[By Duncan McLeod]

Something extraordinary looks set to happen soon in the world of technology. Apple, virtually bankrupt 14 years ago, is on the verge of overtaking Microsoft as the world’s biggest tech company by market value. Is its stock overvalued?

It would take little for Apple to displace Microsoft. Only about 10% separates the two companies when it comes to their market capitalisation — a measure of a company’s value calculated by multiplying its share price by the number of its shares outstanding.

As of Friday’s close on the Nasdaq stock market in New York, Apple’s market cap was US$246bn against Microsoft’s $272bn. The difference, $26bn, might seem like a lot — in rand terms, it’s nearly R200bn, or the market value of MTN. But one positive analyst report could push it over the top.

Apple’s share performance over the past year, and the past decade, has been nothing short of phenomenal. In the past 12 months, Apple is up 119%; Microsoft is also up, but by 48%. Over a decade, Apple has risen by more than 800%; Microsoft has fallen 22% in the same period. If Apple keeps up its performance, its market value will overtake Microsoft’s within the next few months.

Of course, market cap isn’t the only way to measure the size of a company. Microsoft’s revenues and profits are higher. To a large degree, market cap reflects investors’ expectations of future profit rather than providing an accurate measure of historical or current earnings. And investor hubris can distort the value of companies and entire markets. Witness the dot-com bubble when, in 2000, networking company Cisco was briefly the world’s most valuable company, with a market value of more than $550bn.

So the question is whether Apple’s stock is overvalued. Technology pundits often suggest a “reality distortion field” surrounds the company’s products, that anything Steve Jobs announces at his rock star-like press conferences, no matter how bad, will be snapped up by eager Apple fanboys. But does the distortion field extend to Apple shares?

A basic but reasonable way of measuring whether a company is overvalued is to look at its p:e multiple, which shows the relationship between its share price and its earnings (historical or predicted).

Apple’s trailing p:e is 23 against Microsoft’s 16. The average for technology stocks in the US is more or less at the midpoint of the two. On this basis, Microsoft appears to offer more value to shareholders, especially given that it pays dividends and Apple does not.

But that doesn’t necessarily mean Apple is overvalued. Apple could deliver stronger earnings growth into the future than Microsoft — an entirely reasonable assumption. Forward p:e, calculated using expected earnings one year out, puts Apple on 18 and Microsoft on 13,6 — both relatively undemanding for US tech stocks.

Some investors prefer the so-called PEG, which takes a company’s p:e multiple and divides it by its expected earnings growth (sometimes over up to five years). A value of less than one suggests a company is undervalued; over one and it may be expensive.

Using the five-year earnings measure, Apple’s PEG ratio is an undemanding 1,14 whereas Microsoft looks expensive at 1,42. On that basis, Microsoft is vastly overvalued and Apple marginally so.

Of course, PEG ratios rely on difficult-to-predict earnings growth. And they work best when applied to high-growth companies, a category that Microsoft no longer falls into.

What the PEG ratio suggests to us, however, is that Apple isn’t grossly overvalued, despite it being on the verge of overtaking Microsoft as the most valuable technology company in the world, a prospect that was simply unimaginable a decade ago.