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Summary

  • Apple is still priced well for value investors, despite the run-up in share price in the last year.
  • The market has priced Apple entirely for risk, placing no value on its cash or growth opportunities.
  • The risk of commoditization in the smart phone market is not a measurable risk for the next ten years.
  • Apple has foreseeable growth opportunities over the next ten years that could support 12.8% annual growth in absolute earnings.
  • For a ten-year investor looking for value, Apple is a bargain hiding in plain sight.

The Controversy Surrounding Apple

Is Apple (NASDAQ:AAPL) a company with below average prospects? This is the biggest controversy among investors and has been for the last 14 months. Even after its current run-up to around $95/share, Apple's trailing price/earnings ratio of 15.3 is much lower than the overall S&P 500 P/E of 19.4. Its valuation is roughly in line with "peers" if you include in that group many troubled companies seeking a strategy or recovering from significant missteps, such as HP (NYSE:HPQ), Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO), and Intel (NASDAQ:INTC). However, unlike these "peers", Apple shows no obvious signs of being a company in a threatened market; or unable to execute; or without a strategy.

Apple's fundamentals are all measurably better than those of the average S&P 500 company: profitability, brand strength, balance sheet, management and ability to execute are all observably first-class, and it has maintained these characteristics consistently for fifteen years. Reviewing its recent price history one can only conclude that market participants have been applying a severe risk discount to Apple, relative to the average S&P 500 company. To understand how Apple's price compares to its fair value, then, we need a risk-based valuation model. In this article I am going to provide such a model and apply it to answer the question: What is a fair price for Apple?

Taking An Owner's Perspective

To achieve a risk-based valuation, I am going to estimate a price for the company from the perspective of an owner looking to buy the company and hold it for at least ten years. As a ten year investor, one is primarily looking to profit from the productivity of company assets rather than speculative capital gains, and one is counting on being able to sell the company again with assets at least as productive as they were when bought. That is, putting a risk-based price on Apple, or any other company, is about pricing a bet that the company's assets can at least preserve their current earnings power over the next ten years for your benefit as the company's owner.

Assigning a price to a company from this perspective requires a four step process.

  • Identify a risk-free yield you would be willing to accept on the current earning power of its assets;

  • Calculate the risk adjustment you will require to purchase this company's assets, as protection against the eventuality that the assets will lose some or all of their earnings power over the next ten years;

  • Using Owner's Earnings, calculate a purchase price that would give the risk-adjusted yield obtained in the first two steps;

  • Add in an options premium for foreseeable growth opportunities plus net cash on the books.

The core challenge with any risk-based evaluation is that it is impossible to predict which risks will and will not emerge. Even experts are barely better than novices, or not at all better, at predicting the future, as studies have shown time and again. As Daniel Kahneman observed in his best-selling book on behavioral economics, "People who spend their time, and earn their living, studying a particular topic produce poorer predictions than dart-throwing monkeys who would have distributed their choices evenly over the options."

In light of this truth, I will introduce below a method for quantifying investing risk which is more humble and does not require pretending to have knowledge about probabilities of events. I will apply this method to place a value on Apple. To prepare, we need to calculate the Owner's Earnings produced by Apple in 2013. Introduced by Warren Buffett, this concept represents the amount of cash that can be extracted from the business by owners. The formula is,

OE = Net Income + Amortization and Depreciation + Other Non-cash Charges - Maintenance Capex.

Using Apple's 2013 performance, this gives Owner's Earnings of,

$38,775 = 37,000 + 6,757 + 2,253 - 7235.

Step 1: The Risk-Free Yield

What would Apple be worth if owner's earnings were risk-free for the next ten years? This question is easy to answer because we know the current risk-free yield available from the 10-year treasury market, and as of July 14th, 2014 (date of this writing) it is 2.59%.

It is interesting to pause and calculate how much an owner would pay for Apple, if they considered Apple's $38,775 billion in 2013 owner's earnings to be as risk-free as the ten year treasury. The amount is about $1.5 trillion. Given Apple's outstanding float of 6.027 billion shares, the 10 year risk-free price of an Apple share would be about $247 compared to its current price between $94-$95. In other words, if you are certain that Apple will make its owners as much money on average for the next ten years as it did in 2013, Apple is a screaming buy relative to a 10-year treasury bond.

