Apple’s Expensive Valuation Seems Perplexing. These Factors Explain It. 

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Apple

stock, rising in value toward $3 trillion, is one big reason why the

S&P 500

is up 15% so far this year. That makes the valuation, always high relative to the broader market, worthy of a close look.

The stock (ticker: AAPL) trades at about 29 times the per-share earnings analysts tracked by

FactSet

expect the company to deliver over the next 12 months. That is about 50% above the comparable figure for the S&P 500. And it isn’t unusual for the shares to sell for such a premium, especially when tech stocks are in favor.

The conventional wisdom on Wall Street is that the many years of earnings growth Apple can be expected to deliver, the high quality of the business, and the cash on hand, justify that figure. But the growth isn’t that explosive, and the valuation, on the surface, feels ridiculously high.  

With “a pedestrian rate of earnings growth, I would think it’s likely to go down,” Brian Macauley, portfolio manager at Broad Run Investment Management, said of the valuation. Broad Run doesn’t own the stock.

Yet all things considered, the valuation actually makes some sense.

Although there is lots to like about the potential for Apple’s profits to rise, on its own, earnings growth isn’t enough to make the case. The consensus call on Wall Street is that the iPhone maker’s earnings per share will grow at an annualized rate of about 9.8% in the three years starting in 2024. Sales are expected to rise to $489 billion by 2026, for an annualized rate of increase of just over 7%, because the company can raise prices on the newest iPhones and continue to expand in areas such as streaming and payments.

Even if growth in those businesses generally slows, Apple can still make gains in some areas. PayPal (PYPL) appears to have lost share to Apple Pay, according to

Mizuho

payments analyst Dan Dolev.

This growth potential is ultimately rooted in “the power of the Apple ecosystem,” said Wedbush Securities analyst Dan Ives, who sees the market cap reaching $4 trillion by 2025. Billions of people own Apple devices, creating a ready market for any services the company launches.

Buybacks of stock, which reduce the share count and therefore increase per-share profits, are expected to boost EPS growth from what can be expected from a 7% increase in sales to the 9.8% Wall Street has penciled in.

Yet on its own, EPS growth of less than 10% probably isn’t enough to justify the stock’s current multiple. While the S&P 500’s current valuation of 19 times earnings is about 2.3 times the 8% compound growth in aggregate EPS its component companies are expected to achieve over the next two years, the comparable figure for Apple is about 2.93 times.

If Apple’s so-called PEG ratio, as that metric is known, matched the number for the S&P 500, the tech company’s price/earnings ratio would be down to around 22 times, implying a big loss for the stock.

Another important factor is Apple’s $166 billion of cash. While most companies have more debt than cash, which drags on the market value of their stocks, Apple has more cash than it owes. Net of debt, the cash hoard comes out to $57 billion.

In theory, if Apple had no net cash, its market cap would drop to $2.833 trillion from $2.93 trillion today. That would bring the current share price down to $180 from $186, bringing the P/E down to 28, and the PEG down to 2.85, which is still above the figure for the overall market.  

The gap of 0.55 can be explained by investors’ expectation that Apple will be able to sustain modest growth for more years than the garden-variety tech company. The market is giving Apple credit for its ability to leverage its brand and scale to keep expanding, which makes sense because rising profits mean dividends and buybacks can grow, supporting the share price.

Those expectations for consistent profits over the long term are rooted in “the best install-base of any consumer products company in the world,” Ives said. 

The bottom line is that there is reason to believe that Apple deserves to trade at such a hefty premium to the S&P 500. But that doesn’t mean investors should necessarily snap up the stock. The best times to buy it are when it gets caught up in a broader market selloff. 

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com