2 Types of Companies Deserve High Valuations
Apple , one of the world's most beloved companies, trades at nine times forward earnings. Consolidated Edison , easily one of the most boring, trades at 15 times forward earnings.
How can that possibly make sense?
It's actually pretty rational. There are two types of companies that deserve a high valuation multiple: Those in a rapid growth stage, and those with stable and predictable profits. I don't believe Apple fits either. ConEdison does.
Apple needs to reinvent itself year after year, creating new products that are bigger, better, and faster than before. It's done a remarkable job of that over the last decade. But what are the odds that one of its next attempts at reinventing itself will fall short of past successes? Quite high, I'd say. Maybe not this year or next, but any company operating in a short-cycle high-turnover market will eventually miss a step. I struggle to think of another company forced to innovate as ferociously as Apple that has prospered consistently for more than a decade or two.
The point isn't that Apple won't come out with something massively innovative in the near future. It very well may. But it operates in an industry where it needs to in order to stay relevant. The reality that it may not has to be discounted when thinking about Apple's future. It's just very hard to predict Apple's future earnings. And the market hates uncertainty.
Contrast this with Consolidated Edison, the utility giant. Its prospects for growth are abysmally low. The odds that it will grow earnings any faster than inflation round to zero. It is boring. It makes no headlines. It never comes out with exciting products.
But not having to innovate has its advantages. We can say with pretty good certainty that ConEdison will be cranking out profits five, 10, and 20 years from now. Same for a company like Colgate-Palmolive . Toothpaste is boring and has no chance of changing the world. But the odds are high that Colgate will be a toothpaste king 20 years from now, and 50 years and beyond. There's predictability. The market loves predictability, and it's willing to pay up for it with an above-average valuation.
A company can make up for uncertain growth if it's enjoying blistering growth, as the odds of a blowout offset the odds of a stumble. But Apple isn't in that cycle anymore, at least for its existing products compared with previous years. It's already so large and commands such a large share of its markets that future growth rates are very likely to fall. Fourth-quarter net income was virtually flat over the previous year. S&P's Capital IQ shows average analyst estimates call for earnings growth of 15% from 2013 to 2014. That's excellent, but it's a fraction of what the company produced in previous years. There is no shame in seeing epic growth rates fall back to Earth. It is as inevitable as aging. But markets should -- and will -- value the company accordingly.
None of this is a bearish call. Apple could be a great investment at current valuations. Indeed, Altria has produced sensational shareholder returns not despite a low valuation, but specifically because of it.
But for Apple investors, don't hold your breath waiting for big earnings-multiple expansion to something above the market average.
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The article 2 Types of Companies Deserve High Valuations originally appeared on Fool.com.Fool contributor Morgan Housel owns shares of Altria Group and Consolidated Edison. 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.
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