We can see from this quick calculation that Apple's share price implies a substantial risk of impairment to Apple's assets over the next ten years, as it should if the market judges the cost of risk to be greater than the option value of Apple's growth opportunities. In fact, to get Apple's current market capitalization, we need to adjust the yield we demand from Apple's assets from the risk-free 2.6% all the way up to about 6.8%. This is not true of all companies. Growth companies with bubble-like valuations such as Amazon and Tesla have earnings priced more expensively than the yield on treasury bonds and some companies, of course, have substantial valuations despite no earnings at all.

An interpretive gloss for the analysis above: The market as a whole demands a 4.2%/yr risk premium on the yield from Apple's assets to compensate for the risk of owning them relative to a 10-yr treasury. In comparison, in 2013 the S&P 500 had $100.20 in earnings and ended at a price of 1848, for an implied yield of 5.4%. The risk premium priced into the S&P 500 as an index therefore is 2.8%, or 1.4% less than Apple's risk premium. This quantifies exactly how much riskier market participants currently think Apple is, relative to the S&P 500 (and the gap would be even larger if we removed Apple from the index and looked just at the other 499 companies).

Step 2: The Enumeration of Risks

Is the balance of risk and growth for Apple worse than for the average S&P 500 company? We cannot answer this unless we estimate a risk premium. This requires three things,

1) Enumerating risks;

2) Evaluating each risk;

3) Translating the risk evaluations into risk premiums for our required yield.

The challenge for any such system, as stated earlier, is that the future is unknowable and research has shown with convincing clarity that experts are not really better at predicting the course of events than are monkeys throwing darts (and often they are worse). It is an act of hubris to quantify risk by placing odds. But then how can it be done?

With this in mind, the method of enumerating risks is going to substitute an analysis of how long it would take for a risk to emerge and impair Apple's assets, rather than guessing or arguing about how likely a risk is. That is, for investors, velocity of risk is a more reliable guide for determining risk premium than odds of risk. This is true not only because the former can be known while the latter cannot, but also because speed of risk is directly related to how damaging a risk can be to an investment. Slower emerging risks give owners more time to enjoy current profits before owner's earnings become impaired and also more options for responding to the threat, and so slower risks require less risk premium.

I believe this aspect of risk plays a substantial role in sophisticated investor decision making. Consider the crown jewels of Berkshire Hathaway's (NYSE:BRK.A) portfolio: GEICO, BNSF and Mid-American Energy. All of them face serious market risks but none which can harm them quickly. For example, GEICO's earnings (along with all auto insurers) are seriously threatened by the potential emergence of self-driving cars, which would lead to lower rates and significantly lower volume of policies. However it will take at least ten years for this risk to emerge in a way that materially impacts earnings, and in that time Berkshire will benefit from the earnings stream and make moves to diversify GEICO's services or reinvest its earnings in other businesses with less imperiled futures.

Similarly mid-American faces threats from solar leasing and other new financial options for decentralizing power, while BNSF faces threats from build out of new pipelines which would impact the substantial earnings it currently derives from transport of oil and natural gas. In each case, though, these threats are very long term and provide the business's owners the benefit of the company's unimpaired earnings for many years to come and the flexibility of response to deploy a portion of earnings to new business lines or strategic responses. These examples and reflections show how speed of risk, unlike odds of risk, are knowable and usable in rationally estimating the risk premium an investor should demand when pricing a company.

For each enumerated risk Apple faces, I will use this insight to define, analyze, and assign a grade using a standardized scoring system, which can be systematically translated into risk premiums in a way tuned to mirror historical risk sensitivities of market participants. Given the ten year time horizon for our investment, we will apply a one to ten grading scale to each risk area, interpreted as follows,

1 - This risk area is vulnerable to risks which can emerge suddenly and impair owner's earnings within one year.

