iPhone looks cool, but you may not want to buy. . .

. . .stock in Apple. Right now there are millions of articles about the iPhone. But a few of those articles have odd pieces of advice, chummy rumblings like "you better buy Apple stock." One young respondent in an informal San Francisco Chronicle survey half-jokingly wondered if he should open an online stock account just to buy Apple.

Benjamin Graham, the founder of value-based investments, would grimace. He differentiates investment - buying shares in a financially-sound company whose market value is discounted from the fair value, giving the high probability of long-run positive return - and speculation, or buying shares in a company for any other reason. Investors make money in the long run. Speculators can make wild returns, but they can also make wildly bad bets leading to very poor financial results.

A little about AAPL, the four letters that are Apple's ticker symbol. AAPL is trading at a Price/Earnings ratio of around 41.5, well ahead of Microsoft's 26 (Google is roaring along with a P/E ratio of 68, Research in Motion is 62.53). What does this mean? The P/E is stock price, now between $94 and $95 per share, divided by Apple's earnings per share, a very respectable $2.27 in October 2006. EPS is calculated by dividing Apple's net income ($1.99 billion for Oct05-Oct06) by the total shares outstanding (877 million). The P/E can be seen as the market's view of a company's future growth - a company with no growth should trade at its net book value, aka the value of assets (including cash) minus liabilities (like debt and depreciation), + the value of its annual profits, ideally paid in dividends. Valuations above a company's book value (virtually all stocks on the market) are thought to be incorporating future returns. With Apple's P/E of 41, it will take Apple 7.5 years to reach the future level where investors value (or rather, anticipate) Apple to be, if Apple's annual growth retains an average of 50% over the next 7.5 years*. If Apple maintains "modest" annual growth of 25% (an enormous task of any company), it will take Apple 15 years to reach that valuation.The P/E ratio is also a good comparative ratio, allowing the market's perception of Apple's future to be juxtaposed with competition.



An important man


Comparing Apple and Microsoft is not a perfect comparison, but it seems an oddity that the market is more bullish about Apple than Microsoft. To explain this author's view why buying AAPL is more speculation than investment, here are 10 reasons:

1. Apple is not Benjamin Graham's definition of a financially-sound company, because Apple has experienced wild fluctuations in profits and revenue. iPod is the latest revenue fad, which gave Apple in the year ending Oct2004 a 287% increase in net income, 500% in 2005 and 50% in 2006 (25% would be considered very commendable). Yet many consumers have already forgotten that in 2003 Apple only increased net income by 4.6% over 2002 (in 2003 actually lost operating revenue, and only made money on interest off its float), and in 2001 Apple actually lost money. This probably points to the high degree of Apple's linkage to consumer sales, which are exacerbated by market conditions (2001-2002 were trying times for many companies). Further, Apple's recent drop in growth rate (to 50% from 500%) is part due to saturation of iPods in the market, part slowing consumer sales overall, and part the law of large numbers. Microsoft was not hurt like Apple during the 2001-2002 downturn (see below).
   
2. Microsoft has not lost money in any of the last 13 years researched for this article (since 1994). In fact, Microsoft increased net income every year except 2002, when it's $5.36 billion net income was below the $7.35 billion net income in 2001. Apple, in turn, has lost money in three years since 1996: in 1996 Apple lost $816 million, in 1997 Apple lost $1.1 billion, and in 2001 Apple lost $25 million. These are not positive signs for sustainable long-term uninterrupted growth.
   
3. Steve Jobs has a very small, but real, chance of being removed as CEO due to a backdating scandal. He also may have a recurrence of cancer or be incapacitated in a way unforeseen by investors. Steve Jobs seems more vital to the future of Apple than other executives are to the future of their companies.
4. Apple's current business model is the "wow" model. A beautiful product wows consumers, who buy (including Wall Street). This is a dangerous precedent: it's hard to keep impressing consumers (and Wall Street), over and over and and over again. The computer business and iTunes store are nice supplementary ways around this model and Apple should be commended for these, but they do not make up a large enough part of Apple's revenue stream.
   
5. The iPhone, if successful, may compete with the iPod (an Apple cash-cow) for sales.
6. More on the iPhone. The market is betting that the iPhone is a hit like the iPod. This may be true. However, iPod practically created the market for MP3 players and slowly morphed (and improved drastically) from cult hit to must-have accessory. The iPhone doesn't have this opportunity; expectations are already sky-high. Apple has to hit a home-run on the first try.
   
7. Apple makes excellent products, but those products still exist in a fiercely competitive field littered with manufacturers who, although it doesn't seem likely now, could produce a "hit" product which could slice Apple's market share from their valuable iPods. Consumer electronic buyers are notoriously fickle and cold-blooded.
8. Microsoft, not nearly as hip as Apple (see clunky picture), has a near-monopoly on PC operating systems and oogles of software. Monopolies stink for consumers, but make investors lots of money. PC computers come loaded with Windows (Vista will have problems, but people will buy it anyway, for lack of choice). People use MS Office. And as Apple tries to take tiny chunks away from Microsoft's monopoly by selling Apple computers, Microsoft is also working against Apple, creating the not-so-popular Zune and Zune music marketplace, and the Xbox, which may compete with Apple more than the consumer thinks. The Xbox360, and a possible second-generation Xbox360, will attempt to thwart Apple's eventual push to the living room.
9. Microsoft doesn't have to do the work Apple does, and makes lots more money because of it. This means Microsoft can try ventures and cheerily fail at them; Apple isn't quite so lucky. Apple's cost of revenue as a percent of gross income is 71%. Microsoft's ratio is an almost-comical 16% (indeed, Apple's revenue is almost $20 billion, almost double what Microsoft takes in. However, after cost of income, research and marketing, Microsoft is left with with nearly 9x the net income).
   
10. Microsoft pays a regular dividend, and has so since 2002. Apple's last dividend payment was in 1995.
    

No cost of revenue, eh?


This doesn't mean Apple stock won't shoot up tomorrow. Steve Jobs may introduce the iRobot, iMassageTherapist and iToilet, and speculators may continue to boost Apple's share price with their fingers crossed that the iPhone will be the next cash cow. It very well may be, because Apple has done so in the past. It's just not as certain as its stock price may suggest.

This also doesn't necessarily mean Microsoft is a great value, it just seems a better one that Apple. The AAPL story doesn't seem to make sense for value-seeking, long-term investor. It's not that there's something wrong with Apple, Inc. - it's that there's something wrong with the way the market values it.



*To calculate, take the natural log of 41, and divide by % expected earnings.