With a current stock price of $696, Apple (AAPL) performed fantastically over the last couple of years. However, past success doesn't guarantee high returns in the future, and in this article I will provide another perspective on how to think about the valuation of Apple.
The most important product for Apple is the iPhone. As you can see in the below graph, sales of iPhones increased from around 1,000 in Q3 2008 to 37,000 in Q1 2012. Since then sales have declined, and last quarter 26,000 iPhones were sold. However, this decline wasn't a surprise, as consumers are waiting for the iPhone 5 to be released.
As 53% of the income of Apple is related to the iPhone, it is obvious that sales of iPhone are of very high importance to Apple, and while I am convinced that the iPhone 5 will make new sales-records, I am not confident that sales will continue growing at a high rate over a longer time period.
One way to get an idea of the expected future growth rate of the iPhone is to look at the consensus amongst analysts. They estimate that Apple will grow by an annual rate of 21.8% over the next 5 years. I think most of that growth will come from increased sales of the iPad, as the tablet market is estimated to be ten times larger by 2016.
It is my understanding that analysts estimate that earnings of the iPhone will increase by 12.6% y/y, which means that the other segments of Apple will grow by 30%. One way to combine the P/E ratio with the expected growth rate is to calculate the PEG-ratio. The PEG-ratio is defined as the Forward P/E divided by the average annual growth rate over the next five years. Generally, companies with a PEG-ratio of below one are considered cheap while companies with higher PEG-ratios are considered expensive. The PEG-ratio of Apple is (12.8/21.8) 0.58.
Some investors might end their valuation of Apple here, and conclude that Apple is undervalued. However, as I will argue in this analysis, investors need to consider factors such as risk, quality of earnings, earnings after five years and the cash reserves before they make a conclusion.
Assessing risk - A scenario analysis of the iPhone
One way to quantify the risk of a company is through the beta. If the beta of a company is below one, the company is considered safer than the average company, and in the case of Apple, the beta is 0.88. The problem, however, with using the beta is that it only looks at the historical risk, which in my opinion is misleading in Apple's situation. Over the last couple of years, Apple basically did everything right and everything went according to plan or the best case scenario, which meant that volatility was relatively low.
But there is really no guarantee that everything will go "according to the plan" in the future. Whether you are bullish on Apple or not is a bit irrelevant in this case, as you do not know for certain how many iPhones or iPads Apple will sell in 4-5 years.
Therefore I will try to asses some of the risk involved with investing in Apple through a scenario analysis. The first thing I need to decide on is which variables I want to adjust (e.g. should the scenario analysis differ on the future growth of the iPad or the iPhone? Should I change the expected growth rate or production efficiency?).
Though the iPad is expected to catch up in terms of revenue, margins on the tablet are lower, and therefore it is expected to generate less future income than the iPhone. The iPhone is the most important product for Apple, and therefore I will dedicate my first article on Apple to an extensive scenario-analysis of the iPhone.
I decided to make no adjustment to the expected future market size of the smartphone market. Instead, the scenarios differ in terms of the expected future market share of the iPhone.
Below is the expected market size of the smartphone market. As you can see, it is expected that there will be sold around 1500 million smartphones in 2017 from 500 million in 2011. The iPhone currently has a market share of 20%, which means that Apple has sold roughly 115 million smartphones over the last twelve months.
Scenario 1: The optimistic scenario
In this scenario, the iPhone will be even more popular than it currently is today as it will increase its market share at the expense of Samsung. Growth will primarily come through emerging markets, and current users of iPhones will replace their old models with the new version of the iPhone.
Scenario 2: Investors "expected" scenario
This is the scenario that I believe most investors and analysts expect. In this scenario Apple increases its market share from 20% to 21% in 2017. However, in order to remain competitive, the average price of an iPhone is slightly reduced from $650 in 2012 to $575 in 2017.
Scenario 3: The pessimistic scenario
While the new iPhone 5 will be a huge success, some consumers will replace their old iPhone with one of the models from Samsung (SSNLF.PK), Microsoft (MSFT) or potentially some of the cheaper alternatives. As a response to the declining market share, the average sale price is reduced at a faster rate than in Scenario 2, and in 2017 the average sales price is $500. Revenues increase over the period, but margins are thinner and fixed costs represent a higher portion of revenues than in the other scenarios.
Given the above scenarios, below are my expectations for operating profit in the different scenarios.
Given that the other segments of Apple will grow as analysts expects (at 30%), the PEG ratio for the three scenarios can be seen below.