5 - This risk area is vulnerable to risks which require incubation but could impair owner's earnings within five years.

10 - This risk area is vulnerable to risks which require fundamental changes to culture, regulation or infrastructure, and would require ten years or longer to impair owner's earnings.

This score above will represent a quantification of the durability of a risk area's contribution to owner's earnings.

A second impact score will also be applied to each risk area, using a scale of one to nine, interpreted according to the following impact matrix,

Impact Matrix (time to recovery/magnitude of earnings impact)

Short-term (1-2 years)

Extended (3-7 years)

Permanent

Significant (30%+)

5

8

9

Moderate (10%+)

3

6

7

Light (<10%)

1

2

4

The rows represent the magnitude of the risk to earnings and the columns represent the amount of time the company would likely need to recover its earnings level, should the risk emerge. The cells contain the score a risk area receives, according to where it rates along the two dimensions.

The multiplication of (ten minus the durability score) with the impact score quantifies the risk each risk area presents to the company's earnings moat, from the perspective of a ten year investor. By adding these multiplied scores across all risk areas, naturally enough, we arrive at the Moat Score for the company as a whole, which can range from 0 to 81 for each risk area.

The Moat Score can be translated directly into a risk adjustment to the required yield depending on an investor's risk tolerance. I will use the following risk tolerances because they produce risk premiums which fit well the market's historical risk premiums,

Aggressive Investor: 1 bp for each point in the Moat Score;

Fair Value Investor: 2 bp for each point in the Moat Score;

Value Investor: 3 bp for each point in the Moat Score.

The Enumeration of Risks method is to estimate a risk premium for Apple by

  • identifying relevant risk areas for the company,

  • grading each one for durability and impact,

  • calculating a Moat Score for the company, and then

  • translating the Moat Score to a required risk-adjusted yield on its owner's earnings for the three types of investor.

For Apple, I am going to review risk in thirteen areas:

Competitive Risks

Operating Risks

Management Risks

1) Brand/Reputation

6) Supplier risks

10) Management quality

2) Commoditization

7) Channel risks

11) Key persons

3) Product disruption

8) Government actor risks

12) Balance sheet & Cash Flows

4) Business model disruption

9) Cyclical sensitivity

13) Accounting

5) Customer defection

  

1) Brand/Reputation

Durability: 10

Impact: 9

Apple is one of the top five brands in the world, and arguably the world's top brand. Apple's brand stands for high quality, unintimidating technology experiences preferred by creative people with taste and sophistication. If Apple's brand were impaired the impact on Apple's earnings would be severe. However, the company has spent several decades carefully crafting its identity with consumers. Even before the iPod and iMac, in Apple's "dark days", the customers Apple did have were evangelical about the company's products. With the iMac and iPod it was able to begin growing awareness of its brand with a larger audience, breaking through as a global icon and aspirational brand for the mainstream with the introduction of the iPhone.

Most importantly, Apple's brand is strong with young people. An entire generation has now grown up viewing Apple products as synonymous with quality, design and good taste. The impact on its business is seen through figures like the industry leading 76% retention rate for iPhone users. Strong brand affiliations like this stay with people for life. Apple at this point could not seriously impair its brand just with a poor product release cycle or three. It would take generational neglect on multiple fronts.

In putting a timeframe on the risk, it's difficult to find precedents where brands as strong and long-established as Apple's have undergone serious brand impairment. Perhaps the best examples come from retail, such as Sears, J.C. Penney's, and KMart, or fast food if one looks at a brand like Kentucky Fried Chicken which had to rebrand as KFC. In each of these cases, the brand erosion took place for well over a decade and involved both slow evolving cultural shifts and disruptive competitive threats.

2) Commoditization Risk

Durability: 10

Impact: 9

Apple skeptics argue aggressively that people will begin viewing both smartphones and tablets as interchangeable commodities, buying purely based on price. The argument typically focuses on the iPhone, using an argument by analogy: Just as PC laptops and desktops eventually commoditized, seriously eroding the profit margins of all manufacturers, smartphones and tablets will commoditize as well. Therefore Apple's margins are unsustainable and they will eventually experience significant, permanent decline in earnings.

