Equity Valuations in the spotlight from Apple (AAPL) to Netflix (NFLX)

Thousands of people took to Twitter this week questioning and looking for answers of the current state of valuation in public equity markets.  How is it possible that a stock price of a company such as Apple, with staggering profits and massive sales, trade lower when so obviously successful?  I viewed tweet after tweet of confused individuals pointing out the nonsensical low price earnings ratio (P/E ratio) and the massive cash balance of $137 billion leading many to conclude the market is irrational or better still, and my personal favorite, the market just doesn’t know how to value Apple!

My question is, “Is the market irrational or is our current knowledge of finance incomplete?” In my opinion, the current field of finance is so inadequate that it fails to explain anything to anyone.  Using simplistic ratios that current finance and analysts promote like price to sales, price earnings ratios and other remedial relationships do a poor job of explaining valuation to anybody.  Isn’t it time for something new in the field of finance to aid market participants in the understanding of valuation?

On the other hand technical analysts are cheering that their side won – versus the people who use fundamentals. They saw and predicted Apple’s price decline because of various chart formations.  By analyzing market price data alone without the apparent unhelpfulness of fundamental financial data is the only logical way to invest in the stock market they will gleefully say, using Apple as Exhibit 1.  Can this be true?  Maybe these chart formations are picking up something that technical analysts cannot explain but seem to work from time to time.  Maybe market prices and the use of technical analysis are highlighting something that is currently hidden from the technical analyst community in general?

Model Price Theory and Analysis to the Rescue

Using Model Price Theory can easily explain the valuation of Apple.  The market decided, with millions of buyers and sellers coming together, that Apple no longer should trade in a certain zone.  This zone was from EBV+5 to EBV+6.  This zone contained Apple’s valuation since 2004, as I pointed out in this blog.  So what happened this week? Apple changed valuation zones: to EBV+4 to EBV+5.  Apple could stay in this new zone for a period of days, years or decades.  As the balance sheet grows so does the zone in question.  Simple.

Apple is still Apple!  The company will still grow.  But the market is communicating a judgment for those listening and observing that at this time Apple belongs in a new lower zone.  As of the close on Friday, January 25, 2012 this zone, includes a price range of $506.02 for EBV+5 and $366.51 for EBV+4.

Apple Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Apple Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

For those interested, a daily updated chart of AAPL subsequent to this post will be maintained on Facebook, here.

So Apple can trade within this price zone and still have the same valuation.  Plus these dollar amounts of our EBV zones can change everyday.  Why?  Simply put because the balance sheet is changing everyday.  So every night, after the market close, we calculate new daily EBV levels for every stock in our database.

How do we do this?  We take future earnings estimates, add these earnings to the equity of the company and deduct dividends, if the company pays any.  Every quarterly release of financials is updated in our database and the daily calculation from this updated balance sheet is started anew.

Just for fun we have the EBV numbers for Apple one year out.  So EBV+5, one year out is $631.10 and EBV+4 is $457.11.  So you can see the zone growth with the projected balance sheet of Apple. Valuation is the zone the company trades in, not the price of the stock relative to some measure (i.e. price earnings)

So thinking about this for a minute, using model price theory, an investor has two independent variables interacting with each other.  The first is the market price of the company listed on the stock exchange.  Again, millions of people are coming together and transacting on price.  The second is the balance sheet of the company itself.  This is an independent variable that has undergone much scrutiny and as everybody knows the balance sheet has to balance.  (Assets = Liabilities + Shareholders Equity)

Thinking of the current state of finance neither fundamental analysis nor technical analysis can boast two independent variables.  Each camp, fundamentalists and technical, have only one independent variable between them trying to extrapolate price movements by building extraneous irrelevant and sometimes simplistic mathematical relationships to explain stock price valuation.   On top of this fundamental investors dismiss model price charts thinking they are a form of technical analysis.  The technical analysis people look at the weekly price bars and simplistic parallel lines on our model price charts with ridicule.

Yes, our EBV parallel lines look simplistic.  If you the reader spend time and effort understanding these EBV lines would they have a material impact on your investment results?  Absolutely!

Economic Book Value (EBV) lines are one of the keys to understanding valuation.  See every stock trades somewhere within our EBV lines.  How does the market determine what zone a specific equity should trade?  Cause and effect!  The effect is the zone in which the stock will trade which we disclose on our model price charts.  The cause is based on the dynamic of our solvency ratio, theoretical earnings and convexity (see Key Concepts).  Yes, I know you have never heard of these concepts and cannot read about these concepts in any textbook.  That is the point of this blog.  When and if management changes, in a material way, any one of these variables in these highlighted concepts, can and will change the EBV zone the company will trade.  Or when a stock transits an EBV line, either positive or negatively, something is going on with one or more of our Key Concepts.

So you’re skeptical? I get it!  I was once too.

Let’s look at both Apple and Netflix, and see how model price charts prognosticated the price moves we have seen this week.

