Apple, Google: Avoiding the Overvaluation Trap

This is an excerpt from a comment I read on Daily Speculation. It is such a common misperception that I had to write a response:

Great stocks [Google (GOOG), Apple (AAPL)] are to be owned. Companies who dominate their space are to be kept and allowed to grow. Those who have built fantastic franchise names should be accumulated. Buy Google over Yahoo (YHOO). Apple over Dell (DELL). And most importantly, the speculator should be willing to hold on, eschewing the quick buck in search of the really big gains that can be achieved through diligence and patience.

I could not disagree more with this conclusion. In the long run, the performance of a stock in isolation (ignoring the external environment, i.e. interest rates, risk, inflation) is the product of fundamentals (i.e. earnings and cash flow growth) and valuation (i.e. P/E, P/CF).

Google and Apple may have great fundamentals: their innovation has led and may continue to lead to high earnings and cash flow growth. But are they good stocks? They may or may not be. But, more importantly, will they be good stocks at any price? No! If I were to follow the above conclusion, that since Google and Apple are great companies they are great stocks at any price, at any valuation – at 50, 500, 5000 times earnings, then I’d walk into an overvaluation trap.

Take a look at eBay (EBAY) in the late 90s: it was a great company (it still is), but it was grossly overvalued. So, if you bought it in the late 90s and held it until today, despite its earnings going up 100-fold, the stock is roughly at the same level it was then. I’d argue few would have the patience and conviction to hold it through the downturn the stock took in the early ’00s. Most investing in the stock in the late 90s lost money on it.

One of the biggest mistakes investors make in investing is failing to separate a good company and a good stock. A great company’s (fundamental) performance is wiped out by valuation compression. This is the battle of two winds: the tailwind of earnings growth and the headwind of P/E compression.

Also, with a high growth priced appropriately (even to perfection) there is no room for even a small mistake (no margin of safety) left in the valuation - a small disappointment (it doesn’t have to be much) will lead to a substantial decline in price. The latest performance of Starbucks (SBUX) and Whole Foods (WHMI) stocks is a great example of being priced for perfection and delivering slightly less-than-perfect results.

This myopia in differentiating between good companies and good stocks is not just limited to wonderful, exciting, larger-than-life (Google comes to mind here), fast-growing internet companies. The bluest of the blue chip stocks, like GE (GE), Coca Cola (KO), Home Depot (HD), Amgen (AMGN), Johnson and Johnson (JNJ) (and the list goes on) were all great companies that one “had to own” but were terrible (overvalued) stocks in the late 90s. Their earnings have doubled or tripled since but the stocks have not gone anywhere.

I think it was Benjamin Graham who said that “price is what you pay, value is what you get.”

Comments

[akindman]

This may or may not be a good article.

[peter02l]

Great response. Concise and rich.

[Tommo_UK]

AAPL has grown earnings 70-80% YoY the last two quarters. It isn't going to keep that up forever, and will return to a more "normal" 40% this Quarter probably, but seriously, how can you call a stock which is seeing earnings rocket at this rate overvalued, when its going to look cheap in a few months unless growth falls off a cliff - unlikely with Mac sales growing at 35% and the launch of the iPhone and associated revenues alone likely to add 30-40% to AAPL's earnings over the next 12-24 months.

You should learn to think outside the box, to coin a horrid phrase. Your attitude is all very well when talking about companies with little prospect of maintaining stellar earnings growth, but that's not the case with AAPL, and to a lesser degree GOOG (yes, you hear me right - I think AAPL has better earnings growth prospects than GOOG for the next few years). Here are mega-cap companies with tens of billions of dollars in the bank, no debt, and growing like small cap start-ups.

Crazy to buy them? You'd be crazy not to.

[imthewiz]

Please explain the overvaluation .

[Camden]

1. Nowhere in the quoted text does it say these stocks should be owned "at any price".

2. Ben Graham would likely have NEVER owned either GOOGLE or APPLE, which in my way of thinking makes your argument an apples-to-oranges comparison.

3. Tommo's comment is right on target.

[T Muller]

I agree in part to the analysis. GOOG and AAPL are certainly not cheap, but they can trade at higher valuations due to their strong competitive position or "Moat" that will allow them to grow rapidly for many more years to come. financial-alchemist.bl.../

[Russell Bailyn]

Oy--I have to disagree with this article. Google is cheap when compared against hundreds of other companies with higher valuation ratios and less attractive growth prospects. One must look outside of antiquated rules and valuation ratios and check out what's going on in the real world. Google is the future, Apple is the future and Dell or Yahoo are yesterday's news (not value plays!). They just plain stink.

[Stefan Wyler]

FSLR had a P/E ratio of 1000+ in January, their stock is up 300% since then. Price is what you pay, value ist what you get :P

Apple and Google are not overpriced (yet).

[Sonia Mirza]

I doubt the author was stating that GOOG or AAPL are overvalued right now. His point was rather that they 'may or may not be'...you decide. Just make sure to include all factors (fundamental+mkt changing innovation - ie factors not traditionally quantified/recognized in val calx) in your valuations rather than depending on 1 media celeb stating "it's a good co, own it" a la kramer.