The battle for the right price for Apple stock

I don't think anyone has managed to miss the fact that Apple stock is down about 20% in a week (if you have, Barrons has a nice summary of the overall carnage in technology stocks). I've gotten several emails asking me 1) how and why this is happening, and 2) whether I think it will go back up. I am not a financial advisor, but I'm happy to give my opinion. But let's tackle those questions in reverse order.

Will Apple go back up again? My view is almost certainly yes. Why? Because at the end of the day, I know that the stock price will eventually follow Apple earnings. And as I've noted before, Apple is using the iPhone and Apple TV to make its future earnings nicely predictable, since it is taking cash from customers now and recognizing them as earnings over 24 months. Said another way, future Apple earnings are like money in the bank -- literally.

So that's the rosy picture: at some day in the future, Apple stock will be valued at some nice hefty multiple of its earnings. I use 35 as my Price to earnings ration for Apple stock, since that equals its annual earnings growth. But assuming you accept my projection that Apple will earn something north of $5 a share in fiscal 2008 ending in September and more than $7 a share in fiscal 2009, Apple's going to be at least a stock valued at somewhere between $175 and $245 at at P/E of 35. It's easy math.

So what's going on now that's pulling Apple stock back to $155 or maybe lower?

Well, first, the whole market is down, for one thing. The Dow Jones Industrial Average is now below 13,000 for the first time since August. So's the NASDAQ. And as you can see from the graphic above, Apple isn't even the biggest loser among tech stocks on a percentage basis -- companies like Google, Cisco, Research In Motion, and VMWare have had similar or bigger drops.

Secondly, Apple stock has had huge gains year to date, and a lot of mutual funds clean up their holdings prior to paying dividends and capital distributions to their shareholders in December. Many fund managers may simply be selling Apple stock just as a normal rotation in and out of technology around the end of the year.

Third, with the credit crunch bear crushing the stock market as a whole, Apple is likely attracting momentum short sellers, who take advantage of short-term declines in stock price to make some extra dollars, particularly if a stock is considered over-valued and the market is selling off overall. Like rainy days, there's not much to be done about short sellers other than to wait them out.

Fourth, a lot of quantitative hedge fund strategies are pulling down unrelated securities as the result of subprime mortgage losses. I wrote about this phenomenon about a week ago, inspired by the Technology Review article (registration required), The Blow-Up.". So despite the fact that Apple has almost no sub-prime mortgage exposure, automated quantitative hedge fund trading systems may make it behave as if it did anyway.

And fifth and finally, as one insightful reader pointed out, both stock options and hedge fund expirations are taking place this week. Investors usually know about options expiration dates, but what are hedge fund expirations? Turns out that investors in hedge funds have to give 45 days notice before they can withdraw their money. So if any investors want to withdraw their money before the end of this year -- say, to write off losses on their taxes or just to pay bills -- they have to give notice by the end of this week. And assuming that many hedge fund investors may already have given notice because of the down market, hedge funds may be liquidating substantial positions in high-quality stocks just to pay off their investors.

The bottom line: Think of all the red ink in the market this past week as simply a before-Thanksgiving sale on stocks. Once we are past options and hedge fund expirations this week and end-of-year selling for tax purposes, stock prices at large will eventually reflect the earnings of the companies behind them. Companies with innovative products, strong earnings and earnings growth, and no exposure to the credit industry will appreciate in value. And that's true of no company I know more than Apple.

Full disclosure: Of the companies mentioned in this article, the author is long Apple, Garmin, and Google at the time of writing, but has no positions in hedge funds.

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