Apple's Intrinsic Value, Part IV
Parts I, II, III
In Part I we discussed boundaries to Apple's growth and I'd like to add a few more comments here about that. Apple does not have the problem with investing new capital within its moat – new products join the developer-software-user ecosystem and acquire the advantages of Apple's brand. However it does have limitations of growth – upper bounds – for each of the three growth categories described above. Greatly offsetting this problem, these growth categories act multiplicatively together to provide a satisfactorily high upper bound. To emphasize, these estimates are for the upper bound are not estimates for Apple's results which need to stay well within the boundary for there to be any further opportunity. The international expansion assumes no market share increase and just assuming mirroring of present market share to other regions – let's say this accounts for a maximum growth factor of 2 – McKinsey's report in 2006 forecasted that in 2025, China's middle class will comprise 612 million (1.6x USA and Europe combined) with incomes between 25,000 and 100,000 renminbi so China alone might provide half of this 2x growth. Now looking just at established products, let's say the market share combined with industry expansion allows a growth factor of 3 (MacBooks and iPads might only be able to expand 4x on aggregate versus PCs while the more significant iOS market share of smart-phones might only have a realistic potential for 25% with the onset of Android while the smartphone category itself expands by 3x taking share from Nokia); new product expansion might increase the growth boundary by a factor of 1.5. Then the total growth has an upper bound around 2 * 3 * 1.5 = 9 times current earnings. While this upper bound can hardly be expected to be achieved the multiple is sufficiently high to not pose any problem with the conservative estimates we'll be using – the boundary somewhere around this vicinity should however be kept in mind with all the other information as more of a limiting rather than opportunistic factor.
Before proceeding with an estimate of Apple intrinsic value, consider again the three categories of medium-size or large corporations, this time with some added notes: (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 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. What is of important interest about category 3 is that, like category 2, the P/E will begin elevated however it is also 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. The market had a tendency to inadequately raise the market price upon the existence of a strong moat. 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 the company will be able to re-invest any amount of new capital from earnings within that moat. Provided the moat stays intact there is no reason to sell this company at any stage. Even if the company of category 3 is overvalued temporarily and a strategy to sell the company and then buy it back later is attempted, this will undoubtedly fail because in order to simply break even the difference between selling and buying must be at least 30% owing to the tax loss – holding a company forever allows the tax liabilities to be compounded as part of the whole. This hurdle does not exist for companies of category 1 or 2 in which we are exploiting temporary large differences between intrinsic value and market valuation.
As for Apple, category 3 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 1 or category 2. The market is presently giving the company an ex-cash P/E multiple of 11 which is below that of an average company and so treating the company certainly no better than category 1 – 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 that this is what the market believes and this is not how markets work – 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 the two nearly intersect within seven years and usually within three or four years.
With this additional background, let's jump straight to some numbers again. This is always my favorite part, perhaps because it is so easy. Apple plan to have capital expenditure of $8 billion over the next financial year versus $4.3 over the last year. About $1 billion of this might go to their new headquarters however from $4.3 billion to $7 billion is a telling increase. With their history of very careful spending it shows that they seriously intend to expand operations. In their 10-K filing they provided some background to part of the spending: "In our opinion, iCloud is one of Apple’s most important services since the launch of the iTunes store in 2003, given its role as a convenience factor for customers – fostering loyalty within the Apple ecosystem and driving the 'halo effect' that helps sell more devices".
Over the last year Apple earned $35 per share and presently have $75 per share of net semi-liquid cash equivalent investments. We will assume that with the discussion thus far Apple will be earning $70 per share after three more years. This figure assumes that they are unable to release another product category that significantly impacts total revenue growth but they are able to continue to provide convincing product upgrades and continue to erode market share from PCs (with most of this replacement stemming from the increasing interest in iPads rather than MacBooks). The earnings can be taken as conservative given their pattern of growth, the quality of their software in place and the present rate of both ordinary phone to iPhone migration and Windows to iPad/MacBook migration assumed to continue but at a slower rate.
We will also presume that internal relations within management continue to be excellent and the unique culture at Apple is not compromised over this relatively short three year period. After three more years we'll further imagine that growth prospects - from then onwards - are seriously compromised with the threat of loss of smartphone market leadership balanced rather evenly with the prospect of further growth and overall for earnings prospects from the point (considering all product classes carefully) after these three years of growth to be diminished to that of an average company even – quite a step back when viewed against the latent potential of management that will remain in place. This is a rather negative assertion as the same management will still be in place, the smartphone industry has a long way to expand and Apple's iPad/laptop (which I view as one category owning to iPads now displacing PCs) market share is still small with highly desired operating system. In any case we will imagine that after three years Apple's future looks sufficiently unpromising that they at this time trade at an ex-cash multiple below the market average of 10 times earnings.
This would give a share price three years away of 10 * $70 for the enterprise plus approximately $75 per share of current cash and say $125 per share of newly saved cash. This gives share price of $900 per share if the investment was sold after three years during this somewhat depressed state in which the ex-cash P/E has fallen to 10.
In Part 1 I arrived at a central value today of $700 per share which is about as favorable as this central estimate of $900 three years ahead – the estimates are quite compatible. In the event of the ex-cash P/E multiple falling significantly below 10 if for example the share price falls without the earnings falling, the astute investor can simply wait for a favorable time to sell at a P/E multiple that better suits their view of the future earnings. As discussed in the next section, if we wait for the opportunity to sell at a higher P/E then an exceptional return can be realized by the investor buying as late as today given the almost certain near-term excellent earnings growth.