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Apple's Intrinsic Value, Part V



March 08, 2012 – Comments (0) | RELATED TICKERS: AAPL

Board: Apple

Author: Manlobbi

Parts I, II, III, IV

In the earlier four parts we dealt with the subject of management, barriers (limitations) to growth, the subject of sustainability of earnings from long-living moats, two calculations of the intrinsic value and various topics relating to investment principles more generally. In this final section we'll talk about how to deal with a company like Apple trading below intrinsic value.

Estimating the central value of $900 for Apple after three years is not to realize an excellent return over this period period - for we don't have much of a clue that the actual price will be $900 but rather the central fair value will be in that vicinity. We estimated the intrinsic price at that time by combining a reasonable terminal earnings per share (how the market will be likely to look at Apple at that time) and P/E multiple and adding on the change in book value – in this case the increase in cash holdings which without excellent opportunities for capital expenditure can be paid out as dividends.

The superior investment technique for realizing an excellent return is to take advantage of situations where the present share price is heavily discounted from the intrinsic value and then take advantage of future quotes at some point in time in the future where the P/E multiple expands beyond the then-calculated central estimate. A key difference between successful and unsuccessful investors is that the unsuccessful investor will be highly concerned with the time at which this some point occurs. The time in which this occurs does not matter to a more successful investor. The time that one must wait cannot be predicted as this depends on the changing moods of the market and it is indeed those changing moods that are to be exploited. It matters only that the investor takes advantage of the opportunity according to the event occurring rather than according to an unrelated trigger or simply their own changing mood.

If the undesirably high price for Apple is when it trades at a P/E of 18 while a view of the future indicates a narrowing of the moat, only a moderate improvement of earnings and that a reasonable P/E should be 14 – and if multiple of 18 this does not occur after a few years then many investors may give up hope and sell without any gain, or they allow the P/E to reach 18 and then become sufficiently enthusiastic as to hold the shares for longer until the P/E falls back to 12 and in frustration they then sell the stock without a significant return. If the P/E passes 18 at some point in time it will likely be when either (1) other companies are also trading at high multiples owing to a generally higher level of excitement within the market or (2) the earnings of Apple have risen sharply, for example the earnings rising from $50 per share to $80 per share over a year to produce a share price of $80 * 18 = $1,440.

Wall Street has a history of assigning overly high P/E multiples following a period of rapid but temporary earnings growth which is exactly when the P/E multiple should be particularly low to reflect the temporary nature of the higher earnings.

Wall Street also responds to temporary deflated earnings with overly low P/E multiples exactly at the time when the P/E multiple should be particularly high to reflect the temporary nature to the reduced earnings that will be followed with a revision to normal earnings. The following chart shows the market making this error particularly over the last couple of decades:
- In this chart the orange line for earnings is clearly in a high point in the cycle and the blue line (S&P500) will intersect the orange point at a lower range at some point in the future. It is difficult to make a case for the S&P500 not falling below 700 at some point. The market makes the mistake as treating current earnings as permanent. Similarly the market may make that mistake with Apple when the earnings temporarily reach a maximum point of inflection a few years in the future.

Charting the peaks and troughs of earnings with a fixed multiple and the corresponding share price would, if there were only intelligent investors involved, result in the share price similar to a line of best fit through the peaks and troughs. History on the other hand shows that the share price typically only exaggerates the peaks and troughs with even more chaotic swings. These peaks and troughs bring great opportunity to a very good investor to realize returns well above the market average provided the company is correctly understood to be enduring and thus waiting periods to buy and sell on favorable terms can be arbitrarily long. Investors have the freedom to buy and sell when the quote suits them rather than buying and selling according to fixed periods of time or worse, alluring metrics such as a certain small percentage gained or lost which turn one from an investor into a gambler.

The best result for most investors holding Apple, or any other company, is that the intrinsic value rises regardless of what happens to the share-price – for the share price will always intersect the intrinsic eventually, and almost never less frequently than once every seven years. The intrinsic value rises for a company like Apple by either (1) the next years of expected earnings per share rising or (2) any marginal increase in the economic moat width, such as the adaption of iCloud within the Mountain Lion OS release.

Looking further ahead, Apple has not done this for a while but it will occasionally deliver flops or have the existing product lines fall out of favor for some time before returning back into favor numerous years later. Accordingly, while such disturbances cannot be relied upon, it should not come as a surprise if there are opportunities to purchase shares at a greater discount to intrinsic value than today. With high operational margins the earnings have a much stronger chance of remaining relatively robust in the event of exogenous mishaps or one or two lines of products drifting out of favor faster than management anticipates.

With the current management and culture in place Apple will (i) on the whole continue to develop excellent products and powerfully delight the public with new releases not always, but more often than not over the years; (ii) further success will not come from Apple's brand and other intangible assets - management will continue their planning, attention to moat, superior financial management and execution excellence combined with unusual flexibility in the field of product innovation along with market awareness; and (iii) many more people will be using Apple products with many more products sold annually five years into the future compared to now – and with careful consideration to the above discussion of their moat and the continuation of the present management, more products again will be sold annually ten years into the future. Purchasing at today's share price of $500 at an ex-cash P/E of 12 and wearing a blind-fold for the next five years will result in a satisfactory investment result given my estimate of intrinsic value about 40% higher, the existence of a sustainable economic moat and the growth still at an early phase relative to the growth boundaries identified.

Waiting for the opportunity to sell upon the price ever surpassing intrinsic value and replacing with a cheaper opportunity at that time will result in even greater returns. Hint: While waiting study Berkshire Hathaway, it might still be available at 35% discount to intrinsic value at that time as today. But there I'm badly digressing...

- Manlobbi

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