- Apple remains well valued even after the recent run up in price.
- The stock as priced offers at least 50 basis points of growth alpha, which translates to a 13.5% gain potential to my estimate of fair value.
- Once at fair value, investors can expect a total long-term return of 10.48%.
In a prior post I looked at Apple (NASDAQ:AAPL) because I saw it as a value opportunity hiding in plain sight. And it was hard to believe that this value would not be recognized. It was, and so today I am looking at whether Apple might still be suitable for the alpha hunter following the recent run-up in price.
How do different market participants view Apple?
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stock's sector and the stock's industry of operation.
Apple scores high on value, particularly in comparison to the market as a whole, and in comparison with stocks in its sector of operations. It scores high on quality across the board. The score for growth has risen from mediocre a few months ago, to in-line with market, but strong for the sector and industry of operations. And the momentum is now strong in comparison with where it was a few months ago.
AOM Model Recommendation
This stock now appeals strongly to most investor stock selection styles. This includes value and growth style stock selectors. It also appeals to the balanced investor who considers value, growth, quality and momentum equally. It also appeals to momentum investors and to investors with no stock selection style bias. And it appeals to most of the typical capital allocation strategies adopted by investors in that the stock has appeal to all, regardless of whether they allocate capital at sector, industry, or with no sector/industry bias.
Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 100%, and an AOM Strong Buy recommendation for Apple.
The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool that uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
The Case for Apple:
Why look at Apple now?
While Apple is no longer as cheap as it was when I last posted, valuation remains a good reason to look at Apple now. The stock trades at a trailing twelve month P/E below the market P/E, despite superior to market growth potential. The P/E for 2015 is at a level that suggests that there is gain potential from earnings growth, as well as from an expansion in the multiple. With the five year forward growth expectation strengthening since my last post, the PEG ratio has also declined to 1. And the stock still offers a dividend yield in-line with the industry of operations, which is great when considering the additional value to be returned to owners via buybacks.
Apple also scores well on key growth criteria. In addition to a stellar performance over the past five years, and quarter-over-quarter, analyst expectations for earnings growth over the coming five years are strong in comparison with the average for all stocks in the market, all stocks in its sector of operation, and all stocks in its industry of operation.
Apple also continues to display characteristics consistent with a high quality company. Strong institutional ownership displays institutional confidence in the company. Return on assets, equity and investments are all strong. Operating and profit margins remain at market beating levels.
And of late, despite underperformance over the past week, momentum has been positive too.
Is Apple a suitable pick for alpha hunters?
Analyst price expectations
Recently Apple traded at $91.68. From Yahoo Finance, we know that forty-six analysts expect an average price target of $94.42 (median $98.29), with a high target of $115 and a low target of $38.57. This is a wide dispersion in expectations, which suggests risks are high. So far, the bulls are clearly in control.
One of the classic conundrums for value investors is that value stocks tend to go from being very cheap to being rightly valued and back to being cheap. When a stock is rightly valued, it is priced to hold. When it is cheap, it is priced to buy. And one way to determine whether it is cheap or not is to estimate the alpha available with the stock as currently priced.
Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. So we will really never know the extent of alpha created until the actual return is earned. But we can always try to estimate alpha.
Mathematically, the worth of Apple is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. If you do use the above formula, please read this explanatory note.
So let us have a closer look at the different parameters used to determine value.
Beta, co-efficient of determination and alpha intercept considerations
Value Line reports a beta of 0.90 for Apple. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 1.04, and I adjust it to 1.01 on account of the beta's tendency to converge towards one. This low beta adds defensive characteristics to the stock, which is always nice in what is perceived as an over-valued market.
The coefficient of determination for Apple is 30.84%. This suggests that only 30.84% of the price movement in Apple is explained by movements in the market: the residual price movement is based on company-specific factors. This low coefficient of determination suggests that the market related risks are low. And because company specific risks can be diversified, Apple is a great pick for most portfolios at the present time.
