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Apple's Intrinsic Value

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February 16, 2012 – Comments (0) | RELATED TICKERS: AAPL

Board: Apple

Author: Manlobbi

The calculation of intrinsic value needs to pay great attention to business' economic moat. I have spent the last three days almost exclusively researching and thinking about Apple's moat - and not just how it appears right now as the definition of a true moat requires thinking about a changing environment many years out. You can't predict what the changes will be but you have to bet on the environment appearing quite different and think about the elements in place now that allow the business to endure through the changes. Ten years ago  Shareholders of Nokia talked about their company's moat owing to the incredible loyalty towards the brand, the low cost of  product owing to scale dominance and exceptional management. The moat looked wide. But the environment changes. Companies like Coke tend to have true moats because their business is immune to changing environments.

Apple's moat right now looks extraordinary. On paper it is incredible, looking at it less superficially it has some problems but is still difficult to refute. Remember that a moat  needs to be indestructible in order to be a moat. Key moat categories include:

1. Low cost of product or cost advantage. - Ticked

2. Network effect - Ticked owing to: - Feedback loop between numbers of users and number of app developers, similar feedback loop that MS DOS and PC software developers enjoyed. - New products joining this feedback loop so the feedback loop scales with both users, increasing product classes and increasing developers (multiplicative).

3. Switching costs - Half-ticked (still good, some moat companies have it better here). - Nuisance of moving away from Mac Laptops and other products once you get used to them - note that the point about switching  costs needs to be applied only to those that want to move  away from Macs or iPhones for price or other reasons, not the  people who still love them, but stay with the product owing to  tangible or intangible switching costs).

4. Intangible assets - Ticked owing to: - OS architecture (phenomenal abstraction layers being the main thing that defines and differentiates the products). If you give a company a $500B you can't necessary come up with all of this in competitive time. - Huge developer engagement on the computer OS side as well as mobile OS side. - Bubbling brand increasing demand and thus margin power. This part of the moat has staying power however it can fluctuate from decade to decade, but while it is cheery it does provide additional demand and pricing power.

Often for a moat you only need two or three of these for categories provided they are fairly close to indestructible.

Apparent moats however can fall to pieces - such moats are by  definition not true moats so one needs to think deeply about them. Competitors can get through the Network Effect category of moats by  dominating in a smaller niche before expanding the network outwards from  that niche. An excellent example is Facebook concentrating on dominating  a university, then numerous universities (still niche) while MySpace and  Friendster already had the network effect huge head-start that from  which they had no excuse to fail, but did.

I'd be interest to hear people's ideas about serious threats to Apple's moat which over the past seven years has allowed for such superb margins as well as revenue growth.

To emphasize, when thinking about moats we are trying to estimate threats to Apple over a series of ten or fifteen years, not just threats over the next few years. This is then combined with the likely magnitude of sales we may expect ten years away in order to come up with a sensible multiple of today's earnings and arrive at our goal of calculating the intrinsic value - the reasonable value which the share price will be expected to deviate around over a series of five or so years (typical time for share price to intersect intrinsic value). The intrinsic value is relatively stable, it moves with the expected future earnings which in turn move less the annual earnings which are more volatile. The share price however is relatively chaotic, deviating at times below intrinsic value and at times above but intersecting at least once every seven years (more frequently for companies like Apple which is always in the news). What appears to have happened with Apple is that the intrinsic value has moved up so rapidly that the share price has not had enough time to catch up. Trading still dominates the volume and traders will have been entering and exiting euphorically  (nearly always successfully) but the price rate of change might have lagged intrinsic value rate of change.

