Most Wall Street analysts have attempted (and typically failed) to predict Apple Inc's (AAPL) quarterly earnings over the past few years. Their analysis is usually a buildup of lofty expectations of how many iPhones, iPads, iTVs, etc. that they expect Apple to sell in the future. Unfortunately, many of these analysts have been taking a complete shot in the dark since Apple has never really given Wall Street any clear guidance. There is an old financial modeling adage that certainly comes to mind when you think about Wall Street's inability to accurately predict Apple's earnings...garbage in, garbage out.
As this adage clearly states, the output of your model (in this case - Apple's earnings) is driven by the assumptions in your model. In other words, if your assumptions are a wild guess, then the output will also be a wild guess.
So What Should Apple Investors Really Expect Going Forward?
We like to keep things simple (i.e., keep the "garbage in" to a minimum) and our future return expectations for Apple is based on 3 simple drivers:
- Conservative Earnings Growth
- Valuation Multiple Expansion
- Dividend Growth
Based on these inputs, we believe that it is reasonable to expect Apple to produce annual returns of 15-20% over the next 3 years. We'll discuss each of these drivers below.
Conservative Earnings Growth
Wall Street analyst estimates tend to be as volatile as the stock market, because they are largely driven by emotion and momentum. Most analysts want to be "right" more than anything, so their analysis more or less needs to justify the current stock price. If the stock price is rallying significantly, then their earnings estimates also need to keep pace (forbid that their estimates are too conservative). This was definitely the case with Apple. As shown in the graph below, Apple's earnings have grown at a compound annual rate of 57% over the past 5 years.
By looking at this chart, it's easy to see why future expectations were so lofty. Everyone expected this trajectory to keep going (which is the only way you could justify the stock price). However, just as the stock overshot to the upside, so did Wall Street estimates.
Now that earnings have flattened out, Wall Street has now readjusted their future expectations as well (shocker!). That said, investors should keep in mind that analysts tend to overshoot on the downside as well. According to S&P Capital IQ, consensus Apple EPS estimates for the next 3 calendar years are $45.75, $52.44, and $63.78, respectively (see table below). You can see that analysts are being conservative over the near-term (3.7% growth in 2013), but their growth expectations start getting aggressive again in 2014 (14.6%) and 2015 (21.6%).
We'll be the first to admit that we have no idea how to accurately predict Apple's earnings...and we aren't even going to try. However, we do feel comfortable conservatively estimating future earnings growth. Apple will continue to innovate and that innovation will certainly lead to higher earnings in the future. Whether it be the iTV, a cheaper iPhone, or some other product that we can't even fathom yet, we feel confident that earnings will continue to grow (just not at the inflated pace of the past 5 years). As shown in the table above, we conservatively expect Apple to grow earnings 3.0%, 6.0%, and 8.0%, respectively in 2013, 2014, and 2015. We realize that these estimates are probably ultra conservative...but that is the point. We want to hope for the best, but prepare for the worst.
Valuation Multiple Expansion
Investors can benefit greatly from a stock when its valuation multiple expands. When a valuation multiple expands, the market is essentially saying that it is willing to pay a higher price for a company (based on a variety of factors). Investors often use a stock's price-to-earnings ratio (P/E ratio) to compare its valuation to its peers. That said, given that the numerator in this ratio is price, P/E ratios tend to oscillate around a certain base level as the stock price overshoots to the upside and downside. This is why you often hear analysts say that a stock is overvalued or undervalued at certain price levels. As an investor, you want to try to find stocks that are currently undervalued so that you can take advantage of multiple expansions.
That said, let's take a look at how Apple is currently valued compared to its blue chip technology peers.
As shown in the table above, Apple currently trades at a 20% discount to its peers (10.4x vs. 13.1x average). We believe that as Apple's earnings stabilize over the next few years, the stock's P/E ratio will gradually expand to trade more in line with its peers. Conservatively, we expect Apple's trailing P/E ratio to expand to 12.0x by the end of 2015.
Another key metric in total return is dividend growth and Apple certainly has room to grow on this front. As we pointed out in a recent article, Apple may eventually become the best dividend growth stock of all time. Apple currently has a very low payout ratio (21%) and we believe that the company will start to aggressively increase its dividend over the next few years. We definitely don't think it would be a stretch for Apple to increase its dividend 25% per year over the next 3 years. They certainly have the cash available to do it.
Putting It All Together
Based on the assumptions above, we believe that Apple investors can conservatively expect a 15% annual total return over the next 3 years...
...and we definitely think that there is some upside to this number.
What do you think?