The analogy is a bad one on its own terms. While it is true that PClaptops and desktops commoditized, it is not true that laptops and desktops commoditized as a market. Instead, the market split into a high end market completely dominated by Apple, with low end and business markets completely dominated by WinTel PCs. The lion's share of profits shifted to the non-commoditized chip makers and software makers, which is how Microsoft and Intel became hugely profitable companies while Gateway, HP and others struggled. In truth, the market showed just that assembly manufacturing and secondary hardware components are commodities, but CPU's and software are differentiated.

Something like this seems to be happening in the phone and tablet market as well, with Android and Qualcomm being the new, dominant providers for the medium and low end markets while Apple sits atop the high end. The business segment is still up for grabs.

The dynamic only threatens the sustainability of Apple's current profits if the high end market is ultimately going to be smaller than it currently is. However, all the evidence is against such a conclusion based on another way in which the analogy with desktops and laptops fails. The role laptops and desktops played in people's lives were as work and at-home digital appliances. The appliance role did not leave much room for status or aesthetics or concern about self-expression to make its way into purchasing decisions. This is why the high end market dominated by Apple was small.

It is clear that mobile is much different. A phone is something one frequently has on display in front of other people, at work and in social gatherings. One wears a phone. As such, it is a fashion accessory and lifestyle choice that is part of the user's self-expression rather than just an appliance left on the desk at work or stuffed into a corner of the user's household. Beyond the device itself, the software on the device is also not a commodity (software has never been commoditized, hence Microsoft's huge margins) nor is the larger ecosystem users get access to by choosing the device. This is why Google/Motorola's (NASDAQ:GOOG) attempts at commoditization with the Nexus line and the Moto G have had no impact on Apple. At least 15% and maybe 20% of the market buys based on status, fashion, and perceived quality of overall experience, not on hardware specs. As a result, these "commodity" phones have sold to the value conscious and price sensitive portion of the market but have not shrunk the size of Apple's audience.

This cultural role for phones and tablets (but especially phones) is obvious from the breathless reviews and commentaries that lead up to and accompany the release of a new product. The cultural importance is also obvious from the communities of "fanboys" and "fangirls" which have crystallized around the different operating systems and manufacturers, especially Apple's. In contrast, when one thinks of commodities, one thinks of things like potatoes. While I suppose there is minor branding around "Idaho" or "Russet" potatoes, it's impossible to observe similar passion and intense scrutiny directed by the general public towards rumors of the latest rival potato crops.

Apple's executive hires make it clear that Apple knows its product is not a commodity, as the company is stealing high profile executives from places like Burberry, Louis Vitton and Tag Heuer, not Microsoft. People do not buy phones based on commoditized "specs" but based on the experiences they produce and how the phone makes them look in other people's eyes.

Given the aspirational social dynamics of phone use (and tablets to a lesser extent), it is quite plausible the high end of the mobile market is the top quintile of the total market, while the high end market for laptops and desktops was only about the top decile of the total market. Since the unit market overall will soon be two billion, this market size will be enough to sustain Apple's current owner's earnings.

Emergence of the commoditization risk would require a cultural sea change around accessorization and status, around how much consumers care about their experiences with the device, and around what ecosystem consumers feel serves their lifestyle and status needs.

From this perspective, we can conclude people purchase phones more like they purchase cars than like they purchase PCs. Any car will perform the basic function of getting you from point A to point B pretty well, but, while bargain shoppers exist, it does not follow that competence at the basic functions are all people care about when they buy a car. How long would it take for people to start buying cars or purses or shoes as commodities? Culture changes slowly, and status shopping will always trump bargain shopping for a large percentage of people. Apple is protected from commoditization by that fact.

3) Product disruption

Durability: 1

Impact: 2

Product disruption comes in two types.

  • Type one disruption occurs when a new feature or features is introduced first by competitors and gains market traction.

  • Type two disruption occurs when a competitor introduces an entirely new form factor for fulfilling the same basic need as the existing product, which makes the existing product obsolete.

