I have been coming across many comparisons between Apple (nasd: AAPL) and Google (nasd: GOOG) lately, especially given that Apple’s market cap surpassed Google’s last week. A recent example is Felix Salmon, who doesn’t think Apple should be worth more than Google as he argues in “Apple vs Google.” Mark Krieger compares Apple to Google and concludes Apple’s valuation is lofty and due for a pullback. The authors do make some great, valid points, yet their conclusion is ultimately flawed due to the failure of comparing on a free cash flow basis. Cash flow, not accounting earnings, determines an asset’s value. For the matter of an Apple-Google comparison, there are significant differences in free cash flow production, hence return on invested capital (ROIC).

I present the following analysis of the similarities/differences between the two firms.

The primary issue I take, is the common fallacy of valuation comparisons using price-earnings multiples. Last month, I wrote a rather detailed analysis about the disconnect between Apple’s reported earnings and its cash flow (Investors Overlooking Cash Earnings). This gap will widen as iPhone sales accelerate. The iPhone accounting treatment calls for its revenue to be recognized over 8 quarters, yet Apple receives cash in the full sale amount when they occur. A very astute Apple analyst, Andy Zaky, whom I highly respect, echoed my viewpoint in his recent commentary- “Apple Should Be Valued on a P/FCF Basis.” Zaky reported that many are making the mistake of comparing Apple to Google based on reported earnings multiples, which he states is inappropriate. Zaky couldn’t be more correct in that assertion. Andy Zaky and myself are not alone in thinking that the P/E as a value metric for Apple is misguided. Stephen Coleman of Daedalus Capital wrote “The price earnings multiple (P/E) is an increasingly useless metric when valuing Apple’s stock price. The reason why is that Apple now uses subscription accounting”

In summary, Apple and Google can’t be compared on a P/E basis because of the differences of accounting treatment and capital spending levels that affect free cash flow. Reported income doesn’t accurately present either firms real story. To better assess and compare Apple and Google, one must examine each firm’s cash earnings, thus P/FCF is a much more suitable metric for comparison.

Price Multiple Comparisons- Apple vs Google:

The first table illustrates the differences between P/E and P/FCF based comparisons. First, let’s compare the cash flow multiples. According to Morningstar, Apple is trading at 25.6x trailing free cash flow compared to Google’s P/FCF of 38.6x. Google’s P/FCF ratio is more than 50% higher than Apple’s, and that’s on a trailing basis. Consider that Apple will probably sell close to as many iPhones in this quarter, as it did in the past year in total. Also, factor in dozens of new countries that the iPhone will soon be offered, as well as increased exposure through Best Buy outlets. iPhone sales are certain to increase free cash flow relative to reported EPS due to the 24 month revenue deferral. As I mentioned in my July analysis, I wouldn't be surprised is Apple could generate more that $10 FCF/shr next fiscal year. Hence, Apple’s free cash flow is poised to increase dramatically. In contrast, Google’s free cash flow growth will likely match EPS growth, if even that. Google’s has high capital spending needs, and even much higher if considering cash spent on acquisitions. A more detailed analysis on the matter will be presented later.

Evaluating P/E multiples: Apple trades at a higher forward P/E- 28.9x vs 20.6x based on expected FY09 EPS. On the surface, this appears to be backwards, since Googles earnings are expected to increase 23% versus Apple’s 16%, it would seem Google should be afforded the higher P/E multiple. Thus, GOOG would appear to be of better value superficially. However, a closer examination reveals that Apple’s multiple isn’t unreasonable, rather uninformative. There are several justifications for Apple’s higher P/E multiple.

First, Apple’s FY09 estimates are most likely too low. Apple has significantly exceeded the consensus estimates for many quarters going back. 16% EPS growth is not inline with Mac sales growth which has been north of 40%. This spills over into hardware and software sales growth which has been growing roughly 30-40% Yr/Yr in recent periods. Music sales has been north of 30%. More iPhones will continue to support that growth.