By Mark Bern, CPA CFA
In Part I of this two-part series I provided a sense of where the continued growth of Apple (AAPL) revenue and earnings are likely to come from and some of what I expect in terms of new products and service offerings. I started with a review of recent growth acceleration and an explanation of why this phenomenon is occurring. I also discussed why investors have difficulty imagining a continuation of this trend. It defies reason. Such growth has never occurred before in such a large company. This is a totally new paradigm and does not fit into any existing models and therefore cannot be projected or valued with any sort of precision. It's not a new company. It's operating in a maturing industry that still has growth prospects, but nothing like what is being experienced by Apple today. It is gaining a dominant position in multiple industries that have been with us for several decades and is growing much more rapidly than rivals or the industries in which it competes. It is breaking all the rules. And, surely there must be an imminent, inevitable end to such unheard of growth. The problem is, as I stated in the earlier article, that our finite brains just cannot grasp the infinite opportunities that abound in Apple's future. To get a better understand of what I'm talking about, please take a few minutes to read the previous article before you comment negatively on this one. Without the basis of the earlier views it would be impossible to understand the path down which we are about to impart.
First, let me reiterate one salient, historical point from the first article. Over the last three years Apple sales have increased by an average of 43 percent per year. In 2011, Apple sales growth was 63 percent over 2010 results. Over the past five years Apple has increased earnings per share (EPS) at an average compounded annual rate of 65 percent. Over that period the stock price has increased at an average compounded annual rate (total return before the dividend) of 24.8 percent. The price/earnings ratio (P/E) has dropped from an average of about 29 to less than 14 today. Strange that as growth increased the multiple investors have been willing to pay has fallen so precipitously, isn't it? And when we look at the most recent quarterly results we find that the trend is continuing unabated. The street consensus view called for earnings of $10.04 per share while the actual EPS grew to $12.30. Last year's second quarter EPS were $6.40, which means that EPS grew at a staggering rate of 92 percent year-over-year (yoy). This has never happened before in such a large company and analysts just can't model it. Investors just can't grasp the magnitude of the opportunity nor the rate by which the company can continue down the given path. Thus, we cannot fathom what the future holds and tend to err on the cautious, more conservative side. I'm going to do the same thing. But when we look out at a future earnings stream that is likely very low compared to what is actually more probable we find that even then the story is so compelling that we must realize that the current earnings multiple is ridiculously low. It was suggested, and I agree to a certain extent, in the comments to the earlier article that the reason for the low P/E is the uncertainty that stems from the loss of Steve Jobs and the inevitable questions about Cook's ability to maintain the advance. I believe that is part of the problem and do expect that, once the market gains confidence in Cook's abilities to keep growing the company, there may be an positive adjustment. But it really doesn't matter that much. My assumption assumes that the P/E remains depressed until growth slows to bring the two into balance.
Next, I want to stress that, in my opinion, two factors determine the value of a stock: earnings growth per share and dividend growth per share. It is my belief that share price will, over the long term, follow the lead of earnings and dividends. With that in mind, let's jump to a very simple assumption that the average rate of earnings growth for Apple with drop to less than half its current rate immediately (not likely, but let's just keep it simple and cautious); all the way down to 25 percent from 63 percent (or 92 percent if you take the most recent quarter results as the base rate; then we are dropping by more than two thirds). Let's also assume that the dividend grows at an equal pace even though it is more likely that the company will increase the dividend faster than the earnings growth rate because the payout ratio is current only six percent compared to an industry average of ten percent. That equates to a compound annual total return of approximately 27.5 percent. It is hard to conceive of how powerful such a return would be over time and how much it could benefit one's portfolio, but let's take a shot.
After five years, without allowing for earnings multiple expansion or further contraction, the price of Apple stock would grow to a value of $1,729.46 a share. The dividend would grow to $8.08 per quarter, or $32.32 per year, still yielding a mere 1.8 percent. By this time, an investor who had held Apple stock from Friday, May 11, 2012 to May 11, 2017 would have collected a total of $72.76 in dividends from their initial investment of $566.71 (the closing price as of May 11, 2012).
Now let's assume that the earnings growth rate slows down to 18 percent per year over the next five years. That seems like a reasonable assumption, doesn't it? What would happen to our one share of Apple stock during that next five-year holding period? The stock price would rise to $3,956.59 per share and the dividend would rise (assuming the dividend growth equaled the earnings growth rate) to $72 per share each year, or $18.50 per quarter. By this time the same investor, having held his/her share of Apple stock for the full ten year period would have collected a total of $345.85 in dividends.
Now let's make one more assumption; that the earnings growth rate slows once again, but this time all the way down to the pedestrian rate of 12 percent per year and that the company maintains that rate for the next ten years. How would our investor be doing at the end of a twenty-year holding period? By this time the stock price would have risen (once again assuming that the P/E remains at about its current level which is more appropriate but still low for a company that is growing 12 percent per year consistently) to $12,288.57 and the annual dividend would be $229.85 per year. By this time the same investor would have collected a total of $1,800.40 in dividends from Apple for their initial investment of $566.71 a share.
It 20 years the stock would be more than 21 times the current value and the dividends received would equal more than three times the original investment. The problem with this valuation, in my opinion, is that it is too low. I believe that a growth rate more in the range of 30 to 40 percent can be sustained for at least the next decade. I also expect that the growth rate will continue to average at least 20 percent for the ten year period following that. At 35 percent, then 20 percent, the stock would climb to a price of over $70,000 and the annual dividend would be in the range of $1,300 a year. An investor, if I am right, would have collected dividends totaling a staggering $7,369 over those 20 years on an initial investment of $566.71.
I know that sounds crazy. But remember, Warren Buffett was able to sustain nearly 20 percent average annual returns prior to the 1990s with very limited control over an assembly of various companies. Apple management is very focused on an opportunity that may dwarf anything we have imagined in our history, a complete transformation of the entertainment, computing, and communications industries all rolled up into one terrific strategy.
By the way, for those who have not yet read the first article, I should once again point out that I do not personally use Apple products. This is not coming from a guy who loves his Apple devices and hates everything that isn't Apple. It is coming from an analyst who just looks at the numbers, has taken a glimpse of the future product lines and services coming from Apple, and has projected out a relatively conservative expectation based upon Apple attaining only a fraction of what I deem possible. Once again, I reiterate that Apple is a buy at current levels, nearly 13 percent below its recent high. I believe that it should be a part of any long-term, dividend growth investor's portfolio.
Disclosure: I am long AAPL.