Despite Apple's (AAPL) run up, there's still a high probability of making a 20% return through a long position. Our Economic Value model and Monte Carlo simulation suggests that there remains significant upside (Figure 1.1) from Apple's $618.63 share price as of April 2, 2012.
Our Monte Carlo simulation provides a range of 1,000 scenarios to determine the probability associated with making a minimum return of 20%, as well as the probability of taking a loss through either a short or long position.
For each scenario, a random value is generated for the unknown inputs in our discounted Economic Value model. These random values are based on reasonable ranges derived from 10-year historical distributions of company and peer data. While point estimates are often "precisely wrong," range estimates provide a more realistic view of market variability and have a greater chance of the actual outcome falling within the estimated range. Additionally, we scrutinize the inputs of our Monte Carlo simulation through our Economic Value (also known as Economic Profit, Economic Value Added, or EVA) calculation, where adjustments are made to accounting statements to more accurately reflect the economics of each driver.
Our initial estimate calculates a probability distribution of "fair value," ignoring the element of time (Figure 1.2).
For Apple, the probabilities associated with making a 20% return or higher are as follows (Table 1.1):
- Long: 93% chance.
- Short: 1% chance.
The probabilities associated with losing under the following scenarios are as follows :
- Long: 2% chance.
- Short: 98% chance.
However, the question of time still remains. When will a 20% return be achieved and what is the probability of doing so within various time frames? For Apple, the probability of making a 20% return within the next 12 months is approximately 84%.
By calculating Apple's share price volatility and our estimates of fair value, we can approximate probabilities of making a 20% return in the next 3, 6, 12 and 18 months by using a statistical concept known as "first passage times" (Table 1.2).
Apple Ranking in Value Creation and Economic Value
To further validate and provide context to the reasonableness of our analysis, we compare Apple's operating performance with other companies. It's no surprise that Apple dominates in delivering long-term value to shareholders (Table 1.3), as measured through Market Value Added (MVA). MVA is the Market Value (Debt plus Market Value of Equity) less the book Capital employed in the business. MVA represents the accumulated value created over the life of a business, as well as shareholders' expectations of the future stream of Economic Value.
Over the long-term, as Economic Value improves so will the share price of the company. As a result, it's no surprise that Apple ranks highest in MVA along with its Economic Value performance, even when adjusted for size (i.e. MVA / Capital), where the company generates $7.92 in additional market value for every $1 of capital invested. Apple's recent Economic Value / Capital, which equates to the spread between the company's Return on Capital and Cost of Capital comes second only to Baidu (NASDAQ:BIDU). This is remarkable given Apple's size.
Typically, as a company becomes bigger there are fewer opportunities that will create the same level of return for each dollar of capital spent. A smaller company like BIDU is able to initially generate large returns, but as it grows bigger it will become more difficult to find opportunities with the same level of profitability. This is partially due to the fact that large returns attract more competition. Apple, however, has defied this common economic tradeoff of size and profitability because it continues to create differentiated products that spur tremendous demand while maintaining an economic cost advantage (Table 1.4).
Again, Apple defies the law of large numbers by posting revenue growth that makes small high growth companies look slow. Not only is Apple growing at an extraordinary rate, but at a rate that is very profitable. With a Return on Capital of 44%, Apple understands that growth for growth's sake is not what drives shareholder value.
Also, Apple's discipline in growing profitability is highlighted by the fact that the company has struck a healthy balance between profit margins and effective use of capital as demonstrated by its NOPAT Margin and Capital Turns (Table 1.5), as well as its recent decision to return excess cash to shareholders.
The odds of Apple generating another 20% return in the next 12 months provides an attractive margin of safety. These odds certainly look reasonable when considering the fundamental operating performance of Apple compared with other major companies. And although a great company doesn't necessarily equate to a great stock, there is an 84% chance that it does in Apple's case.