Here is the model price chart of Apple Inc. on the close of January 15, 2013.  As I indicated on the chart Apple had a negative transit of EBV+5.  This occurred a week before Apple’s earnings release date scheduled for January 23, 2013.  This negative transit is an equivalent to a “tell” of a poker player.  I warned readers of this negative transit and its implications here and here.

Apple Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Apple Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

This negative transit was telling investors the market will treat, for valuation purposes, EBV+4 and EBV+5 as its new zone.  EBV+5 will be the top of the zone or future resistance and EBV+4 will be the bottom of the zone or future support.  As the balance sheet of Apple grows, which it will at a rapid rate, so does the EBV lines containing this zone.  This is the valuation question solved.  It’s not about price earnings ratios or cash on the balance sheet.  Technical Analysts’ caught the breakdown in price but this particular breakdown was more meaningful then I think they realize as I blogged about here.

If management wants to lift the valuation in Apple in the future they need to change the variables of our solvency ratio, theoretical earnings and convexity.  See my blogs on Apple one year ago – “Four Actions Management Can Do to Double Their Stock Price (Without Breaking a Sweat)!” and “Apple Computer – A Special Dividend of $75 Billion would Reward Shareholders, Management and the Economy.”

As a trader or investor where would you like to purchase a specific equity?  Would you rather purchase at the top of the EBV zone or the bottom of the zone.  Simple, the bottom of the zone!  In the case of Apple, the stock could trade to $366.51 and still be in the same zone.  Also $366.51 will give the stock meaningful support that I’m sure many investors are looking for in this current situation.

Let’s continue on to Netflix.

Here is the model price chart of Netflix on the close of December 14, 2012.  As I indicated on the chart NFLX had a positive transit of EBV+6.  I blogged about this positive transit with the title – Netflix (NFLX) – Breaks Above EBV+6 – Higher Share Prices Expected!

Was I too obvious with this title?

Netflix with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Netflix with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

With NFLX’s earnings news this week the stock had a positive transit of EBV+7 like a hot knife through butter.  Again from a valuation perspective NFLX is in a new zone.  The market is giving management of NFLX “equity dollars” to sign up subscribers as fast as possible.  Try and look up “equity dollars” in any finance textbook.  It doesn’t exist.  However it’s part of our model price theory!

Current chart of Netflix

Netflix with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Netflix with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

For those interested, a daily updated chart of NFLX subsequent to this post will be maintained on Facebook, here.

As one tweeter user lamented NFLX made $8 million in earnings and the market gave it $2 billion in market cap on this earnings news.  AAPL made over $13 billion of profits and the market took away $60 billion of market capitalization.

Yes, this seems nonsensical on the surface but the market is more sophisticated in judging valuation and with keeping your eyes on our EBV zones and possible transits will help you better understand valuation and where the stock prices of your investments are going.

3 responses to “Equity Valuations in the spotlight from Apple (AAPL) to Netflix (NFLX)

  1. LAURIE STAMP January 27, 2013 at 4:42 pm

    Brian , great job explaining both APPLE & NETFLIX , I think I’m really starting to get a good handle on this process.
    My only question is where does “MODEL PRICE fit into the whole equation, $578.32 makes sense for APPLE if we are looking one year out , but $42.36 for Netflix (yes it has had a big move recently but no where near the share price. Thanks for your patience as I work through this.

    • ModelPrice Guy January 27, 2013 at 8:35 pm

      As always Laurie, good question.

      Remember there are two pieces of information I am delivering to you with these model price charts. The first are the EBV lines. For this blog I have focused exclusively on these lines and information they transmit. The second piece of information is our algorithm and calculation of model price. This calculation is largely but not exclusively focused on analysts’ earnings estimates. Analysts were certainly bullish on Apple leading up to their earnings release which inherently effects their numbers. Post the release of Apple’s 1st quarter earnings, the analysts are adjusting their estimates downward which will effect model price, which usually takes a few days.

      I use model price as a guide only. Analysts are usually wrong at turning points in the company’s business where the market with a positive and negative transit of our EBV lines are way ahead of everybody. Just the nature of the security business. Analysts are cheerleaders looking for investment banking business. Keep in mind with the current state of finance very few if anybody can take analysts earnings estimates and translate this information into fair market value in terms of model price in a very robust way, as we do! So analysts give this information out for free and offer some sort of justification for their buy/sell/hold (bogus) recommendations.

      In NFLX’s case, as you can see from our model price chart, model price has more than doubled after NFLX’s earnings release. The analysts here were totally off on their estimates and the stock float had 21% of it short (ouch!). This maybe a case where the stock price leads model price fundamentals because analysts will always be behind the actual business fundamentals. NFLX as a business has what we call “economic velocity” where the market gives companies “equity dollars” to pursue their business plan no matter what model price is.

      Hope this helps.

  2. Marcin Zukowski January 27, 2013 at 10:10 pm

    Let`s put valuation and manipulation aside. Apple is known for its innovation and they have spoiled the public with new cool gadgets in a very short period. So, everyone expects `Wow` factor each time they report but people have to realize that little incremental changes are innovations and really Apple`s products are good quality. That comes from a Blackberry fan.

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