Which of these risks is larger, such that the ten year investor needs to focus on it? As for Type one product disruption risk, Apple has already experienced it, with the introduction of larger screens and smaller tablet sizes by Samsung (OTC:OTC:OTC:SSNLF), along with Samsung's huge marketing push. For Apple, as the market leader with the strongest brand, any successful attack on its products which takes the form of a feature enhancement can only pose a small threat, because it can and will be copied, as we are about to see in the 2014 product cycle. It may take a couple of years for Apple to respond, given its slowish product development process, and it may see some minor margin and volume compression during the interim, but such attacks from competitors do not constitute major impacts from the perspective of a ten year investor.

So what about Type two product disruption? Apple's current profitability is based on the touch screen communication concept. It is different than past phone fads such as the Motorola Razr or BlackBerry messaging device in that it is not a device fad but a powerful new interaction paradigm. The smartphone is a universal computer and communication device, with a maximally simple interface for accessing its computational power. It is deeply right and uncompromising in meeting the need it was created to meet. A proper analogy to the smartphone is the GUI interface for laptops and desktops, not the flip phone.

Such deeply right paradigms have life spans of decades or generations, not years. To get a sense of this, we need only to look at Google Glass and the cultural backlash which has accompanied its introduction. People who talk to their glasses are being called "glassholes" and are subjects of ridicule from television comedians. One is seeing similar cultural backlash even to making calls from wrist wearables, something much less disruptive, and similar reactions were previously seen with Bluetooth headsets. Cultural attitudes like this take a very long time to change. The generational nature of the paradigm suggests Apple's durability rating related to Type two product disruption should be 10, making it a non-risk for ten year investors.

4) Business Model Disruption

Durability: 4

Impact: 9

The greatest harm to Apple would come from attacking its business model. Apple's business model is predicated on charging a premium for a high-end store front (a phone or tablet), then tapping a recurring revenue stream of entertainment and software purchases and, occasionally, complementary devices such as Macs, Beats headphones or the coming iWatch. This is an extremely lucrative model which several other companies (Microsoft, Google, Amazon, perhaps Samsung) are trying to copy.

So far it has not been attacked, except in a very mild way by Amazon and Google, who have attempted to lower the consumer's cost for buying the storefront with the idea of making it up by selling the other services. This is a very unimaginative direction of attack that tested whether the storefront is a commodity, proved it is not, and so has not been very successful.

It's hard to envision what a successful attack would be like but one surely is possible. Executing on it would require several years to stabilize and to market, which is usual for this sort of thing, but the impact would be devastating. Hence the durability score of 4 and the impact score of 9.

5) Customer Defection

Durability: 7

Impact: 6

As cited above, Apple benefits from a stellar 76% customer retention rate for iPhones. In general, Apple's customer loyalty is the envy of its competitors. The durability of its customer retention is tied constitutively to its brand strength, its product resistance to commoditization, and protection from product disruption. Because increases in customer defection rates would be one of the first signs these other areas were in danger, the durability rating here is a shade weaker than for those attributes. Impact of the risk would depend on the extent of deterioration and a middle-high score is warranted to average across scenarios.

6) Supplier Risks

Durability: 1

Impact: 1

Apple is dependent on a vast supply chain. Some suppliers, such as Foxconn and Samsung are critical. While Apple under Tim Cook has been very good about managing potential supply chain risk, supplier issues can arise suddenly. However, the flexibility of the global supply chain allows Apple to respond quickly as well so that impact is negligible from the perspective of a ten year investor.

7) Channel Risks

Durability: 2

Impact: 7

Channel dependency is perhaps the weakest portion of Apple's moat. Apple is disproportionately dependent on iPhone sales for its profits (though it clearly is moving aggressively to diversify). Unfortunately, its profits from the iPhone are heavily dependent on promotion by and subsidies from telecom carriers, none of whom are very happy to be delivering windfall profits to a supplier. They all chafe at the current arrangement and are aggressively looking for ways to change how they do business with Apple. Some carriers are starting to take baby steps in this direction. Others are drawing the ire of protectionist governments, who will force them to change their subsidy levels. One of the business model risks Apple faces is also a channel risk. It would be the emergence and proliferation of House Label phones by major carriers around the world, which could significantly impact channel partner willingness to market and subsidize a competitive brand name phone by Apple or Samsung.

