Wednesday, July 5, 2017

The Strange Valuation of Microsoft Compared to Apple on July 4, 2017

The Strange Valuation of Microsoft Compared to Apple on July 4, 2017

Question:   Below are statistics on market cap, PE ratio, stock price target price, and comparison of target price to current stock price for two companies, Microsoft and Apple.  

Note, Microsoft has a PE ratio of 30.08 while Apple has a PE ratio of 16.83.   This is  a bit odd because Apple is viewed as a growth company and Microsoft if viewed as a value company.

What would the market cap of Apple be if it had the same PE ratio as Microsoft?

What would the market cap of Microsoft be if it had the same PE ratio as Apple?

Do the valuations of Microsoft and Apple seem reasonable to you?





Financial Statistics for MSFT and APPL
MSFT
APPL
Value
526.31
748.19
PE ratio
30.08
16.83
Price
68.17
144.02
Target Price
74.63
158.95
Target Price over Price
9.5%
10.4%


Analysis:   The easiest way to get value of Apple if it had he PE ratio of Microsoft is to multiply the current value of Apple by the ratio of the Microsoft to Apple PE ratio.

(30.08/16.83) x 748.18 billion = $$1.337 trillion dollars.

Similarly, the easiest way to get the value of Microsoft if it had the PE ratio of Apple is to take the current value of Microsoft and multiply it by the ratio of Apple to Microsoft PE ratios.

(16.83/30.08) x 526.31 billion = $0.295 trillion.

The other way to solve this problem is calculate total earnings and multiply by the PE ratio of the other stock.   Total earnings can be obtained by dividing the market cap by the PE ratio.

Note:

 MKTCAP=Price X Number of Shares

(Price x Number of Shares)/ (Price/EPS)

= Number of Shares X EPS = Earnings

 The total earnings of Apple are $44.6 billion. 

Multiply Apples Total Earnings by Microsoft’s PE ratio of 30.08 and get $1.337 trillion.

Discussion of the Market’s View of Apple and Microsoft:  it is very unusual for Microsoft to have a PE ratio that is this much larger than the PE ratio for Apple.

Apple is the growth company.   It is in fact, the single largest holding of VUG, Vanguard large-cap growth fund.

Microsoft is the value company.  It is in fact the single largest holding of VTV, Vanguard large-cap value fund.

I looked at the average PE ratios of the 25 largest holdings of VUG and VTF. I excluded one firm with negative earnings.   The average stock PE ratio was nearly 11 points higher for the growth stocks than the value stocks.   The difference was not significant because of outliers and a large standard error.

Still growth stocks tend to have higher PE ratios than comparable value stocks.

This is not so for Apple and Microsoft.

Why?

I am not sure.

Here are some potential reasons.

Apples product line may be a bit riskier and too dependent on the iphone.

Risk averse portfolio managers and pension funds may limit their stakes in a single company and this risk aversion may limit the growth of the largest stock.  There may in fact be dollar limits on the amount of a single stock that can be held by a portfolio and such rules would limit buying of more Apple Stock.

Apple’s dividend is relatively small.


Apple has some tax problems with the EU and potentially with the U.S. government.

Still even after considering these factors it is obvious to me that Apple has a lot more upside than Microsoft.   I can’t justify the much higher PE ratio for Apple.   Also, Apple has much more upside than Microsoft and I can’t trust the nearly identical ratios of target and current price for the two stocks.

My recommendations are to take profits from Microsoft and cautiously increase shares of Apple should the market continue to dip. 

Authors Note:  I have been working really hard on policy proposals to lower college costs and improve educational outcomes.  Free college and moving everyone to charter schools will not work  A list of my proposals can be found at the link below:

http://policymemos.blogspot.com/p/education-policy-list.html





Monday, May 29, 2017

Price Earning Ratios for Portfolios When Some Firms Have Negative Earnings

The Price Earnings Ratio of a Portfolio Where Some Firms Have Negative Earnings

Issue:  How does one create an accurate measure of price in relation to earnings for a portfolio of stocks when some firms in the portfolio have negative earnings?

Question:    A person owns three stocks Apple, Microsoft, and Twitter.   The stock price and earnings per share for the three stocks are listed below.

