Apple and the Dark Side of Innovation

A new-fangled tool for measuring the value of innovation suggests that some companies may be too inventive for their own good. Could this be the reason Apple (Nasdaq: AAPL  ) sells for a measly 15 times earnings?

The innovation premium
The answer to this question lies in the innovation premium. This represents the amount by which a company's market capitalization exceeds the sum of its current and estimated future cash flows from existing products in existing markets. In other words, it's the premium the stock market gives a company based on investors' expectations that it will launch new products, enter new markets, and thereby generate new income streams.

According to this measure, the five most innovative companies are:

Rank

Company

5-Year Avg. Net Income Growth (%)

P/E Ratio

Innovation Premium

1 salesforce.com (NYSE: CRM  ) 78.7 592.2 75.1
2 Amazon.com (Nasdaq: AMZN  ) 37.6 92.4 58.9
3 Intuitive Surgical (Nasdaq: ISRG  ) 36.4 35.3 57.6
4 Tencent Holdings 75.4 29.1 52.3
5 Apple 60.7 15.4 48.2

Source: Forbes and Yahoo! Finance.

Disruptive innovators
Not surprisingly, most of these companies are well-known disruptive innovators. Amazon introduced us to e-commerce and digital books. Salesforce is revolutionizing business software through web-based software applications. And Intuitive Surgical's da Vinci Surgical System is doing to operating rooms what unmanned drones did to the battlefield.

As a result, most of these companies trade at multiples well above the market's historical P/E average of 16. The glaring exception to this rule is Apple, which trades at a measly 15 times earnings.

What gives?
The obvious reason is that Apple's size prohibits it from growing as quickly as newcomers like Salesforce and Intuitive Surgical. Indeed, for a moment earlier this month, Apple's market capitalization eclipsed that of ExxonMobil's, making it the most valuable company in the entire world. For it to double in size from here, it would have to increase its revenue by an astounding $100 billion. In comparison, Salesforce would only need to increase its revenue by a comparatively reasonable $1.9 billion.

The less obvious but more interesting reason is that this disparity reflects Apple's heavier reliance on innovation to fuel future earnings. There's no question that its current stable of products is amazing. Unfortunately, they'll be dated in a matter of years, if not months. Consequently, both its intermediate- and long-term prosperity completely depends upon innovation. Contrast that with the other companies on the list, which could essentially stop innovating today, ride on the coattails of their existing products, and grow revenue in the foreseeable future simply by gaining market share.

On the flipside, you can argue that Apple is no longer strictly a hardware company, and that its competitive moat is in fact its scalable operating system. Indeed, anyone who owns an Apple product knows that the switching costs associated with abandoning it would be steep. My wife, for one, would be driven to the limits of insanity if forced to switch. That said, the costs of abandoning the iPhone and the Mac are not completely prohibitive, given Windows PCs and Android's presence in the market. Compare that relative elasticity to Amazon's Kindle, which truly has no viable competitors in sight.

The Foolish takeaway 
From a valuation perspective, it is possible to rely too much on innovation. All things being equal, it's better to invest in an innovative company with a durable existing product line than an innovative company without one. Although neither guarantees long-term security, the former provides more of it in the immediate term.

Applying this lesson to Apple leads to the startling conclusion that Steve Jobs' departure, and the subsequent loss of his innovative leadership, may leave Apple up a creek without a paddle.

If you have questions or concerns about this conclusion, feel free to comment below.

The Motley Fool owns shares of Apple and Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft, Amazon.com, Apple, and Salesforce.com; creating bull call spread positions in Microsoft and Apple; and shorting salesforce.com. Try any of our Foolish newsletter services free for 30 days.

Fool contributor John Maxfield does not own shares in any of the companies mentioned in this article. 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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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 30, 2011, at 4:00 PM, 1984macman wrote:

    Wow. Talk about focusing on the trees and forgetting about the forest!

    1. So-called analysts have been saying for decades that Apple is incapable of more innovation. Wrong then, and wrong now.

    2. Kindle has "no viable competitors"? Oh, PLEASE! What do you think the iPad is, or the Nook for that matter?

    3. Comparing Apple with Amazon is like comparing roller skates to a Rolls Royce. Amazon has a huge P/E primarily because it doesn't have much E. Apple has a tiny P/E because it has a huge E. The reality is, it's P simply can't keep pace with its E.

    4. The so-called Law of Large Numbers doesn't apply to Apple yet. It has a miniscule market share in phones, only about a 10% share in computers, and completely ownes the extremely nascent market for tablets. Ergo, in spite of what you term "astounding" numbers, they are destined to get many times larger.

    4. Steve's departure has been well planned for, unlike his original exit. Frankly, by far his greatest success is the company he's leaving behind and its ability to stand on its own two feet!

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