Currently Apple's customer loyalty seems to protect them from channel defection, as carriers do not want to lose customers who prefer iPhones. But it's not clear that telecom carriers must forever be trapped by their desire to compete for Apple loyalists and aspirational buyers. If some carriers do find a way to defect, Apple would see copycat strategies spread quickly and Apple would not be able to react at the same speed. The results would be increased customer price sensitivity on phones (though not to the level of commoditization), which would harm Apple's iPhone margins and lengthen refresh schedules. The hit to iPhone profits could be as large as 40%-50%, which makes this a 7 on the overall impact scale, given Apple's other product lines would provide some cushion.

8) Government Actor Risks

Durability: 1

Impact: 3

As a global company based in the U.S., Apple is in danger of being caught in the crossfire of political interests between governments. As cited above, the Chinese government is making noises about forcing a reduction in subsidies as a way to promote Chinese manufacturers of less expensive phones and they have also recently cited Apple as a national security risk. Given recent revelations of how the U.S. government has infiltrated U.S. technology exports for spying purposes, all U.S. technology companies are vulnerable now to aggressive political actions by foreign governments looking to protect themselves or hurt U.S. interests. Such risks could emerge suddenly and be difficult for Apple to respond immediately to.

9) Cyclical Sensitivity

Durability: 5

Impact: 1

Economic cycles ebb and flow every five to ten years and Apple demonstrated in the once-every-seventy-years calamity of 2008-2009 that it is very resilient to downturns, likely because its customer base is disproportionately well off and insulated from the worst economic pressures.

10) Management Quality

Durability: 5

Impact: 2

Warren Buffett says the best companies are those, such as Coca-Cola, which can be run by dummies and continue to generate their historical profits. Companies like that are companies with simple products, strong brands, stable markets and locked in distribution channels connecting with loyal customers. Unfortunately, Apple is not such a company. For a company like Apple to maintain its profitability, it needs great management that understands the complexity of its products, industries, distribution channels and competitive challenges. Apple seems to be a company whose management is up to that challenge now but this could change over a ten year time frame.

Perhaps the closest precedent was the change from Bill Gates to Steve Ballmer at Microsoft. After that change, Microsoft steadily saw turnover in key positions and lost its vision and cohesion as a company, moving two steps behind competitors and not executing well. Management deterioration there did not happen overnight but took several years and one would expect it would take a similar length of time at a company like Apple. Of course, the change was not enough to erode Microsoft's historical profits, demonstrating how a strong brand and entrenched customers can make up for weakening management, except over the very long term for companies like Microsoft and Apple.

11) Key Persons

Durability: 1

Impact: 1

Apple lost Steve Jobs and continued to grow like a weed. An argument can be made that Jony Ive or Tim Cook is now a key person, and either could be hit by a bus, but neither of them hold a candle to Jobs in importance.

12) Balance Sheet

Durability: 10

Impact: 1

Apple's balance sheet is a fortress whose soundness could not be quickly reversed. Also, Apple generates more than enough free cash flow to maintain operations and fund growth, so it is not reliant on its dragon hoard of cash on the balance sheet.

13) Accounting

Durability: 4

Impact: 2

Apple's accounting is clear for a company its size and shows integrity. The most meaningful questions about how it makes its money and profits can be answered with confidence from its books. The culture which produces its books would likely take several years to change.

