In my last posting, we looked at some calculations for the stock market equivalent of royalties that operators such as AT&T, Deutsche Telekom and O2 are required to pay Apple, and the result was a sum of $90 billion. Let me be the first to admit that this constitutes an exceedingly bold statement.

My estimate was based on set current values (P/E ratio and profits), assumptions (number of iPhone users) and unknowns (royalty regulations). Let’s begin by taking a look at the set values.

The easiest and most common valuation method used by stock market investors is the price-earnings ratio. Finding the P/E ratio is relatively simple; to do so, you divide a company’s current market capitalization by their annual earnings. The higher the P/E ratio, the more expensive the stock and the higher the company’s assumed growth potential (I’ll elaborate more on this issue in a coming blog entry). Apple, as a growth stock, is currently valued at a high P/E ratio of 43. In comparison, Microsoft is only half as expensive with a P/E ratio of 22 and Google has a P/E ratio of 51. Apple’s declared 2007 earnings totaled $3.496 billion, equaling a market capitalization of $150 billion.

Here’s where things start getting more complicated. P/E ratios are volatile and depend heavily on the particular company’s growth prospects. If these prospects worsen, the P/E ratio sinks rapidly; companies with traditionally slower growth rates, such as those involved in the pharmaceutical industry, are valued at a P/E ratio of around 14 to 20. If Apple were to lose its current tremendous growth momentum, the consequences would be drastic – around $100 billion of $150 billion market capitalization would quickly disappear.

The imperative question involves how much growth Apple will need in order to live up to the market’s expectations and how much of their royalty fantasies are already priced into the current P/E ratio of 40+.

This valuation will prove justified if Apple can maintain the 60%+ in earnings growth witnessed in recent years (earnings per stock rose from $2.36 in 2006 to $4.04 in 2007). Apple more or less yielded this growth without revenue from royalties and AT&T has only been paying royalties on the 1.2 million iPhone customers since the 4th quarter of 2007, so the effects will only be noticeable next year. On the one hand, the base of iPhone users will increase dramatically in the following quarters; on the other, Apple collects royalties across all four quarters. Gene Munster from Piper Jaffray recently made the first calculations (approximations) as to how much Apple receives from AT&T per customer and came up with a monthly figure of $18 per customer. When multiplied by 10 million iPhone users, this totals $2.16 billion in additional annual gains!

We can assume that Apple will yield around $5 billion in annual earnings in 2008 (without royalties) based on similar earnings growth as seen in 2007. If we figure in the $2 billion in additional earnings from royalties, we arrive at a sum of over $7 billion in profits – twice as much as in 2007. With an unvarying P/E ratio of 40+, this totals a market capitalization of $300 billion - twice as much as now! I’ll let you do the math based on 20 million iPhone customers yourselves.

These figures absolutely involve a fair amount of speculation. Then again, it’s not only speculation. What will really prove decisive is whether Apple will be able to sustain its extraordinary earnings growth and what the company will do in two years when the exclusive contracts with the operators expire. Will exclusivity be abandoned? What about the royalties? Will they develop a whole new business model entirely? The answers to these questions certainly hold the potential to nix the above calculations, but I’ll elaborate on these thoughts in my next posting.

Next blog: What would happen if… ?