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The new cheap stock on the block: Apple Add to ...

I've written a few Apple articles in my time but none of them is as important to your portfolio as this one.

Investors dream about finding obvious disconnects. Widespread misunderstanding leads to huge opportunity. We have such a scenario developing with Apple. Although Apple is the most widely followed stock on Wall Street, it is clearly the most misunderstood.

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The current perception among traders is that Apple is expensive because of its 150% rally off the March 2009 lows. Seriously, if I polled 1,000 traders, I believe that 95% of them would look at the 33 P/E ratio on their screens and tell me that they'd love to own Apple, but it is just too expensive. What they don't know, is that the 33 P/E is about to drop significantly and will set up the opportunity of 2010.

Most of us have heard that Apple is about to implement a new accounting method that will allow them to account for iPhone sales immediately rather than spread the effect over a 24-month subscription period. A few analysts here and there have made an attempt to explain the implications of this change but most simply ignore it. Why?

Because they don't understand the depth of its impact. I'm going to simplify the explanation so everyone can understand. On my first day in college, I'll never forget my Accounting 101 professor (Norm Nemrow) tell me that the P/E ratio is the single most important number in the world. This number can make investors very rich if interpreted correctly.

Steve Jobs took over the company in 1997, and Apple has generated a profit each fiscal year since 2003. Since 2003, Apple has consistently traded at an average P/E ratio of 32.17, which is consistent with today's current P/E of 33. You can tell that traders have done their homework and are strict followers of the P/E valuation.

If you're like me, you don't care too much about current P/E ratios because they are calculated from past results. The number that really matters is the forward P/E ratio because it is calculated from future estimated earnings. Well, the average forward P/E ratio for Apple since 2003 is 22.48. Any guesses what it is now?

Based on the new accounting rules soon to be put in place, and the 37 billion in cash that Apple has on its books, Apple's forward P/E is below 13. This stock has not been priced this cheaply since Steve Jobs came back to Apple in 1997.

What should Apple stock be priced at according to its historical P/E norms? Based on expected earnings per share of only $11.70 (U.S.) in fiscal 2010 (many think earnings per share according to the new accounting standard will end up closer to $13) the stock should be priced at $263 today and should reach $376 by Sept. 30, 2010. These prices do not reflect great years for Apple, they simply reflect the averages.

You want to know what a great year would look like on Sept. 30, 2010? Let's use the P/E ratio from just before the recession began in 2007. With the iPhone added to the Mac and iPod lines, Apple stock was soaring. Its forward P/E was 28.63 and its current P/E on Sept. 30, 2007 was 39.05. If we used those ratios in 2010, it would put Apple stock at $456 by the close of its fiscal year on Sept. 30.

Making a comparison between 2007 and 2010 is noteworthy because both are years of new product releases. On Jan. 9, 2007, Steve Jobs unveiled the first iPhone and it went on sale June 29. On Jan. 27, 2010, Mr. Jobs will unveil the Tablet, and it should be available sometime in the second quarter.

Both products are revolutionary, but the Tablet arguably is more so because it will single-handedly change the newspaper/magazine/book print industry as well as the mobile Internet and gaming sectors. The iPhone was not nearly as big of a game- changer in 2007.

Are the future prospects for Apple better or worse than they were back in 2007? Today Apple has approximately $40 billion in cash on its balance sheet, it has 3 billion apps downloaded through the App Store, the iPhone's international expansion is just taking off, and of course the Tablet is on its way. All of a sudden, seeing Apple stock at $210 doesn't seem very expensive at all.

As an investor, I have taken advantage of disconnects. I saw one in oil back in August 2008, I saw one in Bank of America(BAC Quote) back in February 2009. This disconnect in Apple is bigger than either one of those.

Eventually, the market will get it right as it did with oil and BAC. The same thing will happen with Apple.

At the time of publication, Jason Schwarz was long Apple. He is an option strategist for Lone Peak Asset Management in Westlake Village, Calif. He is also the founder of an investment newsletter, economictiming.com. Over the past few years, Mr. Schwarz has gained acclaim for his market calls on the price of oil, Bank of America, Apple, E*Trade, and his precision investing in S&P 500 option LEAPS.

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