Peeling Apple: A Long-Term ROE Analysis

| About: Apple Inc. (AAPL)

In modern financial markets, the potential to become paralyzed by information is overwhelming. If there isn't a fresh rumor regarding a new product launch, then there are worries about the impact of the fiscal cliff and if not that then some analyst will have changed their Q1 margin estimate just in time for the herd to follow. With unlimited information at our fingertips, many investors can fall victim to attempting to drink from the fire hose of information rather than taking a moment and filtering out the extra flow, and getting down to what actually matters to investors: How much money have I returned on my investment, and how much money am I likely to return in the future?

Apple (NASDAQ:AAPL) is a fantastic example of this information overload. The irony is that Apple is ultimately a very simple company and a perfect candidate for classic Dupont analysis. What a Dupont decomposition does for analysts is break down the Return on Equity (RoE) into the drivers of that return: Profitability, Operating Efficiency, and Financial Leverage. In some cases, it's useful to break down profitability further to account for tax efficiency and the drain on shareholder profits due to interest payments on debt. However, due to the fact Apple does not utilize external financing, this extended breakdown of profitability is of limited benefit.


What follows below is an analysis of the components of RoE for all 29 fiscal quarters for Apple since December 2005.

Q1 of Fiscal 2012 (reporting 12/31/2011) was obviously a monster quarter for Apple. Their quarterly RoE (Net Income for the quarter / Average Shareholder Equity over the quarter) was simply off the charts and the stock reacted in dramatic fashion. Unfortunately, Mr. Market got a bit carried away and began to assume this would be the new normal in performance for Apple going forward rather than a one-time deviation from the longer term trend. The collapse of the stock during Fall of 2012 reflected market participants' slow realization of the obvious unsustainability of that level of performance for the largest company in the world. Once again however, Mr. Market keeps choking on the fire hose of information and is now convinced the glory days are forever over. As a rational investor, I disagree. Apple returned 10.65% in Q1 of fiscal 2013, dead on its long term Q1 Average including the monster 12Q1 quarter and beating the 9.93% if you remove that quarter. First, this confirms that 12Q1 was an outlier rather than the expected norm, and second, it shows that the glory days are not over, rather that they are right on track.

Despite needing to combat the inherent seasonality in consumer related retail data, it is tremendously helpful to examine a long term time series of the drivers of Apple's returns to shareholders:

The first part of the story this graph tells is the irrelevance of financial leverage (green line) as a driver of RoE for Apple. It appears Apple was operating from a leverage agnostic position prior to 2009, but since then established a more consistent target of 1.5 Assets/Equity. Other than the more recent consistency of leverage, there isn't much to note here.

The next chapter is the strong increasing trend in quarterly profitability (blue line). Since the introduction of the iPhone, Apple has made larger and larger profits with each new product it sells. As an investor, this is exactly the kind of trend I like to see and it makes it clear that the true driver behind Apple ROE is consistent and increasing profit margins.

Finally, operating efficiency (red line) needs to be looked at to determine the ability to convert its enormous asset base into sales. This measure has clearly experienced the greatest degree of variability over the past 29 quarters and from my judgment contains a regime shift. From 2005 to 2009 it appears Apple experience decreasing operational efficiency as it learned to manage its booming iPhone/iPad business. Following 2009, it appears that, accounting for some volatility, operation efficiency has stabilized at a rough average of 27% throughout the yearly cycle.

These three trends in data tell me as an investor that Apple is continuing to grow profits and efficiency on the same long term trend that it has since revolutionizing the mobile phone industry, despite underperforming more recent outsized successes.

A look at a 5 year chart of Apple confirms that the stock price behavior tells the same story that ROE does. After a short period of accelerated growth, it has returned to its long run growth trend:


Now is the part in the conversation where it should be pointed out that a company having fantastic earnings performance and ability does not make for a good investment. For that, you also need to understand its relative valuation. Typically, if an enterprise has above average earnings power as measured by ROE you would expect the enterprise to be valued above the market. As of last filing, Apple has an ROE of 38.41% compared to 25.9% for the S&P 500 or roughly 1.5 times the amount of money returned to shareholders than the S&P 500 on average. What makes Apple a fantastic buying opportunity is the fact instead of Apple being valued at 1.5 times the S&P, it is valued at less than half the S&P 500 on an Enterprise Value to Earnings before Interest and Taxes basis (EV/EBIT) 13.14 Vs 5.31 for Apple. So if a fairly valued Apple would trade at roughly 19.5 EV/EBIT, Apple is trading at almost a quarter of its fair valuation. This kind of valuation discrepancy is rare for a large cap name, let alone a company the size of Apple and you can be sure the market will adjust relatively quickly.

Luckily for long term investors, this long term growth implies a 28.34% price return by the end of 2013. So while I have no idea what Mr. Market will make of the next quarterly earnings, the next product rumor, or the next iOS market share report, I know that as long as Apple continues along its long term RoE trend, I will be a buyer.

Disclosure: I am long AAPL, CRUS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.