Apple Investors Who Sold After Earnings Got It Wrong

By Markets Fool.com

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Apparently, Wall Street wanted Apple to sell a few more iPhones. Image source: Flickr user Krlis Dambrns

On Tuesday July 22, tech giant Apple released its earnings to an anxious market. Overall, the company beat analyst expectations on the top and bottom lines, posting $49.6 billion in revenue and EPS of $1.85 versus consensus figures of $49.4 billion and $1.81. On a year-over-year basis, those numbers are up 33% and 45%, respectively, as Apple appeared to overperform.

So naturally you'd expect a strong surge as investors reacted to a rather successful quarter ... and you'd be wrong. What happened instead was a 7% after-hours drop and myriad headlines declaring Apple's "disappointing earnings." And while Apple beat Wall Street analyst figures, the company fell short of the "whisper number" that speculated Apple would sell 50 million iPhones.

It wasn't as if Apple's iPhone performance was poor, as the company did sell 47.5 million iPhone units. Compared to last year's performance, the company shipped 35% more iPhones and grew product revenue an outstanding 59% -- the kind of numbers that would make many consumer electronics companies happy, while investors quibble about 2.5 million units. The reaction to Apple's earnings confirms that investors expectations are highly irrational.

A voting machine versus a weighing machine
When it comes to value investing, Ben Graham is considered the father of the genre. His seminal book, Security Analysis, was initially published in 1934 and now boasts six editions. His work went on to influence legendary investor Warren Buffett, so much so that Buffett wrote the forward for Graham's sixth edition. Perhaps one of Graham's most well-known quips is, "in the short run, the market is a voting machine, but in the long run it is a weighing machine."

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Graham meant that a specific company's stock may jump around to reflect investors' current sentiment and irrationality, but over the long run the real value of a company's current and future operations will eventually be found. More recently, a new field of behavioral finance has built upon this idea in an attempt to understand how biases and irrational behavior work together to hurt investors.

Personally, I'd say selling Apple off to the tune of 7% for a slight miss on its aging phone iteration -- even while beating analyst expectations in revenue and EPS -- falls in the category of irrational actions. If you're a long-term investor, you should be encouraged with Apple's results.

So, how much does Apple "weigh"?
If you're looking for me to provide a hard price target, sorry to disappoint. In the greater equity analysis industry, there's an intense focus on price targets -- a number analysts expect the company to trade at on a per-share basis in the future, generally 12-18 months out. In many cases, the analyst's firm makes assumptions of future sales and profits, discounts it at a predetermined rate according to risk, then applies a market multiple or adjusted multiple to determine the per-share price. If that sounds like a bunch of assumptions, it's because it is, and in many cases these figures simply don't come to fruition.

And as the 12-18-month period stretches to infinity, the focus is on changes in the price target rather than the accuracy of previous price targets. To be fair, it's very hard to estimate profits, even more difficult to apply the best discount rate, and nearly impossible to gauge how much investors are willing to pay for a dollar of earnings in the future. Throw all three of those things in an equation, and it's nearly impossible to be correct. So while I understand why price targets are used, mostly due to the fact they seem easy to understand, I don't personally believe in hard price targets.

Instead, my philosophy is more like Buffett, who commented, "If I can buy dollar bills for 90 cents, I'll buy them." Right now, Apple trades at a P/E Ratio of 14 with the greater S&P 500 trading for 16. When we do include analyst estimates of growth, 14% (which I think is low, as Apple grew earnings per share 45% this quarter), the company trades at a PEG ratio of less than one while the greater S&P 500 trades at an estimated PEG of 1.62 (lower is better). Personally, I believe in buying great companies and letting them operate. Long story short, I think Apple is undervalued and I'm willing to wait through Wall Street's irrationality to find out.

The article Apple Investors Who Sold After Earnings Got It Wrong originally appeared on Fool.com.

Jamal Carnette owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.