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Apple's Intrinsic Value, Part II



February 21, 2012 – Comments (0)

Board: Apple

Author: Manlobbi

Part I -

Apple's Intrinsic Value Part II

With a company as well-covered as Apple and with so many colorful stories surrounding the company's past and future it is especially important to stick to facts when calculating the intrinsic value – the price that the company will hover around over the years. Intrinsic value has exploded so much over the last ten years that the term “hover around” is hardly as applicable as forever “chasing upwards”. Such past mis-pricing cannot be blamed on the investor – Apple's changes of path and continued extent of success was was in no way predictable from genuine recollections of the past environment not distorted by the present.

Extrapolations into the future can however take into account the qualities of the present management. We must not extend our expectations of continued growth of various figures arbitrarily. The management will need to work extremely intelligently, extremely hard and will require great luck for even one third of the results that have been achieved recently.

This concentration upon management is quite a different line of thought than considering the outcomes of the current sources of revenue or or even more abstractly the financial numerical trends alone. By looking at the then-current revenue sources and estimating their sustainability in almost any given year between 2003 and 2012, the investor would have been mislead into greatly undervaluing the company.

Before proceeding with Apple, consider three categories of medium-size or large corporations: (1) The business will probably grow earnings per share at the rate of an average company for these 15 years – this is not to be sneezed at and well above all the other companies that under-perform. (2) The business grows earnings per share temporarily at a higher rate that the market average (for say 2 to 5 years) before resuming growth at the market average rate. (3) The business can continually (or for 15 years anyway) sustain a well-above-average rate of earnings per share growth. For context, the average United States company grew EPS (earnings per share) at only 1.5% per year after inflation over the last 100 years and so we will say that if a company can sustain EPS growth at at least 7% after inflation for 20 years then it meets this most elite category (it is only this category allows for "multi-bag" returns).

In the case of category 1, the P/E multiple will be by definition hang around the market average of say 13 and vary according to (i) temporary conditions related to the company and (ii) the mood of the overall market. In the case of category 2 investors will raise the P/E to discount the temporary growth of earnings per share; as the company reaches these higher earnings the P/E will contract to the average level as with other category 1 companies. For this reason the investment return is no better than that of the category 1 company owing to the initially inflated P/E. Commonly companies of category 2 have patents or another time-limited economic moat which allows for the sustained elevated growth for some years. It also includes higher quality companies that have a true moat but they are not able to reinvest capital within that moat and so the earnings growth tends towards a common-place rate over time as the size of the business within the moat become increasingly less significant than the total. For category 3, it is particularly interesting that the P/E will begin elevated … and stay elevated even after a series of years of above average earnings growth; correspondingly the investor will be awarded outstanding returns that approximately match this EPS growth. Investments of category 3 are extraordinarily difficult to identify however if one can be find them then a particularly high P/E multiple can be paid by a long-term investor because eventually the earnings will compound to overwhelm the initial earnings. Any company of this category will not only have an economic moat that never seems to dry out but they company will be able to re-invest any amount of new capital from earnings within that moat. In truth the company and their Shareholders will, no matter how impeccable the management is, also require some luck at various stages.

As for Apple, category 4 is not entirely out of the question but we will consider it to be entirely out of the question in our analysis. The question that remains is whether the company is of category 2 or category 3. The market is presently giving the company an ex-cash P/E multiple below that of an average company and so treating the company certainly no better than category 2 – that market believes that the current earnings likely to remain more or less the same on average after inflation for many years. I highlight the word 'believes' because it is not entirely true – the market trading volume is dominated by short-term traders who have the task of outguessing each other and most of the volume is not based upon estimating the market price's relation to the central value of the company – however they nearly intersect within seven years and usually within three or four years.

Philip Fisher stated an interesting condition as mandatory for an excellent investment: “Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?”

The interesting thing about this question is that it is phrased with a focus on management rather than the opportunities as they exist abstractly outside of management. If this question was asked in 2003 years ago it would not be expected that Apple Computers would later be drawing most of their profit from selling iPods however the question would have remained affirmative as applied to the management's determination in spreading to outside sources (“Does the management have a determination to …” ). If the question was asked at the later instance in 2006 then it would not be expected that phones would even later dominate the company's earnings, nor would the opportunity to break into that field prior to their announcement be considered realistic. The management at Apple must be given great credit for this performance and while Steve Jobs cannot support management, the management culture at large and the other members of management at large have not changed – so the answer to Philip Fisher's specific question remains affirmative.

Part III next - will discuss Android

- Manlobbi

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