Apple also has an alpha intercept of 0.35%, which means that if the S&P 500 returns 0%, the stock can be expected to return 0.35%. But because of the low coefficient of determination, the raw beta and alpha are less meaningful.
Over the past five years, the average weekly price change on Apple has been 0.67% (median 0.71%). The standard deviation over the period has been 4.04%. Thus for Apple, the range of normalcy (average plus or minus one standard deviation) for weekly returns is between a gain of 4.7% and a loss of 3.4%. The last time we saw a spike of over 4.7% was for the week of 4/21/14, when the stock rose 8.95%. In recent times the weekly volatility around the average and median price change has reduced, and low volatility is often a time when steady price appreciation is earned by investors.
Source: MaxKapital Beta Calculator
We might believe that Apple is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Apple is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in-line with our long-term expectations on a standalone basis and regardless of broad market valuations.
Mathematically, the worth of Apple is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.04, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Apple, we should be targeting a long-term return of 10.48%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. This chart below displays normalized trailing twelve month earnings over the past five years, together with analyst expectations for the current and coming three years. It also shows Apple's historic revenues and sales estimates for the current and coming fiscal years.
I am very comfortable with $5.76 representing a bottom in earnings, and expect growth to accelerate with a pick-up in the global economic cycle.
Fifty-two analysts included on Reuters data estimate average earnings of $6.31 (High: $6.57, Low: $6.11) during the year ended September 14, with fifty analysts estimating that it will rise to an average of $6.88 (High: $7.80, Low: $5.88) for the year ending September 15. Seven analysts assess long-term growth rates at 15.37% on average, with a high estimate of 29.40% and a low estimate of 9.6%.
I am comfortable with $6.31 as a fair representation of sustainable earnings.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect Apple will pay out approximately 60% of earnings via dividends and buybacks (approximately 35% to 45% via dividends and another 25% to 15% via buybacks) over the long term. An adjusted payout ratio of 60%, assuming nominal earnings growth of 8%, implies a return on incremental equity of 20%: the 40% of earnings retained, invested at a 20% return on equity, delivers the required 8% (40% * 20%) growth. This return on incremental equity is not unreasonable to expect, considering that the recent return on equity is 29.50%, and it has averaged 36.56% over the past five years.
If we use a very long-term growth expectation of 6.1%, Apple is worth $91.68. Apple Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.1% * $6.31 * 60% / (10.48%-6.1%) = $91.68. At this price, it is likely that an investor with a return expectation of 10.48% will be satisfied.
The growth estimate implied by the current market price of 6.1% is low. Alpha is estimated as the difference between actual returns and the risk adjusted return expectation. If we accept analyst estimates of forward five year growth of 15.37%, we get a composite very long-term (fifty year) growth rate of 7.1% assuming that following five years growth at 15.37%, growth reverts to a 6.25% growth rate for the next forty-five years. If Apple grows at a long-term rate of 7.1%, we have growth alpha of 1%. And an investor buying at present levels can expect a long-term return of 11.48%.
If earnings grow at the lowest long-term growth estimate of 9.6% for the next five years, and we assume that growth reduces to 6.25% for the following forty-five years, we get a composite very long-term growth rate of 6.6%, which lowers the growth alpha to 0.50%, and the total long-term return expectation to 10.98%.
Apple should sustain a composite very long-term growth rate of 8%, which is essentially in-line with global potential nominal GDP growth rates, provided it maintains its competitive advantage through innovation. But we cannot presume that it will. Thus, I will go with a composite very long-term growth rate of 6.6%, as calculated above, which I expect will capture growing competitive pressures.
If we use a very long-term growth expectation of 6.6%, Apple is rightly valued at $104 [106.6% * $6.31 * 60% / (10.48%-6.6%) = $104]. So at present, you have 0.50% of long-term alpha, which translates to a 13% upside to "rightly valued," after which you can expect a very long-term total return of 10.48% from the stock.
While Apple remains well valued for the alpha hunter, for those of you who took aggressive over-allocations to Apple when it represented value hidden in plain sight, the time to return to allocation is near.
Disclosure: The author is long AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.