Apple Inc.'s (AAPL) stock price has underperformed the NASDAQ by roughly 30% over the last four months. To many investors this makes it a very attractive buying opportunity. I agree. Apple is attractive from a behavioral finance standpoint and from a fundamental valuation standpoint.
What Is Behavioral Finance?
Behavioral finance basically says market inefficiencies exist because people systematically over-and under-react to information for psychological reasons (there's a more thorough definition at Wikipedia if you are inclined). With regard to Apple , two important behavioral finance concepts are "saliency" (for events that occur infrequently, people tend to overestimate the probability of such an event occurring in the future if they recently observed such an event) and "anchoring" (psychologists have documented that when people make quantitative estimates, their estimates may be heavily influenced by previous values of the item) (Behavioral Finance and the Sources of Alpha, Russell J. Fuller, CFA, pp13-14)
How Has Behavioral Finance Impacted Apple's Stock Price?
Behavioral finance impacted Apple's stock price on its historic rise to the largest market cap stock in the world, and during its significant decline over the last four months. With regard to Apple's historic rise, equity analysts actually started to believe Apple's earnings could continue to grow at an enormous rate for a really long-time. It was a classic example of saliency and anchoring as described above. And when visionary leader, Steve Jobs, passed away, rather than taking their foot off the gas, the analysts misinterpreted the "tribute effect." For example, when Michael Jackson died, Michael Jackson songs immediately shot to the top of the sales list on iTunes as a tribute to the tormented genius that created some of the best music in the history of the world. Similarly, when Steve Jobs died there was an unprecedented outpouring of support for his contributions to the world, and one big way in which it manifested itself was through sales of Apple products. With regard to paying tribute to Jobs upon his death, I certainly won't soon forget images like this one:
(The windows of Apple stores around the world were filled with colorful post-it notes, each containing an individualized thank you note from someone whose life was positively impacted by Jobs contributions to the world. The scale and speed with which this type of tribute spread across the world is an example of the strong emotional attachment people have with Apple products).
In recent months, Wall Street analysts have slowly and reluctantly been lowering their earnings estimates for Apple. And I say reluctantly because I believe the behavioral finance heuristic known as anchoring (described above) has prevented them from lowering them sooner. A quick view of Yahoo!Finance shows that over the last 90 days analysts have significantly lowered current quarter, current year and next year earnings estimates. Also, Apple missed earnings estimates the last two quarters. The market is slowly admitting it was overly optimistic about Apple, and Apple's stock price has come down significantly.
I believe behavioral finance helps explains the way Wall Street analysts forecasted Apple's earnings, and I believe these same earnings estimates were a large driver of Apple's stock price during its historic rise, and during its significant decline over the last four months.
Why Is Apple Currently Attractive From A Behavioral Finance Standpoint?
I believe Apple is attractive because behavioral finance has driven the price much lower (albeit at a very slow pace), and its earnings power once again supports the price going higher. Put differently, saliency and anchoring effects are finally wearing off to the point where Apple is attractive at its current price.
What Is Apple's Fundamental Value?
Free Cash Flow (FCF) is an important metric in assessing the value of a company because it's not easily manipulated and it demonstrates a company's ability to create value. Free cash flow is the cash flow available to the security holders of a company. Free cash flow can be calculated by subtracting capital expenditures from cash flow from operations. In Apple's case, in 2010 -2012, free cash flow was:
- $42.561B = 2012 FCF = $50.856 (cash from ops) - $8.295 (Capex)
- $33.269B = 2011 FCF = $37.529 (cash from ops) - $4.260 (Capex)
- $16.590B = 2010 FCF = $18.595 (cash from ops) - $2.005 (Capex)
- $30.807B = 3-year average FCF (all data from annual report, p46)
Discounted Cash Flow (DCF) Model is one important technique to value a company. The model assigns a value to a company as follows:
- Value = (FCF/WACC) / Shares Outstanding
- WACC = Weighted Average Cost of Capital, and since Apple is financed with equity (the company has zero long term debt and zero outstanding preferred stock, annual report, p63), the Capital Asset Pricing Model (CAPM) can be used to determine the WACC:
- CAPM = risk free rate + Beta x (Expected Return on Market - risk free rate)
- Risk free rate = 1.84 = yield on 10-year treasury (Bloomberg)
- Beta = 0.93 (Yahoo!Finance)
- Expected Return on Market = 8.0% = long-term assumption
- Required return on Apple = CAPM = 1.84 + 0.93 x (8.0 - 1.84) = 7.5688%
Therefore, using 2012 FCF, a zero-growth discounted cash flow model says Apple is worth:
- $597.78 = (42,561,000,000/0.075688)/940,690,000
Or, using a small expected growth rate (1.84%) and the 3-year average FCF suggests Apple is worth:
- $571.66 = (30,807,000,000/(0.075688-0.0184))/940,690,000
Can Apple Grow?
Apple absolutely has the ability to grow at a significant rate. Apple earned a second place ranking on Interbrand's 2012 Best Global Brands list (behind only Coca-Cola), and this strong brand recognition will undoubtedly help the company grow earnings in existing and new products. To quote Interbrand "Few companies have captured our imagination, inspired such devotion, and revolutionized the way we live quite like Apple."
A segment by segment review of Apple's business is helpful in explaining Apple's growth opportunities.
- iPad has been the fastest growing product during the last two years going from 7.6% to 20.7% of total sales (annual report, p30). The growth potential of this segment remains enormous particularly as enterprise use of the iPad increases.
- iPhone is the largest product by sales, and has grown 71% and 87% in 2012 and 2011, respectively (annual report, p30). iPhone continues to present significant growth opportunities, however competition in the smart phone market is fierce.
