Most of us, including myself, suppose that Apple (AAPL) will be around in three years. But the more relevant question to ask is how much should an investor be willing to pay for shares of the company three years from now? Or, in other words, what is the value that investors should assign to the free cash flow that Apple can generate for common shareholders after 2016?
This question is of fundamental importance, because only a very small fraction of Apple's current market value - about $26.00 per share - can be justified by discounting the cash flows that the company is currently scheduled to distribute to shareholders in the next three years via dividend payments, through the end of 2015. Therefore, to be able to justify Apple's current stock price of roughly $450 per share, we need to have clear vision of how successful AAPL's business is going to be in the future and how the company is going to be able to continue to provide cash returns to common shareholders after 2015.
Apple's Existential Risk
Apple is currently a dominant global brand and its products rank amongst the market share leaders in all business segments in which it operates. However, Apple's privileged branding and market share position in the future can hardly be taken for granted, much less the profitability of its various lines of business.
The industry that Apple operates in is notoriously fickle, cutthroat, cruel and unforgiving. The product cycle for Apple's most important product lines - iPhone and iPad - is alarmingly short. In three years or less, the mobile phones and tablet computers that Apple produces today will be obsolete in the marketplace. Furthermore, the competitive landscape will be different three years from now. There will be entirely new products replacing the old ones that are currently in the marketplace, and there will be new companies competing to provide those products with the best possible quality and at the lowest possible price. Absolutely nobody knows what the dominant products or companies will be three years from now.
Only one thing is certain: The Apple that we know today will essentially no longer exist three years from now.
Three years from now Apple may be an even greater and more valuable company than it is today. Or the company's brand may lose its cool, the company's products may lose their dominant market position and profitability, and the company's stock may become worthless. The only thing we can know for sure is that the Apple of three years from now will be fundamentally different from the company it is today - selling fundamentally different products in a fundamentally different competitive landscape, and under a fundamentally different set of circumstances.
As shareholders of former consumer tech darlings such as BlackBerry (BBRY), Nokia (NOK), Motorola Mobility, Palm and Sony (SNE) learned the hard way, companies selling consumer electronics devices such as mobile phones can go from a position of global dominance to irrelevance and near-bankruptcy within less than three years.
Given these harsh realities, Apple investors cannot simply assume that iPhone and iPad will be dominant and/or even profitable lines of business three years from now. They might be or they might not be. Furthermore, while it is possible that Apple may introduce completely new highly profitable lines of business in the future (e.g. Apple TV and/or iWatch), this is something that cannot simply be assumed. They might, or they might not succeed.
AAPL's Risk Profile Relative To Other Stocks
The types of existential uncertainties that Apple's common shareholders face as a matter of course are qualitatively and quantitatively different from the uncertainties faced by shareholders of other public companies dedicated to other lines of business.
For example, shareholders of Exxon (XOM) can be reasonably confident that the products that its company sells such as crude oil and gasoline will be in high demand and generating profits for the company in three, five, ten and even more years from now. Shareholders of Consolidated Edison (ED) and Southern Company (SO) can reasonably be certain that electricity will not be going out of style at any time in the next decade or so. Products such as Coke soft drinks, Pampers diapers and Big Mac hamburgers will be generating billions in worldwide revenues and profits for The Coca-Cola Company (KO), Procter & Gamble (PG) and McDonald's (MCD) many decades from now. Indeed, we can even be fairly confident that companies such as JPMorgan (JPM) and Citibank (C), that operate in relatively risky lines of business, will be generating profits for their shareholders many years from now, for two simple reasons: First, money is never going to go out of style. Second, these firms have demonstrated consistently for over two centuries that they know how to sell it and manage it (money) profitably and that they are able to withstand even the most severe crises.
Apple has been around for thirty-seven years. The company almost went bankrupt several times between 1996 and 1997, despite the fact that just a few short years before it had been the most dominant and innovative company in its field. But far more important to keep in mind than this sober warning from the company's history is the fact that the Apple's product lines that currently generate over 80% of the value of the corporation are less than six years old and will all be obsolete within three years.
Apple is a company that lives under the shadow of a perpetual existential uncertainty. By its very nature, Apple is a company whose very existence is on the line, every day. The clock that counts down the days to obsolescence is always ticking. And every day that goes by that Apple does not create another product that is the most innovative and best quality product of its kind, is another day that Apple lurches perilously close to insolvency.
How Do You Value A Company Like Apple?
How can you value a company that can be the most dominant and profitable force in its industry at one moment, and then become virtually bankrupt within three years?
One thing is for sure: Because the lifecycle for the majority of the company's lines of business are less than three years, you cannot accurately estimate the free cash flows that will be generated from operations and distributed to APPL shareholders beyond a three year forecast horizon within a reasonable margin of error. This fact presents extraordinary challenges for an analyst attempting to estimate the fair value for Apple
In a series of articles that I will publish in the following days and weeks I will demonstrate that virtually all of the methodologies typically utilized by analysts to value AAPL's stock are fundamentally bogus, because they cannot properly take into account the very unique risks (and opportunities) that define the essence of Apple's existence as a business enterprise.
In this introductory article, I will only provide a brief preview of some of the factors and concepts that should be taken into account in valuing AAPL.
- Dividends. We must establish the present value of the cash that is reasonably certain to accrue to current shareholders over the next three years. Remember that we can say very little about Apple's future prospects beyond a three year forecast period. In this regard, present discounted value of Apple's scheduled dividends in the next three years is about $26.00. This accounts for less than 6% of Apple's stock price. Nobody in their right mind would pay $450 for an investment in order to merely receive three years of payments worth a total of $26.00. So what else of value to Apple's common shareholders might help justify a purchase of the stock at the price of $450?
