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This article will describe a method for determining a company's approximate value by extrapolating a number of divergent scenarios for the company's future, then attempting to value the company in each individual scenario. I call this method Scenario Based Valuation.

A scenario is a potential future for the company. For example, for Apple (AAPL), one could easily envision a world in which IOS is the dominant mobile operating system and Apple controls the vast and growing market for consumer computational devices. Alternatively, one could imagine a world in which IOS is marginalized by Android. Or a world in which both Android and IOS prosper as is the current situation. Obviously AAPL would be far more valuable in the first scenario as opposed to the second. For Amazon (AMZN) one could envision a world in which e-commerce grows 40% per year on into the indefinite future and Amazon continues to totally dominate e-commerce, eventually increasing margins and raking in boatloads of cash. Or one could imagine a world in which Amazon can't raise prices without hemorrhaging market share and eventually suffers a cash crunch that basically destroys the company.

One might envision a hundred possible scenarios for any company. Or two. I have chosen as a reasonably representative and manageable number, five.

Scenario based valuation is most useful when dealing with companies having widely divergent potential outcomes in the intermediate term. Companies like Apple, Amazon and Tesla Motors (TSLA), the three companies I will use as examples. This methodology has less use when evaluating companies like Coca Cola (KO) or Exxon (XOM), where there is a wide consensus on the first order terms of valuation. Put another way, it is hard to imagine a world some years in the future in which no one drinks coke. And it is equally hard to imagine a world in which everyone drinks five times more coke than they do today. But it is easy to imagine a world in which tens of millions of people drive Tesla electric cars. And just as easy to imagine a world in which Tesla goes spectacularly broke.

For somewhat arbitrary reasons related to the companies I am going to value in this series of articles, the time frame I have chosen is eight years in the future.

The methodology is relatively simple. For a particular company, I envision five potential scenarios over eight years. For each scenario, I try to work through how present trends might extrapolate over the period and what the company might look like at the end. Given an endpoint, I then estimate the value of the company and its stock at this endpoint, should this scenario become the actual reality of the company in the future. Then I estimate the probabilities of each scenario occurring. At which point it is simply a matter of multiplication and addition to determine what the approximate value of the company might be eight years in the future.

Lots of estimating. Lots of projection. Lots of required understanding of a company and its evolving competitive position. But a reasonable framework for peering, however murkily, into the future. Far better, in my opinion, than trying to crunch accounting numbers in the present, numbers which, in my opinion, only give a look into the company in the present and say little about what might occur in the future for complex disruptive companies. Also better than doing what many amateur investors do -- choosing one scenario and imagining it to be the preordained only possible outcome -- 'Apple has the best products, the best engineering. It must grow and dominate. Android is toast. Windows is yesterday's operating system.' Maybe. Or maybe not.

Once one has determined an approximate value for a company in the future, one has to figure out what that means in terms of the company's value in the present -- the time when an investment decision may or may not be made.

A good metric is to require 10% compounded return from the present. Over eight years a ten percent compounded return will grow about 115%. So by this metric a stock's value in the present is roughly 1/2.15 times its estimated value eight years from now. That is if a stock is valued at $215/share 8 years in the future, its present value is $100/share as that $100 could, theoretically, be used elsewhere to grow 10% per year into $215 at the end of the 8 years.

However we must factor in dividends or yield. If a stock yields 2%, then the stock price only has to grow 8% per year to give a 10% return per year.

So without further ado, let us look at Apple. The largest, most followed, most talked about and, possibly, least understood company on the planet. Scenarios are presented from less favorable to more favorable. We will assume that Apple yields an average of 2% per year over the 8 years. Which means that it only need grow its stock price 8% to get our required 10%. 8% compound stock price growth means the stock price need be 85% higher after eight years.

Scenario 1. The overripe smell of rotting apples

Apple peaks in 2013. Its days of innovation are over. Its stubborn refusal to go after market share ensures that Android is the dominant operating system. Developers begin to desert the IOS ship, making android their preferred development platform, which accelerates the problem. iTV is a bore and generates little revenue. Google (GOOG), Amazon and Samsung continue to encroach on Apple, building viable ecosystems of their own. By 2015 Apple's sales have begun to fall. Profit margins are squeezed. By 2016 EPS is down to $35. By 2021 EPS is down to $20. At a P/E of 5 the stock is worth $100/share.

Things, of course, could be even worse. Each scenario represents not one single data point, but the sum of all the possibilities in its slice of the probability pie. So scenario 1 might represent all the outcomes for Apple between flatline and, say, decline to $150 a share, where the $100 share given is the probabilistic average over all the tiny slices in that segment.

Scenario 2. Stagnation

Apple continues to grow but much slower than projections. China Mobile (CHL) gives it a bit of a shot towards the end of 2013 and a reasonable TV helps sales in 2014 but sales growth slows to middling single digits, as competition and market saturation take their ugly tolls. Profit margins erode slightly and EPS is fairly flat -- around $50 in 2014 and growing to only $60 in 2021. At a P/E of 8 the stock is worth $480/share in 2021.

