Given a plethora of investment articles written about Apple (AAPL) every day, I would generally avoid reporting on this security. I own no Apple products, nor do I have any particular emotional interest in the company.
Yet, Apple just happens to be the largest component of my investment portfolio.
Apple: One-Year Price and Volume
Click to enlarge images.
Source: Courtesy of BigCharts.MarketWatch.com.
Let's review the company fundamentals, current valuation, and offer an investment thesis for owning the common stock.
We'll look at three basic financial components: the balance sheet, the income statement, and statement of cash flow. I like to analyze the business using several straightforward metrics derived from these documents.
Apple continues to sport a fortress-like balance sheet. There are no weaknesses, unless an investor wishes to critique the incredibly large amount of cash and marketable securities on the books. Apple lists $117 billion on the balance sheet as of the most recent 10-Q statement. This equates to $126 a share. These assets are invested quite conservatively. Therefore, the return on cash and investments are relatively weak.
Also remarkable is the fact that Apple has grown to its immense size without incurring any debt. The current ratio is over 1.5, indicating sufficient liquidity. The equity/asset ratio is 69%. Generally, a ratio above 50% is considered strong.
Adding gloss to the figures, over the past four quarters investors have enjoyed a 46% improvement in owners' equity, while the company has increased its cash and marketable securities by roughly the same percentage.
Revenue growth and related margins are outstanding. While all dipped somewhat in the most recent quarter, the upward trend has remained in place for several years. For a company the size of Apple to continue to improve top-line growth by such percentages is truly unique. Gross margin and profit margin have likewise continued to grow as the gigantic increases in revenue continue to dilute production and overhead costs due to economies of scale. In this respect, Apple is deservedly in a class by itself. Here's a five-year chart outlining the previous discussion:
Source: Courtesy of Ycharts.com.
As would be expected commensurate with the aforementioned facts, the return-on-equity, return-on-assets and return-on-investment calculations are likewise stellar. The specifics are as follows:
- ROE 44%
- ROA 30%
- ROI 38%
These figures put Apple in the 91st percentile or better vs. computer and peripheral industry peers. Frankly, it would be difficult to debate that Apple has any true peers.
Let me expand on the previous statement in order to avoid hyperbole: While classified as part of the computer industry, one could make a reasonable argument that Apple is a global manufacturing company, distributor, retailer, and R&D enterprise all rolled into one -- that happens to be in the computer and peripherals business. Indeed, if it chose to more aggressively manage its cash and investments -- perhaps similar to Intel (INTC) -- it could add "heavyweight asset management" company to the list.
Apple has a five-year cash flow growth rate of approximately 65%. This is an outstanding claim. Best-in-class inventory and receivable turnover back up the brutal efficiency of the operation.
This year, Apple finally began to return some capital to shareholders via a modest dividend. My view is that this was not a result of the company losing growth momentum, but a result of carrying the outsize cash hoard coupled with some polite investors murmuring about releasing some of these funds.
Apple has an unquestionably strong set of financial statements. However, is the company stock valued such that investors can still expect a reasonable return going forward? If so, at what price would the shares appear overvalued and mean it's time to exit?
Let's begin by noting that Apple stock has risen nearly 300 points, or 73%, thus far in 2012. That's a pretty good run. However, in order to perform a valuation exercise, we are not so interested in where the stock has been. We want to know where we think it can go from here.
While there are several established ways to evaluate a security's value, I prefer to keep things as simple as possible. If a company has a strong balance sheet, good management, and the demonstrated ability to maintain decent margins, what remains is to review historical P/E multiples and make an educated estimate of future earnings growth. Put the two together and a target price emerges. In general, earnings drive share prices. There are cases whereas operating cash, EBITDA or EBIT may be more appropriate. However, in the specific case of Apple, I believe that placing a reasonable P/E multiple on projected EPS is sufficient.
The following two graphs offer some pictorial insight as to the foregoing discussion. Here is a seven-year chart showing Apple share price (the black line), a normalized P/E over this period (the blue line), and a potential P/E (the orange line) based on the earnings growth rate over the same period of time:
Source: Courtesy of FastGraphs.com.
The first thing that stands out is the fact that the black line has remained below either the normalized P/E or potential P/E for a few years. At the surface, this would indicate that the shares are undervalued. Over time, one could expect that investors will eventually bid up the stock to at least the normalized P/E line (about a 23 times multiple) since the market has done this in the past. However, past performance is no guarantee of future returns, so we need to do some additional analysis. Furthermore, good investing generally involves building in a decent margin of safety.
The next graph can help us do both:
Source: Courtesy of FastGraphs.com.
To begin, we can see that the consensus of 46 analysts indicate that Apple EPS should increase by 25% over the next five years. Closer to home, this growth rate is 21% for FY 2013, and 25% for the following year. I cross-checked this data with Zack's free online data, and its consensus estimates were slightly lower: 20% for next year and 23% per annum for the next five years. Therefore, I suggest a reasonable projection of Apple's EPS growth rate for the next two years should average something around 20% per year.
Next, we need to place an appropriate multiple on the earnings to get a projected share price, since earnings times P/E equals price.
Well, the first chart indicated a reasonable historical multiple of 23 times and a potential multiple of 56 times. However, I suggest that either of these figures may be too rich. Let's use a more modest S&P market multiple of 16 times on earnings and check out the results. This happens to be the Apple's current P/E ratio and is much closer to the valuation placed on Apple shares over the past couple of years.
Here's the math:
FY 2012 projected EPS is $44 a share: 44 X 16 = $704 price target
FY 2013 projected EPS is $53 a share: 53 X 16 = $848 price target
My takeaway is that Apple shares are at a conservative "fair value" right now. Nonetheless, investors look ahead to what is most likely to happen going forward. Therefore, a one-year reasonable price target could be about $850. That's a 20% projected target return. The modest dividend is added gravy.
I may add that Apple has shown a penchant for beating analyst expectations. The Street has become numb to this and expects a "beat and raise" every quarter. So there is some risk there. On the other hand, the target price calculation assumed no multiple expansion despite historical data stating otherwise, and did not back out cash from the current price (remember the $126 per share on the books).
That sounds like we have a decent investment shaping up to me.
If a security is backed by a strong enterprise, and it's below a fair future target value based on reasonable projected metrics, then the remaining analysis entails determining a viable investment thesis. What catalysts or events may provide the impetus to propel the stock up to its target valuation?
In the case of Apple, the answers are fairly straightforward. Catalysts include:
- The current release of the iPhone5 appears to be a smashing success; nearly 8 million units were sold right out of the chute.
- The Samsung litigation solidified Apple's hold on certain proprietary design and intellectual property rights.
- CEO Tim Cook has demonstrated that he is a very capable leader, and has a cast of strong management surrounding him.
- Apple products are a huge hit in China. This market holds tremendous potential for the company on a go-forward basis.
- The Apple brand is considered both best-in-class technology and a status symbol for many users, invoking an almost cult-like following.
Risks should also be noted. All companies, and by definition their securities, contain risk.
Apple share prices are at risk if:
- The future "pipeline" of new products and offerings dwindles with the departure of genius CEO Steve Jobs.
- A "blow away" better product line or OS emerges, or the current Apple OS is compromised in some way.
Of course, general market risk is always possible.
The Bottom Line
I suggest that Apple shares remain a good investment at current levels. While the offering is fairly valued now, the future prospects -- after building in a factor of safety for both earnings and the P/E multiple -- remain compelling. I plan to add to my position via cash-secured puts or keep the premium if the stock continues to rise in the near term.