- iPod sales decreased by 25% and 10% in 2012 and 2011, respectively (annual report, p30). The decrease is due in part from iPhone attrition (the iPhone is an iPod). Growth in iPod sales is challenging, however iPod continues to generate significant revenue for Apple.
- Other music related products and services grew 35% and 28% in 2012 and 2011, respectively. The segment continues to present growth opportunities, especially as new music is constantly developed and iPod users wish to listen to that music on their existing iPods.
- Mac sales grew 7% and 25% in 2012 and 2011, respectively. Macs have a loyal customer base, and present continued growth opportunities.
An important caveat with regard to Apple's growth is to be cautious of anchoring. Just because Apple has achieved such phenomenal growth in recent years, doesn't mean those growth rates will continue. In fact, Apple's growth rate has been far better than most companies, and the concept of mean reversion becomes a risk, especially considering visionary leader Steve Jobs is now gone, and continued high growth becomes even more challenging with a company already as large as Apple. That said, Apple TV presents an enormous growth opportunity for the company.
Can Apple TV Contribute To Growth?
Apple TV currently generates an almost negligible amount of the company's total revenue, yet it has the potential to become the single largest source of revenue if the company can execute.
In case you don't know, "Apple TV allows customers to watch movies and television shows on their high definition television. Content from iTunes, Netflix, YouTube, and Flickr as well as music, photos, videos, and podcasts from a Mac or Windows-based computer can also be wirelessly streamed to a television through Apple TV." Anecdotally, I increasingly come across twenty-something-year olds that seem to spend more time on YouTube and Hulu than they do watching actual TV, and this is an indication to me that the market could one day be amenable to replacing traditional television with Apple TV. That said, Steve Jobs is gone, and without him the successful execution of Apple TV seems dramatically less likely to me. However, new CEO, Tim Cook, seems apt to lead the company in that direction anyway. In a recent interview with NBC's Brian Williams, Cook said: "When I go into my living room and turn on the TV, I feel like I have gone backwards in time by 20 to 30 years. It's an area of intense interest. I can't say more than that." And if Apple TV is a success, then all of a sudden Wall Street's ridiculously high future earnings growth estimates become much more realistic.
Graham's Valuation Formula:
To bake expected earnings growth into a company's valuation, I like to use a simple formula first published by Warren Buffett's mentor, Benjamin Graham, in the 1940's: stock price = EPS x (8.5 + (2 x growth rate)). Considering Apple's 2012 earnings-per-share (EPS) was $44.15, and if the company grows at roughly the same rate as the market (I use a long-term capital market assumption of 8%) then Apple is worth $1,081.68:
- $1,081.68 = 44.15 x (8.5 + (2 X 8.0))
However, if we assume Apple's earnings will grow simply at the rate of inflation (10-year Treasury = 1.84%) then Apple is worth only $537.75 (which is still more than it is trading at today):
- $537.75 = 44.15 x (8.5 + (2 X 1.84))
And if Apple TV becomes the success many people hope, it's more reasonable to accept the average five-year earnings growth rate forecast of the 40+ analysts covering the stock according to Yahoo! Finance, which is 20.89%. And plugging this growth rate into Graham's formula gives Apple an astounding valuation of $2,219.86:
- $2,219.86 = 44.15 x (8.5 + (2 X 20.89))
Personally, I believe it's unlikely for any company as large as Apple to grow at this rate, and a valuation this high seems unreasonable, however if Apple TV is a huge success then this valuation all-of-a-sudden becomes more reasonable.
Like any company, Apple faces a variety of risks that could drastically reduce its value. Some of the larger risks are described below:
- Market Decline: If the market declines significantly, Apple will likely decline with it. A struggling economy could reduce consumers' ability to spend, which would reduce the demand for Apple products, and reduce the price of Apple's stock.
- Failure to Innovate: Apple has only a few products (albeit blockbuster products), and if these products fail, Apple fails. The company's success has been driven by its ability to innovate. If Apple is unable to continue to innovate then its existing products will become obsolete and the company will not be able to develop new products to meet market demands. This risk is higher than in the past because visionary leader Steve Jobs is now gone.
- Earnings Downgrades: Many Wall Street analysts have already lowered their earnings estimates for Apple, which has put downward pressure on the stock. However, additional downward revisions could cause additional selling pressure.
- Margin compression: Apple's high profit margins will likely decrease for existing products. Competition will drive down prices. Additionally, supplier costs may increase. Both would materially impact Apple's ability to profit.
- Poor Management: Legendary leader, Steve Jobs, is gone. The company is already changing as is evidenced by recent dividends and share repurchase programs demonstrating Apple may be struggling to find a use for all of its cash. Excess unused cash on Apple's balance sheet is not in the best interest of shareholders, and Apple has a huge amount of cash on its balance sheet.
- Competition: Competition is fierce, particularly in the smart-phones market- Apple's largest business segment by revenue. Competitors may develop new products that drastically reduce demand for Apple's products, which would reduce the company's ability to profit.
Both behavioral finance and fundamental valuation metrics suggest to me that Apple stock is undervalued. I believe Apple is attractive and will outperform the market for the next 3 to 5 years, at least, and much longer if Apple TV is a success. However, I do not own shares because I believe there are better risk/reward opportunities elsewhere. Steve Jobs was the visionary leader that grew Apple into the great success that it is today, but now Jobs is gone. Apple is still a great company without Jobs, however I have less faith in the company's ability to extraordinarily innovate and implement as it has done in the past. Steve Jobs was one of the most imaginative, creative, visionary leaders ever. He left an indelible mark on the world, and he changed the lives of hundreds of millions of people for the better.