Understanding the Valuation Discrepancy Between Apple, Inc. and Alphabet

Image source: Apple.

For all intents and purposes, Apple (AAPL 0.52%) and Alphabet (GOOG -1.96%) (GOOGL -1.97%) are tied in the superficial race to see who has the largest market cap. Alphabet surged to take the token title of "world's most valuable public company" earlier this week in the wake of a strong fourth-quarter earnings release, only to give it back to the Mac maker just a couple of days later.

Let's just call it even. But as both tech giants boast similar market caps, their valuations are still drastically different. Why is that?

One of these is not like the other
For starters, let's lay out a few key metrics.

Source: Reuters, Morningstar. All figures shown on a trailing-12-month basis.

Apple's top and bottom lines are meaningfully higher than Alphabet's, and revenue actually grew more over the past 12 months. But Alphabet earns over three times the valuation multiples shown. Alphabet enjoys higher gross margins since the company predominantly offers software and services, with little meaningful hardware operations compared to Apple, but its operating margin is slightly smaller (more on this later).

Generally speaking, valuation metrics are a function of future growth prospects more than anything else. Investors clearly think that while Apple and Alphabet are worth about the same in absolute dollars (market cap), Alphabet is worth a lot more in terms of its future growth potential.

Doors of perception
There are few reasons this makes sense. Since Apple's top line is so massive, it does take a lot more to move the needle financially for the company. There's this unshakable suspicion that Apple's revenue is peaking, a view that's reinforced by guidance for the current March quarter.

Meanwhile, the market perceives Alphabet as having a plethora of untapped opportunities. This perception is indeed justified considering the company's penchant for experimentation, but at the same time, the market does not perceive that Apple is capable of the same thing. There's a slight disconnect, here.

The whole reason Alphabet is now called Alphabet is because the company reorganized in order to give greater transparency to these Other Bets. The company just reported its first earnings release following the restructuring, and it finally shed some light on these hopeful moonshots.

Source: Alphabet.

Alphabet has lost $5.5 billion over the past two years related to Other Bets. This is largely why Alphabet's consolidated operating margin is lower than Apple's. The stand-alone Google segment operating margin last year was 110 basis points higher than Apple's overall operating margin.

Everybody's doing it
Here's the thing: Apple is working on a lot of the same things. They just won't tell you about any of it. I hear that the company tends to be secretive about what it's working on. There are a handful of very promising major tech trends on the horizon, areas that all of the tech giants are investing in. Things like self-driving electric cars, connected homes, virtual/augmented reality, or deep-learning artificial intelligence, among others.

Both Apple and Alphabet are absolutely looking into all of these topics; that's not the question. Apple will do it as secretly as it can, save for the occasional headlines about its hiring activities, while conveniently absorbing any related operating loss in its overall consolidated results. R&D expenses have been rising as a percentage of overall revenue, after all, but just because Apple won't disclose these projects as its own operating segment doesn't mean it's not thinking ahead.

To be clear, Apple is likely only focusing on these bigger ideas, not the true "moonshots." I don't think Apple is all that concerned about smart contact lenses or Internet space balloons. So, to some extent, investors are underappreciating Apple's potential in many of the same areas where they recognize Alphabet's. That's a disconnect that contributes to the valuation discrepancy between the two companies.

The real test will be how each company executes in each of these burgeoning fields, and how well they can build businesses around these new technologies. It's still true that it will take a lot more for Apple to ever launch a product as successful or financially game-changing as the iPhone, so you could say Apple's valuation is a victim of its own success. But that doesn't mean it's not trying.