- Cash hoard. Apple's cash and marketable securities are currently valued at about $144 per share in Apple's financial statements. However, this number does not represent its true value to shareholders. First, as acknowledged above, AAPL will draw down this cash hoard during the next three years in order to pay dividends to common shareholders and so that already-earmarked cash must not be double counted. Second, the value of the cash hoard after dividends must be adjusted to reflect the value destruction inherent in the negative real returns that these assets are generating, adjusted for the company's cost of capital. Third, the cost of capital applied must properly reflect the inherent risk that the cash hoard may be mal-invested in the future, or perhaps even have to be drawn down to cover future losses if the company's fortunes deteriorate. Finally, the worth of whatever portion of the cash hoard that is projected to be distributed to AAPL shareholders in the future (in whatever form) must be adjusted to reflect its tax treatment. On this basis, AAPL's cash hoard may be worth considerably less than the $144 that is currently reflected in AAPL's books. By my estimation, depending on the assumptions used, and taking all of the aforementioned factors into account, Apple's cash hoard is probably worth anywhere between $59 to $84 per share. (Note that some strategic alternatives could enable Apple to realize somewhat more value.)
- Free cash flow from operations. Apple is going to generate substantial amounts of free cash flow from its forecast operations in the next three years, including capital expenditures. Applying a 10% cost of equity capital, I conservatively estimate that this cash generated during the forecast period has an after-tax net present value of approximately $110 per share.
- Option Valuation of Terminal Value. Apple is rather unique in that its relevant forecast period, for purposes of estimating the value of the stock, is probably no more than three years. Any forecast of free cash flows beyond three years would be speculative, to the point of being misleading. Apple could plausibly generate fabulous amounts of cash flow beyond 2016, or the company could plausibly become a money loser. How do we account for this fundamental uncertainty regarding the value of Apple beyond 2016? We can think of the value assigned to Apple's "terminal value" in 2016 as a sort of "call option" on the value of Apple's ongoing business operations after 2016. In order to formulate a reasonable estimate of the value of this "call option" I will outline a method of valuing terminal value that applies a few principles of option valuation.
The first step in deriving a reasonable estimate of Apple's worth is estimating the company's most tangible sources of value. Conservatively estimating the present value of forecast dividend distributions ($26), the present after-tax value of the cash hoard ($59), and the present value of free cash flows generated during the three-year forecast period ($110) through the end of 2015, the present value of Apple's stock would only be around $195. This $195 in relatively tangible and realizable value through year-end 2015 compares to AAPL's current share price of around $450.
This implies that current shareholders are paying approximately $255 per share for AAPL, as an ongoing concern beyond 2016.
To many, $255 per share will seem an absurdly low sum to pay for Apple's operating business as of 2016. For them, this systematic method of breaking down the value of AAPL's stock and specifically isolating the value being placed on its "terminal value" beyond 2016 will seem to highlight the fact that the Apple Corporation is being grotesquely undervalued in the stock market.
To others that attach considerable weight to the recent histories of other major public companies in this sector such as BlackBerry, Nokia, Motorola Mobility, Palm and Sony, the $239 billion in value represented by $255 per Apple share will seem to be a very lofty figure, since it represents more than five times the current combined market values of all of the above companies - all of which were at one time dominant players with attractive global brands in this field. In this regard, it is highly interesting to note that with a single exception, all of the above companies were at one time valued with a higher concurrent market capitalization than Apple's. It is also interesting to note that the $239 billion in value assigned to Apple's unknown and fundamentally unknowable operations after 2015 is larger than the current market cap of all but five companies listed in the US, including Microsoft (MSFT), AT&T (T) and many other giants corporations that possess businesses with relatively secure and reliable earnings streams.
Indeed, if anybody even six years ago had proffered the prediction that the combined market value of those five great companies listed earlier that produce cell phones would be less than one fifth of that of Apple within six years and that all five of them would be faced with insolvency/reorganization or the imminent prospect of it within that time span, that analyst would have been labeled as crazy.
It is for that very reason that some might plausibly argue that assigning a $239 billion market cap to Apple's ongoing business operations in 2016 (ex cash hoard), would be excessive to the point of imprudence. Indeed, it could be plausibly argued that any value assigned to cash flows that cannot be accurately estimated within a reasonable margin of error is, by definition, highly speculative.
In coming weeks, I hope to be able to provide some analytical tools and insights that can enable investors to consider all of these various factors and concepts in formulating a reasonable fundamental estimate for the fair value of AAPL stock.
In June of 2009, I predicted that, under certain conditions, AAPL's stock price might reach $700 by 2012 and that it could reach $1,000 by the end of 2015. In light of Apple's recent share price drop from above $700 to the current price of around $450, and due to the numerous controversies surrounding the stock (including David Einhorn's recent proposal regarding the issuance of preferred stock) I believe that it is an opportune time for me to perform a thorough review of the investment case for Apple.
In this essay, I have completed the first step in this process by properly identifying the extraordinary nature of the existential risks that perennially face the Apple Corporation and its shareholders. Now, we must go on to consider a number of other important considerations, including the extraordinary potential rewards that Apple and its shareholders may be able to reap in the future. And in particular, we must estimate a value for that "terminal value" beyond 2016, conceived of as a "call option" on the uncertain prospects for Apple's business beyond that date.