The simple reason why so many Apple investors got burned

January 22, 2013, 7:52 PM UTC

FORTUNE — While riding the exercise bike at my health club during lunchtime, I’ve been pedaling through Benjamin Graham’s classic, The Intelligent Investor. Last week, I read a passage that made me pedal faster. In Chapter 12 of the updated 1973 edition (with excellent notes by Wall Street Journal columnist Jason Zweig), Graham states that studying a company’s average earnings over several years can prove a far better guide to its future performance than extrapolating future results from a run of exceptional quarters. “In former times,” Graham writes, “analysts and investors paid considerable attention to average earnings over a fairly long period in the past. It was thought to give a better idea of the company’s earning power than the results of the latest year alone,” a view he heartily endorses.

Indeed, throughout The Intelligent Investor, Graham argues that big spikes in earnings often arise from extraordinary circumstances that don’t last. The catalysts are everything from a surge in the business cycle to the launch of breakthrough products. For Graham, a fundamental error is relying on a price-to-earnings ratio based on the past year’s earnings alone, especially if those profits are spiking far above the company’s past growth trajectory.

In other words, a PE based on “inflated” profits can make a stock look cheap when it’s really expensive based on what the company used to earn, and will probably earn again.

Spinning through this field of wisdom, I immediately thought of the travails surrounding Apple (AAPL). Was Wall Street using the same faulty thinking to misjudge Apple that Graham warned against decades ago? Since reaching a record high of $705 on September 21, Apple’s stock has tumbled 29% to $500, erasing $184 billion in market value. Apple will release its first quarter results (its fiscal year ends September 30) on Wednesday in the most eagerly-awaited announcement of the earnings season.

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For Graham followers, the question is whether Apple’s gigantic jump to profits lulled investors into falsely believing its stock was still cheap at $705. In fact, it actually looked reasonably priced, assuming its unprecedented profits were the “new-normal-and-growing.” On the other hand, it looked extremely expensive based on the past earnings history that the sage considers so important. That’s the message the market seems to be delivering now. So let’s determine what the Graham’s earnings test would have shown when Apple stock reached at its pinnacle last fall.

In late September, Apple’s market cap stood at $663 billion, the largest in US history, dwarfing Exxon ($411 billion), Wal-Mart and Microsoft (both $230 billion). Still, the shares hardly looked pricey based on Wall Street’s favorite metric for judging if a stock is cheap or dear, the PE ratio based on the last four quarters of earnings. For fiscal 2012 (ended September 30), Apple earned $41.7 billion, an extraordinary 39.5% rise from $29.9 billion in 2011. Though the market value was epic, so were the earnings. Based on those fiscal 2012 profits, Apple’s PE, using the standard trailing four quarters of earnings, stood at a modest 15.9. Wall Street seized on that number to tout Apple as a great buy.

The “average earnings” test preferred by Graham pointed in the opposite direction, towards danger. The 16 multiple meant that Apple would need to generate substantial earnings increases, over and above the $41.7 billion, to keep the stock rising. Investors were still expecting an annual return of around 8.3% (that’s the earnings yield of 6.3% plus 2% anticipated inflation). In August, Apple went from a no-dividend policy to paying out $10 billion a year to shareholders. At the September peak, that dividend represented a 1.5% yield. So investors expected an additional 6.7% (the 8.3% expected return minus the 1.5% yield) from growth in future earnings.

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The nearly 7% growth requirement sounds like a snap, given Apple’s explosive record. The problem is that, at $705 a share, the market was anticipating significant increases on top of already gigantic increases and gigantic earnings. By 2017, Apple would need to earn $58 billion to hand shareholders that 8%-plus return, and its valuation would soar to over $900 billion.

So what’s the picture if investors had also weighed Apple’s past performance? Over the past five years, Apple’s average earnings, based on four trailing quarters, is $16.1 billion. Over the past three years, the figure is $22 billion.

Neither number gives a definitive view of Apple’s future earnings potential. But they indicate strongly that Apple’s stock in September was not cheap at all, but an extremely pricey, risky bet. Even using the $22 billion number, its adjusted PE was 30. At those levels, any disappointment causes a steep sell-off. And that’s precisely what happened.

The Wall Street pitch was that Apple had reached a new earnings threshold, and that profits would soar from there — just the kind of prediction that the Graham method debunks. In October, Morningstar, Merrill Lynch, Morgan Stanley, JP Morgan, Deutsche Bank and Goldman Sachs placed target prices of between $714 and $880 a share for 2013 on Apple’s stock, which had already declined to around $600. Those projected prices all exceed the September peak, and average $776.

To support their view, the Wall Street firms all forecast big gains in earnings, ranging from 8.2% to 23%, and averaging 10%.

But reviewing Apple’s 10K, investors would naturally fret whether the fantastic margins that propelled the tech colossus to over $40 billion profits were not just repeatable, but eminently beatable, as the analysts were forecasting. For fiscal 2012, the iPhone and related products accounted for 51% of Apple’s revenues, and generated gross margins, before R&D and corporate overhead, of 56%, 20 points higher than the iPad and iPod.

Margins that high are a magnet for competitors, and almost always prove ephemeral. Now, the iPhone is facing a highly-publicized challenge from Samsung’s Galaxy. It’s not even clear that Apple is a bargain now after its almost 30% fall, based on the average earnings test. There’s nothing like re-reading old Ben Graham to keep a check on Wall Street’s wild expectations.