We only need to look at the likes of Apple to see how the mighty have fallen. The shares fell from around $230 to a low of just over $140 and now stand at $157. This has literally wiped hundreds of billions of dollars off the value of Apple. It also perfectly reflects the dangers of buying stocks which are afforded significant premiums by investors.
The benefits of high premium stocks
If the market is rated on a forward price-earnings ratio of 12 (for example) you may see some stocks valued on a price-earnings ratio of 18 or even 20. These are stocks which are positioned for significant growth in the short, medium and longer term. This degree of “certainty” means that many investors will buy into the story pushing the price higher and higher. One of the main benefits is the fact that the company can use “paper” i.e. its own shares, to acquire other businesses.
If these businesses are rated on a price-earnings ratio less than the highly rated company then immediately it is earnings enhancing. In many ways this is a self-fulfilling prophecy, until the company hit problems!
Losing the premium and more
If a company suddenly goes ex-growth then there’s a good chance it will lose its premium relatively quickly. A forward price-earnings ratio of 18 may suddenly drop to a price-earnings ratio of 10. So basically the company has lost its premium and has also dipped below the general market price-earnings ratio. In effect, the company is rated on a discounted valuation to the market because of the concerns about short, medium and long-term growth.
You will often see fallen idols struggling to claw themselves back to anywhere near their recent highs. As their paper is now valued at a discount to market rates, any acquisition will not immediately be earnings enhancing. This makes it difficult to create an argument for acquiring businesses with paper and raising finance in a “difficult environment” could be even more costly. End result, unable to raise funds the acquisition strategy which may have proved extremely lucrative in years gone by comes to a crashing end.
Nothing lasts forever
While there is every chance that Apple may well claw back the majority of its recent losses it will take time and there has been reputational damage. This is a company which has micromanaged news flow in recent years, managing expectations and delivering on the upside. As suppliers began to issue their own profit warnings, with many suggesting Apple products were not selling as well as they were expected to, the focus turned to Apple. The company was unable or unwilling to confirm rumours of a pending profit warning which created significant concern amongst investors.
Ironically, when the profits warning finally came the shares fell but rebounded strongly. There was no concern and confusion now, the bad news was out, the company was forced to open up and we started to see a gradual recovery. The medium to long term situation is a whole different ballgame, has Apple gone ex-growth, are consumers willing to pay inflated prices and when will the management finally dip into that massive multibillion dollar war chest?
We will leave you with these questions as nobody yet knows the answers……