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Apple Versus Facebook: How to Use Price Multiples to Figure Out a Company’s Value

Investing, Investments

How do you know when a stock is pricey or when it is a bargain? Sizing up the value proposition of a stock is not rocket science, but it requires more than a quick glance at a stock’s price.  For example, one might think Apple is overvalued because of its high price, and one might assume Facebook is a great deal – but is this really the case?

We will walk you through how to use a few fundamental ratios analyze these two popular stocks: Facebook (FB) and Apple (AAPL).

Why Valuation is Important

We all know that Apple stock is worth a lot and Facebook stock is tanking right now – but does this tell us whether we should be buying either?  No: we need more info.  Valuation multiples might seem boring at first, but they provide essential context in understanding what stock prices really mean. If valuations are high, then the stock is either overpriced or has high growth expectations. If valuations are low, then the stock is either a bargain or considered a dangerous risk.

In general lower valuations trump higher growth expectations for future investment returns.  Academic studies have shown that, in multiple timeframes and across multiple markets, stocks that sell at the deepest discounts to sales, earnings, and the accounting values of their equity have enjoyed higher returns than stocks that sell at higher valuation ratios. On the basis of overwhelming empirical evidence, these valuations are a useful starting point for stock investing.

Step 1: Collect Your Data

Finding data for stocks traded in public markets has never been easier. You can find information at http://finance.yahoo.com or http://google.finance.com, among many other sites. Though this data is typically reliable, you should be warned that it is not 100% perfect or up to date. You should cross-check values from any source (including your broker’s website) with other data and SEC filings.

We are primarily interested in how much economic value a dollar will buy when we purchase a share of a stock. How much does it cost to by a dollar of annual sales? How much does a dollar of earnings or net assets of a stock cost?

Step 2: Figure out the Price Multiples of a Stock

To answer these questions, we must consider the price multiples of a stock. This is different than considering the raw price of a stock. Price multiples compare the market capitalization of a stock to the economics of a company: sales, earnings (profit), or net assets (assets minus liabilities). The market capitalization is the price of one share trading in the market multiplied by all the shares of the company. It’s a crude estimate for the total price tag to buy all the stock in a company. For example, as of this writing:

  • Facebook traded at $20.40 per share and there are 2.14 billion shares of Facebook stock outstanding, so the market capitalization of all Facebook shares is $ 43.7 billion.
  • Apple trades at $638.17 per share, has 937.41 million shares outstanding, and has a market capitalization of $598.22 billion.

With market capitalization as a price tag, we now need to explore different ways of assessing the value of what we are buying.

Step 3: Calculate the P/E Ratio

The most popular price multiple is the price-to-earnings or P/E ratio. This is the ratio of a stock’s market capitalization divided by its annual profit. (Usually earnings are taken from the last twelve months of a company’s financial reports.) This ratio tells you how much money it takes to buy one dollar of earnings in today’s markets.  For example:

  • As of this writing, Apple trades at a 15.0 P/E ratio.   This number means that every $15 spent on Apple stock would buy $1 of historical earnings.
  • Facebook’s price-to-earnings ratio is much higher at 70.59.

By this ratio, Apple is theoretically a better value because it takes less money to buy a fraction of Apple stock that corresponds to $1 of historical earnings than it does to buy a portion of Facebook stock that corresponds to $1 of historical Facebook earnings.

Two big caveats in comparing P/E ratios in general:

  • P/E ratios vary drastically across industries, depending on stability and risk within the industry.  Since Facebook and Apple are both in tech it’s an apt comparison, but if you compare other types of companies you need to apply the appropriate P/E ratio for that particular industry when looking at a company’s expected future earnings.
  • High growth expectations can justify a high multiple.  A high P/E ratio or price multiple can be justified in cases where a company has very low earnings now but is expected to grow a lot in the next quarter or so.  Pandora is a good example of this.

Step 3.5:  Try Out the P/S Ratio

Another popular price multiple is the price-to-sales multiple or P/S ratio. This is the ratio of a stock’s market capitalization divided by its historical sales. Presently, Facebook trades at a 10.35 P/S ratio while Apple trades at a lower 4.11 price-to-sales ratio. Apple affords investors more value per dollar invested since investors can purchase a fraction of Apple’s stock that corresponds to $1 of historical sales for $4.11 while they would have to pay $10.35 for $1 of historical sales in the market for Facebook shares.

Step 3.75: Why Not Try the P/B Ratio, Too?

A third popular valuation multiple is the price-to-book multiple or P/B ratio. This is the ratio of a stock’s market capitalization divided by the accounting value of its equity. The book value or accounting value of a firm’s equity is the value of a firm owned by shareholders (after all debts have been paid) based on accounting principles. Apple has a 5.47 P/B ratio and Facebook has a 3.36 P/B ratio.

By this measure Facebook is cheaper. The book values of tech stocks are not highly regarded because the brands, patents, and trademarks developed inside of a company are not given accounting values. Much of the value of Apple and Facebook lies in these intangible assets.

Step 4: Compare Your Options – Facebook Versus Apple

Let’s look at Facebook and Apple valuations versus the holdings of two exchange-traded funds:

Security (Ticker Symbol)

P/E

P/S

P/B

Apple (AAPL)

15.00

4.11

5.47

Facebook (FB)

70.59

10.35

3.36

S&P 500 (SPY)

14.10

1.29

2.05

S&P 500 Growth (IVW)

15.60

1.79

3.35

 

Notice that Apple and Facebook both trade at price multiples that are higher than Standard & Poor’s index of 500 largest (by market capitalization) stocks. However, Apple does have a lower price-to-earnings ratio than an index of growth stocks from the S&P 500. Its price-to-sales multiple is high, but not as high as Facebook’s multiple.

With all this in mind, Apple stock appears to be trading at more sensible valuations than Facebook stock. Oddly, analysts expect average earnings growth for Facebook to be 27.23% for the next five years, barely exceeding 24.02% earnings growth expectations for Apple. This is not enough of a difference to justify Facebook’s massively larger valuation multiples.

Valuation Saves the Day

These numbers argue that Apple is a better investment than Facebook at today’s stock prices. Though each share of Apple has a higher price than Facebook shares, each dollar invested can hypothetically buy more value.