The price of a share of Apple (AAPL) is almost 30% below the high that it set back in September 2012—about five months ago. Even before its peak, the price of Apple shares had already made it the most valuable company in history. In those heady times, Apple shares reached $702. Today, they are at $503. Even today, however, Apple remains the largest single holding in the S&P 500 at about 3.6% of the total index. It is mind boggling to consider that the market value of the most valuable public firm in history could decline by 30% in five months, without some sort of catastrophic event. But this is the situation and there are some lessons to be drawn.
When you buy a share of Apple, what are you really buying? First, you are buying a specific percentage of this company. If the company was closed down and everything of value was liquidated tomorrow, your share of Apple would be worth about $125, the book value of a share. Over the past twelve months, Apple has generated earnings equal to $44 per share and the company is expected to generate $57 per share next year. In theory, as a shareholder, this $44 to $57 per share in earnings belongs to you. In practice, however, the company is retaining most of this money to fund the growth of the firm. The only share of the earnings that you can expect to pocket directly is the dividend, which is $10.60 per year. It is important to understand, however, that a company does not have a contractual obligation to maintain a dividend. While investors own their share of earnings in theory, they cannot demand that share of earnings as a ‘payment’ for owning the stock.
So what is the value of what you own in the form of a share of Apple? Your ultimate value is determined by the market price of a share on the day that you decide to sell. There is no particular reason to believe that this price should necessarily increase or even be stable through time. Of course, shareholders hope that the consensus opinion of the other investors will be that a share in Apple six months from now is more than the value today. But owning an asset in the mere hope that someone will be willing to pay more tomorrow than you paid today sounds more like speculation than investment.
When a company goes public, it is selling a piece of itself to investors who seek to buy this. Funds raised from the IPO go to early investors looking to monetize their positions and to the company itself to fund further growth. When you buy shares in the secondary market (e.g. other than at the IPO or other share issue), you are simply getting those shares from other investors—the company does not directly benefit because you are willing to pay more today than a share was worth last week.
What all of this means is that it should be no surprise that the price of a share of Apple can change very rapidly. The market value of a company like Apple is primarily determined by the collective beliefs of its investors. This is very different from other types of assets. Consider, for example, what it means to buy a bond. When you buy a bond, the issuer of the bond has an obligation to repay that debt with interest. The issuer may default, of course, but it is important that there is a formal agreement between you, the bondholder, and the issuer as to the value of that investment if the bond is held until maturity. The value assigned to a share of stock does not have a similar ‘anchor’ for its value.
Again, in theory, investors should expect a positive return on their investment in company stock because they are providing ‘risk capital’ to companies that need money to grow. This is, however, an overly simplistic view. When a company goes public, the IPO price provides actual risk capital to the company. Purchases thereafter do not fund the company’s growth (except in the case of an additional share issue). I have heard the situation explained in the following way. If you provide money to someone starting a restaurant in exchange for a share of future earnings, this is like an IPO stock purchase. If you buy and sell stock in the stock market, this is more like people in a restaurant parking lot betting on how many customers will go through the front door. This metaphor is imperfect. Owning a share of Apple does confer real ownership and value (as opposed to simply betting), but it is naïve not to recognize that, on any given day, a large portion of the price of Apple is a matter of betting on the number of customers. This is, in fact, an apt interpretation of the drop in stock price as it was reported that Apple was cutting orders on parts for the iPhone 5.
I am in no way bashing Apple and I have no opinion as to whether the shares are over-priced or under-priced. The fact that the value of the largest single component of the S&P 500 is so dominated by investor and consumer sentiment says something about the state of the stock market, however.