Apple’s expensive valuation seems confusing. These factors explain it.

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Apple

The value of the stock rises to $3 trillion and is one of the main reasons behind it

S&P 500

is up 15% so far this year. That's why the valuation, which is always high compared to the overall market, is worth a close look.

The stock (ticker symbol: AAPL) trades at around 29 times analyst-reported earnings per share

FactSet

expect the company to deliver in the next 12 months. That's about 50% more than the comparable value of the S&P 500. And it's not uncommon for the stocks to sell at such a premium, especially when technology stocks are trending.

The conventional wisdom on Wall Street is that Apple's long-term earnings growth, high quality of business, and cash on hand justify this number. But growth isn't that explosive, and the valuation feels ridiculously high on the surface.

“Given subdued earnings growth, I would think it's likely to come down,” said Brian Macauley, portfolio manager at Broad Run Investment Management, of the valuation. Broad Run doesn't own the stock.

But all in all, the rating makes sense.

While there are many positive reasons for Apple's earnings growth potential, earnings growth alone isn't enough to prove these arguments. The consensus on Wall Street is that the iPhone maker's earnings per share will grow at a compound annual rate of about 9.8% for the three years beginning in 2024. Revenue is projected to grow to $489 billion by 2026, at a 1.5% compound annual growth rate — just over 7% as the company increases prices on the latest iPhones and continues to expand in areas like streaming and payments.

While growth in these businesses is generally slowing, Apple can still make gains in some areas. Accordingly, PayPal (PYPL) seems to have lost shares in Apple Pay

Mizuho

Payments Analyst Dan Dolev.

Ultimately, that growth potential is rooted in “the power of the Apple ecosystem,” said Dan Ives, an analyst at Wedbush Securities, who expects the market cap to hit $4 trillion by 2025. Billions of people own Apple devices, creating a mature market for all of the company's services.

Share buybacks, reducing the number of shares and thereby boosting earnings per share, are expected to drive EPS growth to the 9.8% forecast by Wall Street from what would be expected on a 7% increase in sales will increase.

But EPS growth of less than 10% alone is probably not enough to justify the stock's current price. While the S&P 500's current valuation of 19 times earnings represents about 2.3 times the average 8 percent growth in earnings per share that individual companies are expected to achieve over the next two years, that's comparable for Apple at about 2.93x.

If Apple's so-called PEG ratio, as this metric is known, matched the number for the S&P 500, the tech company's price-to-earnings ratio would fall about 22 times, marking a big loss for the stock.

Another important factor is Apple's $166 billion in cash. While most companies have more debt than cash, which hurts the market value of their stock, Apple has more cash than it owes. After deducting debt, the cash position is $57 billion.

In theory, if Apple had no net cash, its market cap would drop to $2.833 trillion from $2.93 trillion today. That would take the current share price down from $186 to $180, P/E to 28, and PEG to 2.85, which is still higher than the overall market value.

The 0.55 gap can be explained by investors' expectation that Apple will be able to sustain modest growth for several years as the all-around tech company. The market is giving Apple credit for its ability to use its brand and scale to keep expanding, which makes sense since rising earnings mean dividends and buybacks can rise, supporting the stock price.

Those expectations of consistent earnings over the long term are based on “the best installed base of any consumer goods company in the world,” Ives said.

The bottom line is that there's reason to believe that Apple deserves to be trading at such a large premium to the S&P 500. But that doesn't mean that investors should necessarily buy the stock. The best times to buy are when the company is caught up in a general sell-off in the market.

Write to Jacob Sonenshine at [email protected]