Real Kato Blog: Experts Are Dumb

Or maybe this guy just isn't an expert.

I read an article in USA Today about whether Apple stock was a good buy or not. (Disclaimer: I own Apple stock). The article was written by this guy, Matt Krantz, who is a "financial markets reporter". Whether that means he has any economics background, I don't know. But the article has some serious flaws in it.

To evaluate Apple's stock, he uses his "four-step Ask Matt test". The steps are: (1) compare the stock's risk and reward, (2) examine the stock's earnings multiple, (3) calculate the company's value using forecasted future cash flows, and (4) check the USA Today Stock Meter score. According to Matt, items (2) and (4) suggest the stock is a good buy; items (1) and (3) suggest it is not. But let's look at (1) and (3).

In item (1), to compare the stock's risk and reward, Matt looks at the stock's volatility (standard deviation) compared to the market, and then looks at the stock's expected annual return compared to the market. Because the stock's volatility is 250% higher than the market and the return is just 24% higher than the market, he says that "logically, it's not a good deal".

That's absolute garbage, of course. There are two serious flaws with this argument, which should be apparent to any math major. One is that volatility is not a pure measure of risk; that is to say, standard deviation over a short period of time is not a predictor of expected future value. The other is that even if you wanted to use volatility as a measure of risk, there's no reason to believe that it's linearly correlated with returns; if I took made a graph of stock volatility versus return rate, I very much doubt I would get a straight line. So comparing the 250% to 24% is comparing apples to oranges (no pun intended).

In item (3), he uses something from NewConstructs.com, which is apparently some stock analysis service. From what he gets there, he calculates that Apple would have to have 8.1% revenue growth and a 29.3% profit margin for the next 100 years, in order to achieve stock growth of another 50%.

If revenue grew at 8.1% per year and the profit margin remained steady, that means that over a 100 year period, earnings would be 2313% higher than what they are now (1.081 ^ 100 = 2413.067). But the stock would only be up 50%? How does he figure that?

If he's only talking about the stock going up over a five year period, then why would Apple need to maintain growth for 100 years?

I don't know what methodology NewConstructs.com is using, but either it's wrong, or Matt is interpreting it wrong.

Which just goes to show you: don't believe everything you read in USA Today. If you really want advice on whether to buy Apple stock, you should stick with stock market fundamentals: the company's guidance on revenue growth, stock price targets from real financial analysts, and your own personal gut feelings on whether Apple can continue to sell innovative new products.

And if you want my advice, which is at least as good as Matt's, I'd say this: Apple stock will likely outperform the market over the next couple of years, and the recent sell-off has probably created a buying opportunity. It won't skyrocket like it has in the past two years, but most indications point to more earnings growth and improved sales for all of Apple's product lines. So my rating is a "Moderate Buy".

Permalink 2 Comment

Posted by Ken in: commentary

Comments

Comment #1 from JuanC (Guest)
2006 Feb 3 - 9:41 am : #

And this just confirms what I believe about stocks...
Unless you have a LOT of free time to study this stuff, why would you buy anything but an index fund (or a company managed "indexish" fund like I have)? for any reason other than A) You like the company, 2) Entertainment purposes.

The real reason is C) One might actually think they are smarter than people who do this all day. Which may be valid based on the "expert" USA today hired.

Comment #2 from Ken (realkato)
2006 Feb 3 - 10:26 am : #

Well, for me, it's kinda like gambling (say, like playing craps). Except that there's no house edge against you, so it's even better.

Comments are closed for this post.

Search This Site