Intrinsic value in action
To better help us understand Intrinsic Value, let's look at two completely different companies. Both are making money and doing fairly well. One is well known and one is not. The first one is Apple Inc (NASDAQ:AAPL). The second one, Air T (NASDAQ:AIRT), is a small ($70 million in annual sales) company that focuses on regional delivery of airfreight and aircraft servicing equipment (such as deicing and catering lifts). For simplicity, we are not going to look at their balance sheets. Instead, we are only going to focus on earnings. To summarize their earnings picture:
- Apple's 2007 earnings increased by 71% ($4.04/share vs. $2.36/share in 2006); trailing 12-month earnings are $4.56/share (see conference call transcript)
- Air T's 2007 earnings increased by 22% ($.94/share vs. $.77/share in 2006); trailing 12 month earnings are $1.29/share
If we were to take these numbers and extrapolate them for the next 10 years, AAPL would have earnings of $567.57/share and AIRT would be earning $7.72/share. This is probably not realistic, especially for Apple--just consider how many computers and iPods have already been sold.
How much growth?
If instead we assume each company’s earnings grow by 20% annually for the next 10 years, you would get the following (discounting at 5%-- the current yield on high quality corporate bonds):
- Year 10 earnings of $28.11/share, present value is $17.26/share
- The discounted earnings for the next 10 years add up to $101.74/share
- Year 10 earnings of $9.42/share, present value is $5.78/share
- The discounted earnings for the next 10 years add up to $32.26/share
Keep in mind that we are not looking at any assets as part of intrinsic value, just earnings. While it would cost money to do so, the Apple brand clearly has a lot of value (goodwill) that could be monetized through licensing, royalties, etc.
Is this good or bad?
What does all this mean? As of yesterday (2/5/08), AAPL closed at $129.36/share and AIRT was at $10.83. Assuming these companies can grow earnings at 20% per year (10 years is a long time--life in prison sometimes lasts only 7 years), we can say the following:
- AAPL's current price, about $130, indicates it's going to grow earnings at about 25% for the next 10 years
- AIRT's current price, about $10, implies it's going to grow earnings at about 1% for the next 10 years
How fast are earnings going to grow? This is where stock research comes into play. One things is clear: 71% earnings growth is not sustainable for 10 years. Given the length of time, I would say that 20% is more likely. At this growth rate, earnings in 10 years would be a little over 6x higher than today. If AAPL kept the same margins, their sales in 10 years would make them almost as large as GE today. Why not 25%? At 25% earnings growth (assuming the same margins), AAPL would be larger than GE and approaching the size of today's Chevron --I'm having a little bit of trouble seeing this.
This leads me to believe that even 20% earnings growth may be optimistic. Still, let's leave the 20% earnings growth estimate for both companies. Here are some additional thoughts, starting with Air T Inc:
- If 20% earnings growth is sustainable, AIRT is currently priced at about 40% of its intrinsic value
- Even if earnings grow at only 3% per year, AIRT is still priced 10% below its intrinsic value
- AIRT has a great financial position (see my previous article) which, combined with the upside potential, provides a nice margin of safety
- About half of AIRT's business depends on Fed Ex (risk); with that being said, they have been working with Fed Ex since 1980 (stability)
Here are some thoughts on AAPL:
- Assuming a 20% earnings growth for 10 years, at $130, AAPL is still priced about 30% above its intrinsic value
- At $130, AAPL's earnings will have to grow at about 25% for the next 10 years to justify this price (i.e., for the Intrinsic Value to be about $130/share)
- AAPL also has a great financial position, although it needs lots of cash to constantly reinvent itself and its products (I have 4 Apple computers; each one was only sold for about a 6-7 month period before being replaced by a newer model)
- Ten years is a long time; about 10 years ago, rumors of AAPL's demise and even bankruptcy were widely circulating
While both companies are very successful in their own right, AAPL has lots of execution risk and most (if not all) of the upside is already built into its current price. As it's currently priced, Apple’s earnings will need to continue to grow at about 25% despite economic downturns, competitive pressures, and shrinking margins--not to mention the vagaries of consumer likes and dislikes. In contrast, AIRT is priced very attractively. Even at modest single-digit earnings growth, AIRT is below its intrinsic value. Even though the margin for error in aviation is virtually nil, its business is very straightforward. The company's strong financial position also provides a nice margin of safety.
Disclosure: The author is long Air T and Apple Inc.