Summary of the Enumeration of Risks

Risk Area

Durability Score

Impact Score

Moat Score

(10-Duration) x Impact

1) Brand/Reputation

10

9

0

2) Commoditization

10

9

0

3) Product Disruption

1

2

18

4) Business Model Disruption

4

9

54

5) Customer Defection

7

6

18

6) Supplier Risks

1

1

9

7) Channel Risks

2

7

56

8) Government Actor Risks

1

3

27

9) Cyclical Sensitivity

5

1

5

10) Management Quality

5

2

10

11) Key Persons

1

1

9

12) Balance Sheet & Cash Flows

10

1

0

13) Accounting

4

2

12

  

Summary

218

The Moat Score for Apple as a company is 218 (lower is better). Let's translate this into a risk adjustment to our required yield as we described above:

Value Investor

Fair Value Investor

Aggressive Investor

3-to-1

2-to-1

1-to-1

654 bp

436 bp

218 bp

The table above is interpreted as follows: a conservative investor will ask for risk premium on current owner's earnings which is 654 bp over the risk-free yield; a fair value investor will ask for a yield 435 bp over the risk-free yield; and an aggressive investor will ask for a yield 218 bp over the risk-free yield. Since the risk-free yield is 2.6% as given by the U.S. Treasury rate, to compensate for risks, the conservative investor should look for 9.14% yield on current assets; the fair value investor should look for 6.96% yield; and the aggressive investor should look for a 4.78% yield.

Step 3: Calculate the Risk-adjusted Company Value

Now that we have the risk-adjusted yield based on an enumeration of risks, we can use owner's earnings to calculate the risk-adjusted price each kind of investor should be willing to pay for Apple. Recall that Apple's owner's earnings in 2013 were $38,775. Below is the risk adjusted purchase price for each class of investor,

Investor Type

Required Yield

Risk Adjusted Company Value

Risk Adjusted Per Share Price

Value Investor

9.14%

$424B

$70

Fair Value Investor

6.96%

$557B

$92

Aggressive Investor

4.78%

$811

$135

Step 4: Add Back Cash and a Growth Premium

The prices above account only for risk: these are the prices investors would be willing to pay only for current owner's earnings, discounted for the possibility that the earning power of the company's assets may be impaired across the next ten years. But of course companies, including Apple, have balance sheets as well as income and cash flow statements, and upside potential as well as downside risk. The value of these need to be added to the company's risk-adjusted value before an investor can arrive at a final valuation.

At the end of Q2, Apple had $150.6B in cash, $18.4 held domestically and $134.2 held abroad. The cash held abroad is not available for owners unless it is repatriated, which makes valuing it tricky. A repatriation holiday seems to be the only thing Democrats and Republicans can agree on these days, so, from a ten year perspective, I am willing to somewhat generously assume only a 7% tax when the money is finally brought back home. Let's adjust the $134.2B in foreign cash down by 7% to $124.8B, which along with domestic cash gives cash on hand of $142.6B. From this we can subtract $24B in debt, giving a net cash number of $118.6B.

Investor Type

Required Yield

Risk Adjusted Company Value

Risk+Cash Adjusted Company Value

Risk+Cash Adjusted Per Share Price

Value Investor

9.14%

$424B

$543B

$90

Fair Value Investor

6.96%

$557B

$676B

$112

Aggressive Investor

4.78%

$811

$920B

$153

Everything to this point has been to estimate a price for Apple's current earnings and cash. To complete the analysis, we need to determine what we should pay for the growth option. Where are Apple's growth opportunities?

Opportunity

Comment

Size of Earnings Opty (low end - high end)

Geographic Growth, Existing Mobile Devices in the Consumer Segment

Apple's low market share in Europe, BRIC and other Emerging/Developing markets is a large opportunity. This statement is not a prediction, just observation of a mathematical fact. India, in particular, is huge and hardly penetrated. There is room to double or triple current sales by bring market share in these markets to 15% over the next ten years as Apple experiments with new strategies and the middle classes of emerging nations continue to grow.

$20B-$30B

Segment Growth, Device Sales to Enterprises

Apple has an opportunity to siphon business from the enterprise market, which their recently announced partnership with IBM seems to indicate they will pursue aggressively. This opportunity is not only mobility but also Macs.

