A fellow Seeking Alpha contributor wrote an article suggesting that Apple's (NASDAQ:AAPL) return on invested capital is too high to continue, and lower future ROICs suggest a much lower stock price for Apple in the future. While the author's math is technically correct, it leads to a conclusion that Apple's stock price should be around $240 per share. Any reasonable amount of economic intuition would suggest that this conclusion is, quite frankly, absurd.
The argument goes like this: Apple's return on invested capital fell from 340% in 2011 to 271% in 2012. With "the lack of innovation and issues with new products" this trend of declining ROIC will apparently continue unabated until it reaches the same 70% figure as Microsoft. Or perhaps the ROIC will decline until it reaches 20%, a figure that is "high in the consumer electronics sector." These figures would lead to intrinsic stock valuations of $295, or even $162. Apple, therefore, is currently overvalued and should be sold.
This overly simplistic analysis reflects a fundamental misunderstanding of Apple's business and balance sheet. Apple has an unusually low level of "invested capital" for its size because of the way it does business. Rather than having large investments in physical plant and equipment (such as factories), Apple contracts out with other companies for manufacturing much of its product offerings. This allows Apple to avoid the cost of building factories and foundries at the cost of its vendors' profit margins. A small increase in invested capital, such as what happened in 2012, can therefore have a large and misleading impact on the ROIC ratio. In Apple's case, its 2012 earnings were 60% or $15.8 billion greater than its 2011 earnings. Because it invested capital of $11.6 billion in 2012, this reduced its ROIC. Let me drive this home: the author of the previously mentioned article actually argues that investing $11.6 billion for an earnings increase of $15.8 billion in one year is somehow a bad thing, and cause to sell Apple stock.
Another issue that article fails to address is Apple's substantial cash hoard. In cases where debt and cash are similar in magnitude or small relative to the value of the equity, this is an understandable and insignificant oversight. Neither of these conditions is true in the case of Apple. Apple's quite substantial cash holdings, $145 billion or about $154 per share, have substantial value, even if Apple has to pay the marginal corporate tax rate on all of its overseas cash. Not taking into account $154 per share in fungible investments when assigning a value of $162 per share to the stock is extraordinarily short-sighted.
As a final exploration, let's examine some of the consequences of an ROIC of 70%. The author of the previous article went through a number of calculations that we can use to evaluate the worth of the ROIC metric. One of these calculations is net operating profit after tax (NOPAT). The NOPAT margin in the author's scenario would be under 7%, the lowest level Apple has seen since 2004, 3 years before the iPhone was first introduced. Although there are legitimate serious concerns about Apple's margins declining, even the most pessimistic analyst models margins higher than 7%.
Apple's invested capital will continue to rise for a number of reasons, including an increase in manufacturing in the United States and its taking on debt to buy back shares instead of repatriating cash held by foreign subsidiaries. These are widely hailed as good business decisions, and yet they will contribute to invested capital. When good business decisions impair a metric used to evaluate a stock, users of that metric need to evaluate if those decisions are exceptions, or whether the metric needs to be reevaluated. In either case, ROIC is a terrible metric to apply to Apple valuations. Investors would be well advised to stick to more standard measures like earnings or cash flow.