Scenario 3. Consensus

Apple does more or less what the consensus of analysts expects. It grows 12-15% per year for the next 5 years and then 10% per year thereafter. Growth comes from penetration of foreign markets, penetration of enterprise, a slow introduction of a more complete line of products, an ever stickier eco-system, a great Apple TV and possibly one other major innovation that is invisible in the present. EPS is $110 in 2020. At a P/E of 12 the stock is worth $1330/share at the start of 2021.

Scenario 4. Power

Android turns out to be the security and efficiency dog that some folks think. Apple introduces a full line of computer device products by the end of 2014. Screens from 2.5 inches all the way to super high def 80 inch TV's, each screen size having a plethora of options. By 2019 Windows is mostly a legacy system. Apple owns the bulk of the remaining laptop business, 50% of the tablet business, 40% of the smartphone business which, itself, continues to grow 15% or more per year, and 30% of the TV business. Apple's content sales continue to blossom. By 2021 they sell 40% of all software, movies, TV shows, music, books and anything else that can be sold electronically. Cable companies are marginalized as Apple deals directly with content producers. Apple sales hit 1.2 trillion dollars in fiscal 2020. Their margins are somewhat lower than today but the 1.2 trillion in sales translates to $170 billion in profits or an EPS of $180. At a P/E of 13 the stock is worth 2340/share.

Scenario 5. Domination

The all electric, gorgeous, supremely functional iCar, introduced after Apple buys Tesla in 2015, totally dominates the auto industry by 2019. In 2016 the JOBS virus infects all android devices, displaying a smiling photo of the founder and a picture of a nuclear mushroom on all screens of all Android devices. JOBS keeps reinfecting Android devices despite all efforts at cleansing, causing the Android operating system to collapse and Android users to abandon ship. Apple denies any responsibility though questions linger. There is no other viable mobile operating system save IOS. In 2018 Mac OS and IOS merge into a single operating system called Monster. In June of 2020 Apple purchases California from a broke and desperate US government for three trillion dollars and declares their new country an international tax haven, saying the reason they were always so miserly with their cash hoard was that they were saving up for this purchase. By 2021 90% of all computer devices are built by Apple and run Monster. Dominating computers, phones, tablets, cars, California and pretty much all home entertainment worldwide, as well as being the gatekeeper for virtually all electronic media, Apple does an incredible 3 trillion dollars in sales in 2020 with EPS of $500. At a P/E of 15 the stock is worth $7500/share.

Although this is, perhaps, a bit fanciful, the possibility of total domination of the computer device market, the electronic media market, the home entertainment market and, somewhat less likely, the auto market is viable. It probably won't happen but it could. Which means that AAPL could still, possibly, hit a ten bagger from here.

Let's put this in a table:

Apple in 2021: Possible Scenarios -- Reasonable Probabilities

Scenario IScenario IIScenario IIIScenario IVScenario V

EPS

$20

$60

$110

$180

$500

P/E

5

8

12

13

15

Share Value (SV = EPS * P/E)

$100

$480

$1320

$2340

$7500

Probability (P) Sum =1.0

0.10 (i.e 10%)

0.20

0.50

0.18

0.02

Scenario Value (SV * P)

$10

$96

$655

$421

$150

To get the expected value (given all the many assumptions) in 2021 we simply sum the numbers in the bottom row getting $1332. Dividing 1342 by 1.85 (the 10%, including dividends, compounded return for eight years) yields a present fair value of $720/share. That is, assuming my numbers are reasonable, if you bought Apple for $720/share you could expect, on average, over the possible future scenarios, a compound return of 10% over the next eight years.

Here is a table Apple bears might like a bit better:

Apple in 2021: The Bear Case

Scenario IScenario IIScenario IIIScenario IVScenario V

EPS

$20

$60

$110

$180

$500

P/E

5

8

10

12

15

Share Value (SV = EPS * P/E

$100

$480

$1110

$2160

$7500

Probability

0.30

0.40

0.25

0.04

0.01

Scenario Value (SV * P)

$30

$192

$277

$85

$75

Which is $659 in 2021 or $356 today.

I think this case is very instructive. Even if you believe that there is basically a 70% chance that Apple will either crash and burn or totally stagnate, and only a 5% chance that it will do really well, the stock is still worth more than $350/share. This is where the low current p/e sets a bottom to the long-range valuation.

And one for you Apple bulls:

Apple in 2021: The Bull Case

Scenario IScenario IIScenario IIIScenario IVScenario V

EPS

$20

$60

$110

$180

$500

P/E

5

8

14

15

18

Share Value (SV = EPS * P/E)

$100

$480

$1540

$2700

$9000

Probability

0.01

0.05

0.50

0.30

0.14

Scenario Value (SV * P)

$10

$24

$770

$810

$1260

Which is $2874 in 2021 or $1553 today.

Obviously I have not solved the bull/bear problem for Apple. There is still huge room for disagreement. But what did you expect? No one really knows anything remotely like a 'fair' value for Apple. Apple is an incredibly complex company enmeshed in a bewildering competitive landscape as many of the most powerful and innovative companies on the planet vie for a piece of the rapidly growing market for computer devices, the software that runs them and the sale of the electronic media which can be used on them. Which is a pretty damn good reason for the volatility of AAPL.

Be that as it may, I hope to have elaborated a method for framing the issue of valuing a disruptive company like Apple by looking at a range of its potential futures, rather than declaring one or another of those futures inevitable.

Source: Scenario Based Valuation: Part I - Apple