategy is well devised.
But we will get into the details of this analysis as we go deeper into the report. The reason we are bringing this up is that it will be providing us with a lot of context of the common errors that independent analysts and individual investor tend to make. And that is formulating investment strategies that are far too aggressive as they fail to contemplate the principle of reasonable conservatism. Getting too aggressive tends to lead to huge losses. Getting overly aggressive with a forecast for P/E expansion will lead to unrealistic expectation, unrealistic price targets, unrealistic investment strategies and losses where there should be gains.
Thus, you want to be thinking of where the floor is in terms of the price target and you want to be pretty conservative when doing so. You just need to be reasonably conservative with that floor. Then you invest based on a very conservative mid-range. For example, a lot of people think Apple is going to $600 to $700 by January 2013 -- and that may be the case -- but we will be investing on the notion that Apple is going to $500. We will get into that later in the report.
In Part 2 we will get into the objective and subjective elements necessary to forecasting Apple's P/E Ratio in the future. Remember, this is not a forward P/E analysis. This is an analysis of what Apple's trailing P/E ratio and trailing earnings will be at some point X in the future. What we are doing here is forecasting what the market environment for Apple will be like and what market demand for Apple will look like at a particular point in the future. This means knowing what the market will give Apple in terms of a trailing P/E ratio based on the trailing earnings and forward expectations from that point in the future.