<$1B-$5B

Segment Growth, Mac Sales To The Consumer Segment

Microsoft has stumbled badly with Windows 8, while Apple is introducing tighter and tighter integration between its mobile devices and its Macs. There is an opportunity to leverage the halo of the iPhone and iPad to significantly increase market share of Macs over the next ten years. Apple is currently estimated to make a 28% margin on about 16M Macs sold per year.

<$1B-$12B

Organic Growth, Existing Products in Digital Entertainment

Apple is already a very strong player retailing digital entertainment from music to TV shows and games. They have made it clear they intend to pursue growth in this area aggressively through both their game initiatives like Metal and improvements to Apple TV. The high def game market alone, where Apple gets no revenue now, is $60B.

<$1-$6B

Organic Growth, Software Sales to Consumers and Enterprises

Apple booked $10B of revenue through the app store in 2013, without productivity or enterprise apps significantly contributing. This is an area where huge growth is possible.

$10B-$30B

New Services, Payments and Financial Services

Apple is well positioned to use Touch ID, iTunes and its huge cash balance to cover both online and physical payments and offer unsecured credit. This is a very attractive cash cow opportunity in which Apple should be able to record higher margins than Visa/MC. Six hundred million iPhones in the hands of affluent purchasers could register well over $1T/year in purchases offline and online, and if Apple broadens into financing they could double earnings from payments alone.

<$1B-$15B

Interest Rate Increases

Apple's cash hoard is earning very little. A return to a normal interest rate environment would add billions of earnings at no cost.

$<1B-$6B

New Devices, Wearables, Home, etc.

iWatch, iTV, Beacons, etc. This is a real unknown. The iWatch could be anything from a total flop to another iPad-like hit. Same for other potential devices not being talked about.

$<1B-$30B

New Services, Home Automation and Remote Control, Auto, etc.

Garage doors, home doors, lighting, appliances, central A/C., etc. The opportunity here is to generate 3rd-party revenue by licensing development and application rights to the iHome platform.

$<1B-$3B

New Devices, Medical Devices and Health Records

Integration with mobile and wearable computing; expansion into healthcare professionals market. The size of the opportunity here is also very unknown, from miniscule to huge depending on how aggressively and successfully Apple pursues it.

$<1B-$10B

Taking the mid-point of potential earnings increases, we get an $89.5B earnings increase opportunity over the next ten years. If realized, that increase would represent a $12.8% compounded annual growth rate from current levels. Who says Apple is too big to be a growth company anymore!

To estimate a value for the option on Apple's growth, I will use a 30% discount rate for the Value Investor, a 20% discount rate for the Fair Value investor, and a 10% discount rate for the Aggressive investor. This yields a value on the growth option of,

  • $72B for the Value investor;

  • $116B for the Fair Value investor; and

  • $205B for the Aggressive investor.

Plugging these numbers into our valuation table,

Investor Type

Required Yield (on current earnings)

Risk Adjusted Company Value

Risk+ Cash

Value of Growth Option

Value of Company (Risk + Cash + Growth Option)

Fully Adjusted Per Share Price

Value Investor

9.14%

$424B

$543B

$72B

$615B

$102

Fair Value Investor

6.96%

$557B

$676B

$116B

$792B

$131

Aggressive Investor

4.78%

$811B

$920B

$205B

$1125B

$187

The rightmost column gives the estimated value of Apple shares, adjusted fully for risk, cash on hand and growth opportunities. The numbers are striking. We can see here how deeply undervalued Apple was last summer, when its share price was close to $70. It was priced entirely for risk, at a value investor discount level, with no value at all placed on its cash or its growth opportunities. When all aspects are fully priced in, we can see that even now at about $94-$95/share, it is priced below even the sizable margin of safety required by value investors and is far below its fair value of $131/share. I have to remark that the current market is a risk-on, aggressive investors market, with few companies priced at or below a fair value level. For Apple's share price to reflect the same risk/reward posture towards Apple as market participants currently take to other companies with similar low risk/high reward profiles, its shares should be selling closer to $190 than $90

Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.

Source: Apple: A Low-Risk Bet On $130B Of Earnings Within 10 Years

Additional disclosure: The author is long Jan 2015 and Jan 2016 AAPL LEAPS.