The next thing to consider of utmost importance beside Apple's moat is their opportunities to expand sales over a series of many years. When you think about people with an iPhone, iPad and MacBook Pro upgrading each product once every two years - a hardcore customer - there comes a point where they just can't spend more money each year - so the product cross-filtering only works up to a point (not continuously scalable). The more important avenue for growth is gaining new customers and some opportunities  include:

1. Entering China - presently there but only 5% market share of SmartPhone market (and this high end phone market itself expanding rapidly and Apple's 5% will rise within that also). Nokia still dominant there - Chinese do not like having fake copies of things and prestige in owning original Apple products already similar size to US but China  market will end up being quite larger than the US. 2. Established products, other than iPhone, still have a long way to grow: i. iPads continuing to take market share from Windows computers - have a long way to grow. ii. MacBooks continuing to take market share. Presently  only 5% in largest market - US) from Windows computers. 3. While the above continues growing, introduction of new products starting with TVs that do not replace existing products but use their branding, iTunes and Apps moat as competitive advantage. Like the iPhone did, the  TV will cross-fertilize buyers to other products.

Some businesses have moats but a limit upon the sales growth. For example you could be a coffee shop with loyal customers but only one shop - you might make a lot of money with everyone coming to your shop but in trying to expand you might find that the moat does not extend to the next shop - so you just retain the one shop and keep making a huge return on equity (more customers continued year after year). Of the three growth points above, only the third point has a relatively low upper bound - while 1 and 2 can provide the opportunity (this does not mean it will happen but we must first consider where the bounds are) for revenues increasing vastly (the upper bound might be five times current sales, so sufficiently high that the boundary is not a significant concern versus the kind of multiple I'll be assigning to the current earnings).

Next relating the moat and growth opportunities to current earnings.

When assigning a P/E multiple it is important to look at a  conservative estimate of how earnings will be sustained or grow over a really long period of time such as 15 years. The use of the word 'conservative' is important, not merely because it provides a margin of safety, but much more importantly because it causes one to think about the relationship between the moat and the future earnings. In estimating earnings conservatively we attempt to throw all sorts of obstacles at the company and ask whether we expect it will still be making the same amount of money 15 years ago, and if more, then how much more after throwing all the obstacles at it.

Given the existence of the moat combined with somewhat tempered conservative long-term (15+ years) growth opportunities  we might assign a P/E multiple today of 20, versus the broad market's historical average P/E of 13. This multiple appears fairly rich however it must be placed against the above discussion of Apple's moat and combined with their significant, even if bounded, growth prospects.

In their last conference Apple expected the next quarter will bring earnings of $8.50 per share. Last year they sustained their earnings through Q2, Q3 and Q4 which rose in Q1 owing to people delaying iPhone 4S orders until its release. In any case as I am factoring growth from the current earnings and *not* future  earnings in selecting the P/E multiple of 20 above, it necessary to use the trailing earnings per share of 14+7+7.9+6.5 = 35.4 which gives an intrinsic value of approximately 35.4 * 20 = 708 per share.

This is not to say that the stock might not rise significantly higher owing to (1) the company having a temporary condition at some time in the future, let's say 2015, of extremely high earnings which  cannot be sustained; (2) Wall Street becoming excited about technology valuations at some stage in the future and accepting a high earnings multiple (say 25) temporarily. Often the excitement and high P/E ratios correlate with temporarily high earnings so you have price spikes which aren't rational but happen anyway. For example earnings of $70 per share in 2015 combined with a P/E of 23 would give a shre price of $1,610. This seems ridiculous now but the environment changes.

This seems to move away from the subject of investing and into speculating, however the last paragraph is not entirely of no value. A investor will favor price volatility as something to be taken advantage of rather than something used against them and so an expectation of a valuation above intrinsic value at some point in the future (even with the time not known that is not important) will provide an excellent exit strategy. For this reason there has to be a notion of what "above intrinsic value" is, rather than resorting to an arbitrary price or based upon the percentage gain that you have recently received.

In any case (1) buying at $500 is 29% below my view of the current 'correct' value of $700, (2) there is presently strong share price gain momentum which increases prospects looking one year out when this point is taken in isolation, (3) the higher volatility of Apple's stock price should make the time in which price intersects intrinsic value shorter than the average time you need to wait (generally less than 7 years, likely more frequent with a more volatile company more prone to periods of euphoria and disillusionment).

- Manlobbi

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