You might think that a PEG ratio of 1.15 in the "worst-case scenario" isn't that bad. But as I will argue below, Apple will turn out to be extremely overvalued if scenario 3 becomes reality.
The problems with P/E and PEG and how this applies to Apple
1st problem: Depreciations and CAPEX
To obtain a high future growth rate Apple needs to spend a lot of money on capital expenditures (CAPEX), which decreases the free cash flow, but has no impact on reported earnings. Instead, depreciations are subtracted from profit in the income statement. But depreciations only show the decline in book value of the noncurrent assets of Apple. So for high-growth companies, that barely have any "noncurrent assets", depreciations will be very low, while actual spending on CAPEX will be much higher.
Over the last twelve months, Apple has spent $10.5 billion on CAPEX, but only $2.8 billion on depreciations. On the other hand Microsoft depreciated for $2.9 billion even though CAPEX were only $2.3 billion. This is a signal that Apple is a growth company and Microsoft a mature one, but if we want to compare the companies to each other, we need replace depreciations with the expected investment rate that is necessary to obtain the expected growth rate.
2nd problem: Cash and interest rate
So while the earnings of Apple might be artificially high, others will argue that Apple is still cheap on P/E due to the fact that is has over $100 billion in cash. This is good point, and below I will show my method on how to calculate an adjusted P/E-ratio which takes cash into account.
- Apple has earned roughly $800 million in interest due to the investments in MBS. Those $800 million should be subtracted from the TTM earnings.
- $117 billion in cash should be removed from the market value of Apple.
Given the first two problems, I have calculated the adjusted PEG-ratios for scenario 2.
Apple looks even cheaper now then it did prior to the adjustments as the PEG is significantly below 1. So can we now conclude that Apple is undervalued?
3rd problem: PEG-ratio tends to overvalue high-growth companies and it doesn't look at potential growth after 5 years
It's actually a myth that PEG fully takes growth into account. Here is one example that illustrates why: Company A has an estimated 5-year CAGR of 30%, and a forward P/E ratio of 20. Company B has an estimated 5-year growth rate of 1% and a forward P/E ratio of 3. The PEG ratio of company A is (20/30) 0.67, while company B has a peg ratio of (3/1) 3. But in my opinion it's pretty obvious that company B is a whole lot cheaper than company A, so therefore we can't use the PEG-ratio high-growth or low-growth companies. PEG-ratio should primarily be used for companies with growth rates between 10-16%. At 21.8% Apple is supposed to trade at a PEG-ratio below one.
I also believe that the growth-opportunities after five years are very limited for Apple, as the technology sector is very volatile. Personally I think Apple will generate less income 15-20 years from now than what they do today, which further strengthens the argument that Apple should trade at a discount PEG-wise.
Questions investors need to ask themselves
Assume you are aware of the traps of using the P/E- and PEG-ratio, and after having done your due diligence you still believe Apple is slightly undervalued. You estimate that the fair P/E-value (non-adjusted) should be 18.5, which implies a PEG-ratio of 0.66. Therefore you believe the fair share price for Apple is $800.
But despite your due diligence there are still risks involved with your investments. If scenario 3 becomes reality, your investment in Apple is heavily overvalued, and the price of Apple needs to come down by $256 to maintain the "fair-value" PEG-ratio of 0.66.
So even though you believe Apple is undervalued, there is still a lot of downside potential to the stock. Investors need to estimate the probability that Scenario-3 will happen.
Below are a few questions that I believe all Apple bulls should answer in order to assess the downside risk.
- Do you see it as unlikely/likely that the Windows Phone will obtain a market share above 10% by 2017?
- Do you expect Samsung at a more rapid pace than I do in my scenario analysis?
- Did the presentation of iPhone 5 impress you?
- Do you think the brand value of Apple will be maintained even if the competitors offer products at a similar or higher quality?
- Do you think the market share of the iPhone will increase or decline over the next 5 years?
- How likely (percentage wise) is scenario 3?
Personally I think Apple is losing its edge. Don't mistake me. I still think the iPhone is a great phone, and the brand value of Apple will make consumer's down-prioritize the value-for-money concept. However, nothing lasts forever, and the smartphone market is very competitive. Over time I believe you need a significant competitive advantage to obtain high margins, and I think Apple might be losing it. I am not suggesting to short Apple, and I am not even implying that Apple is overvalued, but I think investors should think twice before they buy the stock.