In this article I present a real time quantitative analysis of Apple (NASDAQ:AAPL) vs. Google (NASDAQ:GOOG) that demonstrates the power of free cash flow in the investment process and I give an opinion on how an investor should act based on my research. I decided to analyze these two companies in a side by side comparison because I am a big fan of each companies' products and thus would love to own them in my portfolio.
First let us begin by saying that both Apple and Google, from a qualitative point of view, each score perfectly on all "15 Points" outlined by Philip A. Fisher (the idol of Warren Buffett and father of qualitative analysis) in his book "Common Stocks and Uncommon Profits." We are not here to talk about quality of management or which company dominates on Main Street. This is already a given as they both rank in the top echelon of the greatest companies in the world. Here are Philip Fisher's "15 Points" from his investing masterpiece, so you can see for yourself what I mean.
15 Points to Look for in a Common Stock
- Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
- Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potential of currently attractive product lines have largely been exploited?
- How effective are the company's research and development efforts in relation to its size?
- Does the company have an above-average sales organization?
- Does the company have a worthwhile profit margin?
- What is the company doing to maintain or improve profit margins?
- Does the company have outstanding labor and personnel relations?
- Does the company have outstanding executive relations?
- Does the company have depth to its management?
- How good are the company's cost analysis and accounting controls?
- Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company will be in relation to its competition?
- Does the company have a short-range or long-range outlook in regard to profits?
- In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
- Does the management talk freely to investors about its affairs when things are going well but clam up when troubles or disappointments occur?
- Does the company have a management of unquestionable integrity?
You can find hundreds of articles here on Seeking Alpha that talk about product lines and the competition between the two companies as they go head to head in mobile, so you don't need me to do that. So let us now begin our free cash flow analysis and see which one will come out on top.
This analysis will use the following six free cash flow ratios:
- Price to Mycroft Free Cash Flow
- Mycroft/Michaelis Growth Rate
- Free Cash Flow Payout Ratio
- Free Cash Flow Reinvestment Rate
Those new to this analysis can find an introduction by going here that will explain in detail how each of these ratios is calculated. When used together, these unique ratios will generate a quantitative picture of a company's underlying fundamentals, including strengths and weaknesses.
The "2014 Mycroft Free Cash Flow Per Share" estimate in the table above was generated by taking the trailing twelve months (TTM) free cash flow result for both companies and then adding my Mycroft Michaelis Growth Rate into the equation in order to generate forward looking estimates for 2014. That growth rate is generated by using my FROIC ratio (Free Cash Flow Return on Invested Capital). Basically FROIC tells us how efficient operations are as it zeros in on how much free cash flow is generated for every $1 of total capital employed.
Apple has a FROIC of 30%, which means that for every $100 of invested capital, they generate $30 in free cash flow.
Google has a FROIC of 15%, which means that for every $100 of invested capital, they generate $15 in free cash flow.
Now my Mycroft/Michaelis Ratio takes the FROIC result for each company and multiplies it by the firm's free cash flow reinvestment rate. The reinvestment rate that I use is a free cash flow reinvestment rate instead of the standard one used by analysts that simply uses net income:
Free Cash Flow Reinvestment Rate = 100% - (Free Cash Flow Payout Ratio).
Free Cash Flow Reinvestment Rate = 100% - (Total Dividend/Total Free Cash Flow).
By replacing net income in the payout and reinvestment ratios with free cash flow, I am thus able to make my analysis more precise by incorporating capital spending (Cap Ex) into the equation.
Therefore from this we can determine that Apple has a reinvestment rate of 75% and went on to use 25% of its free cash flow to pay out its dividend. Thus by taking 30% (FROIC) x 75% = 22.5% (rounded off at 23%). From there we add the dividend yield of 2.3% (rounded off at 2%) and we have a Mycroft/Michaelis growth rate of 23% + 2% = 25%.
Google for its part has a reinvestment rate of 100% as it does not pay out a dividend. Thus the Mycroft/Michaelis growth rate is equal to its FROIC or 15% (FROIC) x 100% = 15%.
Apple's Mycroft Free Cash Flow per share of $58.85 was generated by taking its TTM free cash flow per share and multiplying it by (100% + 25% or 1.25). Once we have our result, we then take its current market price of $518.36 and divide it by $58.85 and get a Price to Mycroft Free Cash Flow result of 8.8. I consider a Price to Mycroft Free Cash Flow per share result of less than 15 to be good for purchase, and anything under 7.5 to be excellent.
Google's Mycroft Free Cash Flow per share of $42.51 was generated by taking its TTM free cash flow per share and multiplying it by (100% + 15% or 1.15). Once we have our result, we then take its current market price of $1,031.55 and divide it by $42.51 and get a Price to Mycroft Free Cash Flow result of 24.27. I consider a Price to Mycroft Free Cash Flow per share result of more than 22.5 to be a sell, so at 24.27 Google comes in at a sell.
The higher you go above 15, the more overvalued a company becomes. I use a Price to Mycroft Free Cash Flow per share result of 22.5 as my sell price, and 45 as my short price.
An appropriately priced stock should trade around a Price to Mycroft Free Cash Flow per share result of 15. This benchmark result was determined by backtesting.
Buy (opinion) = A Price to Mycroft Free Cash Flow per share result of less than 7.5 is considered excellent (50% below the initial Hold level), and anything under 15 is attractive.
The result I give as my Buy opinion in the table above uses a Price to Mycroft Free Cash Flow per share result of 7.5.
Hold (opinion) = 15 to 22.5 (I use 15 in the table).
Sell (opinion) = 22.5 or higher (50% above the initial Hold level). (I use 22.5 in the table).
Short (opinion) = 45 or greater. The Price to Mycroft Free Cash Flow per share result of 45 was determined by going back to the peak of the market (in the year 2000) and averaging the Price to Free Cash Flow per share results for the key players at that time. (I use 45 in the table).
The CapFlow ratio result that you see in the first table above is an original ratio I created in order to tell me how much capital spending is used as a percentage of cash flow. A result of less than 33% is considered ideal and with Apple coming in at just 19%, means that 81% of the company's cash flow is actually free cash flow and can be used to buy back stock, which I am a big fan of. Google on the other has a CapFlow of 28%, which allows it to use 72% of the company's cash flow to buy back stock. Both companies score great on my CapFlow scale so we will give them each a high grade and then go deal with the issue of valuation.
Apple earlier in the year was an extreme bargain as its stock price fell down to $390.55 on April 19, 2013, and was selling 11.5% below my buy price. Anyone who bought it then made a very smart move as my hold price or where I think Apple should be trading at is $882.75. Google on the other hand I believe is overvalued relative to its free cash flow results as my research shows that it should be trading at around $637.65.
In conclusion we have two companies that have results at opposite ends of the spectrum with Apple having a lot more upside potential by a wide margin compared to where Google trades. Again these are two great companies but the entire issue here is stock market valuation.
In my opinion the so called efficient market has got it wrong and I am expecting both stocks to eventually end up at where they should be trading at, which is my 2014 hold price opinion from the table above. My estimates on Apple may seem a little too generous and those on Google may seem to be too low, but my Mycroft/Michaelis ratio is based on the work of George Michaelis, who used to run Source Capital. Mr. Michaelis was unfortunately killed in a tragic accident when he was 59, but while he ran Source Capital Mr. Michaelis achieved over 15 years an 18% annual compounded rate of return in his closed end fund. By replacing the Return on Equity in his formula with my FROIC I was able to make my estimates more conservative as I include capital spending or CapEx in the equation.