Thursday, January 7, 2010

There IS Accounting For Price With Apple and RIM

Apple (AAPL) and Research In Motion (RIMM) are clearly two of the best companies around. A quick look at their returns on equity over the last several years shows just how successful the companies' investments in research, production, and marketing have proven to be:

These are exactly the kinds of companies that Philip Fisher would want to own. (Philip Fisher was Warren Buffett's mentor when it came to growth stocks.) So why don't these stocks appeal to value investors? Quite simply, because of the price.

While the stellar returns on equity depicted in the chart above are clearly attractive, one must consider how much one has to pay for that equity. As we saw when we compared investments in Office Depot and Staples, adjusting returns for the price of the equity can have a dramatic effect on the attractiveness of a stock from an investor's perspective.

AAPL has a price to book value of almost 7 (meaning investors have to pay almost $7 for every $1 of equity that is in the company), while RIMM has a price to book above 5. Adjusting the above chart to reflect each companies' returns based on the market value of equity yields the following chart:

Clearly, things have to go very right for these companies in the future to justify an investment at current price levels. While the companies are extraordinary and it is quite possible that they will continue to grow and innovate and thus reward shareholders even at these price levels, downside risks are also present. Unexpected negative occurrences could take a large bite out of stock prices when they are at such high levels. If future products are not as successful as past products, or if competition and new entrants are able to slow the growth of these companies, the stock prices will have to correct dramatically.

On the other hand, there are plenty of companies with strong returns on equity (albeit not as strong as those of AAPL and RIMM), but which trade near their book values. As such, if things go wrong, the stocks don't have as far to fall. In many cases, the stocks even trade at levels such that the companies' assets offer investors protection from downside risks. This is the space in which the individual investor, who is not limited to companies of a certain size, should be playing.

Disclosure: None


Luis said...

This is a great way to illustrate the impact of price on returns!

How did you adjust the ROE chart to reflect each companies' returns based on the market value of equity yields?

Would you please share the arithmetic?

heterocedastico said...

A very interesting duel happening right now is AAPL-RIMM vs NOKIA. A duel of growth versus value.

Sure AAPL and RIMM can continue to gain market share. They are definetly the leading innovation force of the market right now. But let's not forget that Nokia has more market share (37%) than the next 3 competitiors together. And it has one of the most admired brands in the world. And they are the low cost producer. And they have really huge positions in emerging markets. And they have big cash balances to deal with short-term headwinds. And has a price book of 2.4.

If average price sale continues to fall and if innovation somewhere gets stalled, Nokia will come back. They have the know how, the cash and structure to do so.

Just to get things in perspective. RIMM is almost 75% of Nokia's market cap. Apple is bigger than Johnson & Johnson by market cap.

Saj are you connected on LinkedIn?

Tax preparation said...

Its very nice an interesting blog post. nice i really enjoyed.

Saj Karsan said...

Thanks Luis and Tax!

Hetero, unfortunately I'm not on linked-in, no.

Luis, there's not much to it, I just substituted the current market value of equity for the book value of equity in the ROE equation.

Bullshift said...

Hey man, I have been a RIMM investor for about 9 months now and am offended at the valuation the market has placed on RIMM. Despite RIMM consistently doing well and improving there business, do you feel that any of the bad press is warrented?

If RIMM was trading at $100 a share right now, and had the same earnings, would you still buy it?

Saj Karsan said...

Hi Bull,

I think the company has been a bit slow at rolling out new products compared to the competition. However, at this price I do still like it. I don't think I would be a buyer at $100, no.

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