[Author's note (January 22nd, 2012): One of my formulas was lacking a couple of parentheses and this was underestimating the terminal value of the stock under the "Valuation" section of the article. I have never been a huge fan of "terminal values" because it is hard to predict that much into the future. But in order to be consistent, I've corrected the numbers and replaced the spreadsheets.]
In this article, I'm going to show a valuation analysis for Apple Inc. (AAPL) that uses conservative assumptions and Buffett's "owner earnings" methodology.
The key about this model will be that I will be using safe estimates and assumptions in order to take into account that the future of technology is much harder to predict than future Coke consumption or something more simple. I will be posting links to Excel spreadsheets where the calculations were made along with the data from the company -- you can plug in different numbers and assumptions if you wish.
Let me also point out that I'm not suggesting that Buffett himself would buy Apple stock. He has already made it quite clear that he is unlikely to buy tech stocks given their unpredictability. This article is about Buffett style methods, not Buffett's opinion.
I will be using Buffett's owner's earnings metric to define the degree of profitability of the company and discount the future earnings stream back to the present.
He defined his method in the 1986 letter to stockholders:
"These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges... less (C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since must be a guess -- and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes... All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include plus -- but do not subtract ."
There is some degree of variability of what would constitute "owner earnings" from company to company, depending on the business model and the sector. Let me outline the key assumptions made for both this metric and other factors affecting the valuation:
- Owner's earnings were defined as Operating cashflow minus Capex (Capex was obtained by adding "Cash used for acquisition of technology," "Purchase of property, plant, and equipment," "Purchases of long-term investments" and "Payment for acquisition of intangible assets"), adding asset sales (since they represent a recovery value of old Capex) minus the "other" figure from the 10-K's statement of cashflows (investing activities section).
- We outlined three scenarios for growth going forward with certain probabilities assigned to them. They were the Baseline scenario (70% chance), Pessimistic (20%) and Optimistic (10%).
- In all scenarios, we assumed that Apple's above average owner's earnings growth rate (31% compounded since 1999) would normalize within 10 years or less (sometimes much less, depending on which scenario). This is key to make this a safe assumption, and not some grandiose vision on how Apple will dominate the universe.
- In the baseline scenario, we assumed the following growth rates in owner's earnings:
2013 - 25%, 2014 - 20%, 2015 - 15%, 2016 - 10%, 2017 - 8%, 2018 - 8%, 2019-2022 - 7%, 2023 - 6%. 2024 into infinity - 5%
Why the declining earnings growth? Because in capitalism, above average growth rates are the exception, not the rule. Apple has benefited greatly from the a global boom in mobile devices consumption in which it had little to do with creating the technology that enabled the boom in the first place. For instance, Jobs didn't invent wifi, touch screens, high performance memory and CPUs in small size, etc. -- Apple was simply able to put together those components in a way that pleased its customers. Apple deserves credit for that, but not excessive credit to the point where someone might think it can manufacture another boom at will -- that is very unlikely. As the mobile industry matures, profit growth will slow and margins contract:
So at some point, it is an economic certainty that Apple's growth rates will at least converge to the growth of World Nominal GDP. They could possibly go below that (specially in the tech sector, where technologies can become obsolete quite quickly).
Looking at Apple's growth performance, I'm certain that part of Steve Jobs' "genius" was merely the result of a cyclical global boom. Looking at spreadsheets, one can see that there were two periods of growth during his second shot as the CEO. I labeled them Jobs #1 and Jobs #2. During Jobs #1 (1999-2006), the compounded growth rate in owner earnings was 6.3% (hardly genius like), during Jobs #2 (2007-2012), it was 44.6% when global demand for mobile devices exploded. Steve Jobs did a very good job of meeting that demand, but he didn't create it in the first place (the demand was "created" by the technologies that enabled mobile devices to become more useful like small wireless antennas, better touch screens, cheaper and better CPUs and memory in small sizes, among others. As people saw that these devices were both highly portable and more useful than they ever were in the past, they started a buying spree). It's not like if he didn't invent the iPhone, we wouldn't be seeing anyone else fill that market. It's extremely likely that someone would. Apple does not hold a monopoly on good ideas.
That makes me confident the current profit explosion is unlikely to continue no matter what Tim Cook does because as the industry matures, competition will only get more fierce, options will expand and prices are likely to come down faster than expected.
-Apple's required return is 12% (the rate at which the future cashflows are discounted back to the present). I'm assigning a higher discount rate than CAPM would suggest due the risks of the technology sector and its volatility. I don't think the market has been very good at predicting the pace in which technological changes impact corporations in that sector, so 1 year beta is understated, in my view.
-Long-term normalized growth in the Baseline and Optimistic scenarios is 5%. This is a rough estimate of what World Nominal GDP is likely to be going forward.
-As margin of safety at the start of the valuation, I took Apple's owner's earnings and decreased by 25%. The reason I did this is due the fact that most of the earnings from Apple comes from overseas, and the cash being held outside the U.S. is not available for stock buybacks or dividends. The rate in which this cash would be decreased if it were to be repatriated to the U.S. is not 25%, but it is hard to estimate because it depends on several factors like the reinvestment rate of return in the specific country (enabling the cash pile to grow before it gets repatriated), the presence or lack of repatriation holidays (sometimes Congress creates tax reductions for repatriation during a certain period), etc. This 25% decrease also takes into account cash liabilities that are unexpected like lawsuits, government fines, patent violations and other unexpected charges.
In the "Growth Period," we put forward the inputs that are probably the most relevant, the rate of growth in cashflows over the next few years. I assumed that Android competition and market saturation would bring that growth down, even in the optimistic scenario. I feel quite confident that the mobile market is in the maturity stage and companies will start to compete in price. If you disagree with these assumptions, you can input something else.
I arrived at the fair values of:
$831.01 in the baseline scenario (normal growth period then 5% long-term growth)
$1352.95 in the optimistic scenario (strong growth period then 5% long-term growth)
$572.85 in the pessimistic scenario (weaker growth period then 1% long-term growth)
With that 70%, 10% and 20% probability distribution, the expected value of the stock would be $831.56 ($831.01 * 0.7 + $1352.95 * 0.1 + $572.85 * 0.2). But there is one thing that Apple has that a lot of other companies don't, and this needs to be taken into consideration in a DCF analysis -- that is its cash pile. This is a very good article that does the cash analysis. Apple currently has about $76 a share in cash. This number has to be added to the DCF valuation, why? Imagine that $76 disappeared from the balance sheet and was added back 1 year from now in the form of a special gift sent from all Apple users worldwide. Any DCF model would add this value into the model and discount it back to the present. This type of addition is not needed in most companies since the cash is not that big as a percentage of the entire company, but in Apple's case, the cash it is so large that removing it can distort the fair value analysis. The cash can be used to benefit its owners immediately without affecting operations in any significant way, so adding it is important, in my view.
Adding that $76 a share to the $831.56, we reach $907.56.
The issue is that "owner earnings" when you are not really the owner of the company can overvalue the fair value given that you don't really have access to those cashflows (unless the company sends it back to shareholders by dividends and buybacks, but a minority shareholder can't control the size and timing of those distributions directly). Usually, the control premium of a corporation is valued at something like 20-30%. If we deflated the fair value by 25%, we would reach the stock price of $680.67, and this is my actual fair value for the stock.
Using conservative estimates and Buffett's owner earnings methodology, Apple's stock appears to be currently undervalued by more than 25%. Hardly a huge bargain, but a technical oversold panic bottom in the coming weeks should provide an attractive entry point for a long-term investment in Apple stock.