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Ian Campbell

Ian Campbell

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Growth: In the Context of Share Price

If you trade or invest in shares in companies - or have others do that on your behalf - you ought to focus on what has happened to Apple's share price in the past few months, and relate that to perceptions of Apple's prospective growth. More importantly, you ought to use what you learn in the context of Apple to seriously reflect on the importance of economic growth generally as an underlying principal driver of:

  • the world economy;

  • country-specific economies;

  • the financial markets indexes and company specific share prices; and,

  • what happens going forward in the 'big business towers' and on Main Street in the developed countries if economic growth rates do not improve from current forecasted levels.

You may have observed that in the past few months the price of Apple shares has fallen about 35% from a high of +/-$700 in September to a close yesterday of $457. As discussed in this commentary, where Apple's share price goes from here will be to some large degree a function of what the financial markets and their participants continually (read 'daily') re-assess Apple's prospective earnings growth to be.

When reading this commentary, you might also want to read Should Apple be a $200 stock? written by Bethany McLean. Ms. McLean is a contributing editor to Vanity Fair magazine. She is known for her work on Enron, and on the 2008 financial crisis. While her article discusses Apple's stock price, along with such things as Apple's competition and gross margins, from my perspective the 'heart' of what she says is found in her following statement that centers on 'earning power':

"But while the (Apple) stock is cheap based on the profits of the past few years, value investors generally look to what they call normalized earnings, or true earnings power. To put this in a different way, price-to-earnings ratios don't matter that much when you don't know what real earnings are. We won't know for a few more years, but there's an argument that Apple's last few years of blowout earnings have been well above normal. If that's true, then Apple's real p-e ratio might be much higher than it appears."

From my perspective Ms. McLean's statement is a good starting point, but needs to be expanded on:

  • first, focus by a value investor (or corporate acquirer) on 'normalized earnings', while an interesting observation, is fraught with difficulty. This is because 'normalized earnings' must, as a practical matter, rely more on history than on possible future operating results. In practice, if one 'normalizes historic earnings', one must factor growth into the equation by adjusting the price-earnings ratio that is adopted to account for the expected growth rate in earnings over time. This is because value (and hence 'price') at any given point in time is the present value of all future expected after-tax profits (or better, after-tax discretionary free cash flow) available for (1) distribution to equity holders, or (2) corporate growth. A capitalization of 'normalized earnings' approach to value (and 'price') is simplistic, fraught with many broad assumptions, and typically not as disciplined as is a 'discounted after-tax discretionary cash flow approach' to value (and 'price');

  • second, I don't think the term 'true earnings power' is particularly meaningful - particularly in today's complex and volatile economic times and financial markets. Perhaps what Ms. McLean is referring to is 'the cyclically adjusted price-earnings ratio advocated by legendary value investors Graham and Dodd. Graham and Dodd argued that one-year earnings were too volatile to rely on as a measure of the 'true earning power' of a business - certainly something in today's economic and financial markets world if magically resurrected Messrs Graham and Dodd would be virtually certain to agree with 'in spades'. Graham and Dodd advocated smoothing, or 'normalizing' earnings by averaging up to ten years of historic earnings adjusted for inflation as an earnings base. Graham and Dodd's approach to 'normalized earnings' subsequently was promoted by Yale economist Robert Shiller; and,

  • third, that said Ms. McLean strikes an important chord that I would state slightly differently than she does. A key driver in the current value of any company's shares is expected growth, irrespective of how that expected growth is built into the 'value equation'. Simplistically, the financial markets typically build that growth expectation into the 'value equation' by adoption of 'price-earnings' ratios at any given point in time that reflect future 'growth in earnings expectations' for any particular company and hence its share value (or point in time 'price').

Accordingly, the question as to whether in the long term Apple's share price will increase, stay at current levels, or drop in price from here will be largely dependent on the current and future ever changing 'point in time' earnings growth perceptions of the financial markets (read financial market participants) with respect to Apple's prospective earnings growth rate or decline.

I have not done a detailed analysis of Apple's business, and have no opinion with respect to the 'prospective growth or decline rate' of either Apple's after-tax earnings, or of its after-tax discretionary cash flows. Hence I have no opinion on Apple's current stock price, or the future direction of that stock price.

Importantly, the theory and importance of growth assumptions set out in this commentary is not particular to Apple, but generally applicable to the world economy, country-specific economies, and all businesses - be they public or private.

You might want to read Global stock markets boom, but where's the growth?. That brief article questions whether the recent rapidly rising world financial markets are getting ahead of themselves where "The U.S. is growing just at only two percent a year, Europe is not growing at all, Japan is also stagnant".

Topical Reference: Should Apple be a $200 stock?, from Reuters, Bethany McLean, February 6, 2013 - reading time 4 minutes. Also read:


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