Earnings Per Share and Price Per Share of Three Stocks

AAPL
MSFT
TWTR
E 
8.52
2.27
-0.62
P  
153.61
69.96
18.23

A person invests 40 percent of her funds in Apple, 40 percent in Microsoft and 20 percent in Twitter.   What is the PE ratio of this portfolio?

Background:   In a previous post I explain that negative PE ratios have no economic meaning.   Firms with negative earnings generally have a lot in common with high PE startups that have small current earnings and high expectations for future earnings.   Moreover, a firm with negative earnings that is close to zero will have a lower PE ratio than a firm with huge losses. 

Some analysts appear to average all firms (both firms with negative and positive earnings) to get a portfolio PE.   This approach is nonsense.

Other analysts simply omit information on PE ratios for firms with negative earnings.   This approach ignores important information by understating the deviation between perceived value of stocks measured by price and earnings for the current year.

How does one create an accurate measure of price in relation to earnings for a portfolio of stocks when some firms in the portfolio have negative earnings?

My Solution:   My solution is based on the statistic (P-E)/P.  The advantage of the (P-E)/P statistic compared to the P/E statistic is that it has the same economic meaning for firms with positive and negative earnings.   This statistic compares the amount the value of the price of stock exceeds earnings for one year.   This difference represents future expected earnings, liquidation value or some combination of the two. 

When earnings are negative as in the case of Twitter (1-P)/P will exceed 1.0.

Using algebra, it is easy to show that there is a one to one relationship between (P-E)/P and P/E.   Denote (P-E)/P as f.  Use algebra (shown in appendix below) to show 

P/E=1/(1-f)

My procedure for finding the P/E of the portfolio involves three steps:

·      Find (P-E)/P for all three stocks
·      Take weighted average of (P-E)/P for all three stocks
·      Plug weighted average of (P-E)/P into formula for P/E shown above to get portfolio P/E.


Step One: 

The value of (P-E)/P for the three stocks are presented below.


Earnings Per Share and Price Per Share of Three Stocks

AAPL
MSFT
TWTR
E 
8.52
2.27
-0.62
P  
153.61
69.96
18.23
(P-E)/P
0.94
0.97
1.03
1/(1-(P-E)/P)
18.03
30.82
-29.40
P/E
18.03
30.82
-29.40


Note the correspondence between (P-E)/P and P/E is correct.

Step Two:  

Find weighted average of (P-E)/P where weights are 0.40 of Apple, 0.40 for Microsoft, and 0.20 for Twitter.   This can be done with the SUMPRODUCT function in Excel. 

The SUMPRODUCT of the (P-E)/P vector with the portfolio share vector (0.40,0.40,0.20) is 0.971637.

Step Three:   Transform the weighted average of (P-E)/P to a P/E ratio.

1/(1-0.971637)  or 35.25.

Concluding Thoughts:    Many analysts citing PE ratios for Tech stock ETFs claim that Tech stocks are not overvalued.   The analysis presented here suggests this claim is incorrect.  I suspect these analysts are overvaluing the Tech sector by failing to accurately incorporate information about firms with negative earnings in their calculation of Tech Sector PE ratios.

My finance post discusses the literature on PE ratios and looks at the frequency distribution of the PE ratios in Vanguard Tech fund VGT.



I am concerned that we have entered a bubble that will not end nicely.  

A Note:   When firms are near bankruptcy (P-E)/P could be quite large because earnings are a very large negative number.   The PE of this firm might not have a large impact on the P/E ratio because the low share price of a firm near bankruptcy will lead to a portfolio share near zero.   However, if portfolio share estimates are not up to date the inclusion of firms near bankruptcy in the PE calculation might overstate financial risk because the investor cannot lose more than the value of the outstanding shares.

The Tech firms in VGT have negative earnings with high stock prices that have risen in future months.    These high-flying firms need to be included when assessing portfolio risk.

Appendix:    Show that P/E = 1/(1-f) where f is (P-E)/P using P and E data for Microsoft.     The algebra is shown below.

0.94453 = (P-E)/P

Rearrange this equation to solve for P/E.

 (1-0.94453)*P =E

or

P/E= 1/(1-0.94453)

The more direct way to get P/E is simply divide P by E.   Confirm that both statistics equals to 18.029 for Microsoft.