Iron Capital Insights

  • Iron Capital Insights
  • August 31, 2012
  • Chuck Osborne

The Price of Everything But The Value of Nothing

Oscar Wilde famously described a cynic as a man who “knows the price of everything but the value of nothing.” If he was right, Wall Street must be full of cynics.
There really has been little news on the investment front of late. The Europeans have been on holiday – which, I must admit, is a much happier word than vacation. I mean – who wouldn’t prefer to holiday as opposed to vacate? But I digress. Regardless of what they call it, they have not been at work, and out of sight is out of mind. We seem to have temporarily forgotten that Europe is falling apart. Domestically our economy continues to slow, although there have been some signs that the real estate market may have finally hit a bottom.
During this quiet period the market has managed to rally, seemingly entirely on the hope that central banks will flood yet more currency through their pipes. While we wait to see if that occurs, the financial media have been discussing the price of Apple’s stock in an absence of anything else to cover. This distraction allows for a moment of insight and hopefully a little investing education.
To paraphrase the legendary investor Peter Lynch, no data point is more easily found or more meaningless than the price of a stock. The price of a share of stock is really just an accounting decision. Apple is now selling for approximately $670 per share. If management wished they could simply say each share is now ten shares, and (assuming no market movement) abracadabra, it would be selling for $67 per share. That means absolutely nothing. Conversely there have been pundits asking, “Is Facebook now a bargain at under $20 per share?” Again the $20 share price means nothing.
The value of a company is the present value of future cash flows. There are many sophisticated ways of calculating this value but one of the simplest – and frankly still the best – is the price to earnings ratio. What matters to investors is earnings. The real price of a stock is not the accounting number that is arbitrarily assigned to it, but the cost per dollar of annual earnings. Apple is selling at 15 times earnings while Facebook is selling at 100 times earnings. In other words an investor can buy a dollar per year of Apple earnings for $15 or that investor could pay $100 for a dollar per year of Facebook earnings. Yet the pundits, with nothing better to talk about, fret on Apple being expensive and Facebook being cheap. To make it even funnier, Facebook went public at $34 per share, which at the time equated to a price per dollar of earnings of $84. Its earnings have gone down more than the stock price. Apple on the other hand is growing like crazy. It is arguably the best company in the world today and its $15 price tag means it is selling for approximately the same price as the S&P 500 average.
Let me be clear at this point: this is not a recommendation to buy Apple, nor is it a recommendation to short Facebook. I use these two companies simply to illustrate a point. The market often pays attention to meaningless issues, which can create mis-pricings and therefore investment opportunities.
This happens in stock-specific stories like the ones above and sometimes in the market as a whole. The market has rallied since the end of July based solely on a few speeches and speculation that central banks will conduct more bond buying or so-called quantitative easing. Yet nothing has actually happened, and it is far from certain that anything will. Even if the central banks do go through another round of quantitative easing, it is not clear at all that these policies will have any lasting positive effects. This market reaction is based on the logic that when central banks ease, monetary policy stock prices rise. This historical relationship is true because in normal circumstances monetary easing stimulates economic growth. However, there is no evidence that the quantitative easing which has already been tried twice has had any positive effect on the economy.
Almost everything in life has what economists call diminishing returns. The first bite of chocolate cake is more satisfying than the last bite; in fact eat enough and it will make you sick. Likewise, central banks lowering rates from 6 percent to 5 percent has more economic impact than trying to take them from 0 percent to artificially lower than 0 percent through the magic of quantitative easing.
When you take these curious developments one by one it may just seem like the musings of an analyst with a wry sense of humor and too much time on his hands. But, put them together and things become a little clearer. For Apple to be selling at the same price per dollar of earnings as the market, there must be a disconnect. One of two things must be true, either the market is too expensive or Apple is too cheap. Combine that with the likes of Facebook selling at 100 times earnings and a rally pumped up on nothing but rumor and hope and the answer starts to emerge.
Caution is still in order.
Chuck Osborne, CFA

Managing Director