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Thursday, November 10, 2011 — As we explained in Chapter 2, anyone who can forecast Apple’s future earnings and future trailing P/E ratio can forecast Apple’s stock price. In fact, Apple’s stock price is nothing more than multiplying Apple’s trailing 12-months (TTIM) of earnings per share (EPS) by its price-to-earnings ratio (P/E Ratio). If you know both variables, then you know Apple’s stock price. For example, if Apple trades at a 12.5 P/E ratio in October 2012 and the stock reports $44.00 in earnings per share on a trailing 12-month basis, then it necessarily follows that Apple trades at $550 a share. That is a mathematical fact.
More on the Limitations of Financial Analysts
While most analysts do spend a tremendous amount of time forecasting Apple’s earnings, you’ll notice that not a lot of analysts give a basis or a well reasoned argument for why they believe the stock will trade at the multiple they assume in their analysis. I find this to be rather shocking as getting Apple’s P/E ratio right is far more important than getting the earnings number right. A forecast that misses Apple’s fiscal year EPS by $1-$2 has far less of an impact than a forecast that under or over-estimating Apple’s P/E ratio by a factor of 1 or 2.
Here’s why. Suppose Analyst A holds a 1-year price target of $572 a share based on his forecast that Apple will trade at a 13 P/E ratio on $44.00 in earnings. The analyst believes that Apple will trade precisely at $572.00 the day after it reports its fiscal Q4 2012 earnings. Now suppose that Analyst A missed on his earnings expectations by $2.00 but got the trailing P/E ratio number right on the dot. If this were the case, the stock would trade at $546.00 a share or just $26.00 or 4.55% under his price target. That’s no big deal at all. He pretty much nailed it.
Now suppose Analyst B perfectly forecasts Apple’s EPS number of $42.00 a share but completely over-estimates what type of a P/E ratio Apple would trade at. For example, suppose instead of believing that Apple’s P/E ratio would contract, that he believed in the notion that Apple would see P/E expansion. Instead of forecasting a 13 P/E ratio, Analyst B believes that Apple will trade at a 15 P/E ratio and thus holds a price target of $630.00 a share. Notice that $42.00 x 15 = $630 while $44 x 13 = $572.00.
By over-estimating the P/E ratio by a factor of 2, Analyst B completely missed his price target. Even though Analyst A missed on earnings, he got the price-target almost exactly right. And that’s because he was able to understand what the market would be willing to give Apple in terms of a valuation in 2012.