After the market closed last Thursday, Apple announced quarterly earnings per share of $1.26, slightly higher than the median forecast and higher than earnings for this quarter last year. Yet, Apple’s stock price plummeted. Let’s take a longer-run perspective.
In theory, the intrinsic value of a stock is equal to the present value of the future income it generates, which might be measured by dividends, dividends plus share repurchases, earnings, free cash flow, economic value added, or some other appealing metric. Because the future is unknown, analysts often use the most recent observed values of dividends, earnings, and so on, with the ratio of the stock’s price to this income measure providing a rough valuation metric. For examples, dividend yields and price-earnings ratios are familiar valuation barometers.
One fundamental problem with such metrics is that corporate income fluctuates with the overall economy. We shouldn’t use current earnings, for example, to benchmark the intrinsic value of stocks if the economy is temporarily in a deep recession. That’s why stock prices don’t fall as much as earnings during a recession. Investors expect the recession to eventually end and earnings to return to normal.
Nobel laureate Robert Shiller has a sensible way of dealing with short-term fluctuations in earnings for the overall stock market. First, he calculates monthly inflation-adjusted earnings for the S&P 500. Then, he calculates “cyclically adjusted earnings,” the average value of these inflation-adjusted earnings over the preceding ten years. Finally, he calculates a cyclically adjusted P/E ratio (CAPE) by dividing the inflation-adjusted value of the S&P 500 by cyclically adjusted earnings.
Using monthly data from Shiller’s website, this figure shows that the March 2023 value of Shiller’s cyclically adjusted earnings is $144, which is 19% below the actual value of S&P earnings. Relative to the level of the S&P 500, the value of CAPE is 28.
In a recent Fortune article, recycled by Yahoo Finance and countless others, Shawn Tully applies Shiller’s CAPE to an individual stock, Apple, the world’s most valuable company. I don’t recall Shiller ever applying CAPE to individual stocks and there are good reasons for his reluctance to do so.
The title of Tully’s article reveals his provocative conclusion: “Now could be the worst time to buy Apple stock. Yes, really—just look at Robert Shiller's famous CAPE metric.” An application of Shiller’s CAPE logic to individual stocks is superficially appealing but, as the English proverb goes, there is many a slip twixt the cup and the lip.
The figure below shows Apple’s inflation-adjusted quarterly earnings over the past 10 years. Two factoids are immediately apparent. First, as with many companies, there are considerable seasonal fluctuations in Apple’s earnings—which is a good argument for smoothing earnings. Second, as is true of many rapidly growing companies, average earnings over the past 10 years is a completely misleading measure of current normal earnings, let alone future earnings. Shiller’s intent in calculating cyclically adjusted earnings is to smooth out business cycles. When applied to a rapidly growing company, it ignores the fact that the company is growing rapidly.
Apple’s earnings have been growing at an impressive 13% a year over the past 10 years. As a consequence, Apple’s most recent quarterly earnings are a full 33% above its 10-year average. Apple’s earnings won’t grow by 13% a year forever but using $0.95/share as the new normal for its future quarterly earnings is extraordinarily conservative, bordering on oblivious. The consensus earnings forecast is for Apple’s EPS to grow by 8% a year over the next 5 years, not to fall by a third.
A curve fit to Apple’s inflation-adjusted quarterly earnings indicates that, after accounting for seasonal fluctuations and growth, a reasonable smoothed value for Apple’s most recent earnings is $1.64, well above its actual quarterly earnings.
Another factor overlooked by a simple CAPE calculation is interest rates, which affect the required returns use to determine the intrinsic values of stocks and other investments. When interest rates are historically low, as they have been in recent years, CAPE values should be historically high—and they have been. The recent elevated CAPE values are not a sign of a stock market bubble but simply a reflection low interest rates.
A simple way to take interest rates into account is to calculate a stock’s earnings yield, which is a ballpark estimate of the anticipated real return. The current value of CAPE for the S&P 500 is 31.75, which implies a cyclically adjusted earnings yield of 3.2%. Using $6/share for earnings and $182 for a recent price, Apple’s earnings yield is 3.3%.
The current real interest rates on long-term Treasury Inflation Protected Securities (TIPS) are around 1.9%. Investor decisions to buy Apple or the S&P 500 depend on their risk premiums but it certainly doesn’t look like this is the worst possible time to buy either Apple or the S&P 500.
