This article looks into the relationship between cash and stock price for Apple (AAPL) and discusses the rationale for considering current valuation to be fair.
It is relatively easier to value a company which holds real assets such as industrial commodities, agricultural commodities or real estate. Although one assumes that the business is a going concern, the analyst can still estimate the value per share in case of liquidation based on the holdings of real assets.
For companies in the technology sector, this does not hold true and valuation becomes relatively more complex. The analyst can still look at the future cash flows and arrive at a fair value using DCF valuation or several other valuation techniques. Mr. Aswath Damodaran, professor of finance at the Stern School of Business at NYU recently valued Apple at USD710 per share. From that perspective, Apple is still undervalued.
Coming to the worst case scenario for investors, if Apple were to liquidate, the cash per share for investors would be USD125 based on the third quarter cash and marketable securities for Apple. Also, the total assets per share would be USD174. At the current price of USD650, Apple is trading at 5.2 times cash holdings. Can we consider current valuations to be expensive?
Before I discuss further, I would like to mention here that excessive cash holdings can also be negative for the company if the cash does not generate meaningful returns.
It is also important to understand here that I am not suggesting that Apple should be at USD125 per share. The critical point is related to innovation and the capability of Apple to command premium valuation based on its continuous innovation.
The chart below gives the equity price per share and cash per share for Apple. Clearly, there is a strong relation between the two and it can be explained by fundamentals. The stock price has been appreciating in line with an increase in cash, which is directly related to the business growth.
The second chart gives the price to cash ratio from 2005 until most recently. The current price has been divided by the third quarter cash and marketable securities holdings.
The chart is critical as it provides a strong support to the argument that Apple is not expensive or in a bubble purely from a growth and cash perspective. Apple was trading at 5.2 times cash holdings in September 2005 and is currently trading at the same level. During this period, the stock prices have appreciated by 1,122%. Therefore, from the cash perspective, Apple is no more expensive than it was in 2005. Again, the willingness of investors to pay five time cash or fifteen times earnings is solely based on Apple's ability to innovate.
Another company, which thrives on its ability to innovate, is Google (GOOG). It would therefore be interesting to see the price to cash ratio for Google. Slightly higher than Apple, Google is trading at a price to cash ratio of 5.6x. On several other valuation metrics, Apple looks attractive compared to Google. Therefore, on a relative basis, Apple might still seem to be a good investment.
On a standalone basis, I do have some concerns, which makes me feel that Apple is trading at fair value. In other words, investors considering exposure to the stock at these levels might not witness significant stock price appreciation. Further, another significant run-up in the stocks might be a good time to exit.
My first concern relates to innovation and its sustainability. As mentioned earlier, the price Apple commands is largely on its reputation of innovation, which drives revenue growth. Can Apple still innovate and come out with products in an economy, which might be getting increasingly price sensitive due to a prolonged economic setback?
Apple might still have the ability to innovate. However, my concern would be an increasing saturation in the smartphone market in the United States. Nearly 55% of mobile subscribers in the US own a smartphone and 74% of subscribers aged 25-34 own smartphones. With a 33% market share for smartphones in the US, the addressable market size for Apple is shrinking. A counter argument would be the willingness of individuals to adopt new technology or phones at a higher price. The price sensitivity issue comes in and a regular launch of new versions might not generate the same excitement as the launch of iPhone5.
My second concern relates to cash and its use. Very often investors have seen companies with significant cash going for pricey and untimely acquisitions. Any such scenario can spell disaster for Apple. However, I don't foresee Apple going for any major acquisition. Investment of cash in Treasury bonds and other relatively safe securities yields low returns for the company and might catch the investor's eyes if the shadow of innovation gets smaller.
Share buyback is a good idea to the extent that Apple continues to invest meaningfully in research and development. If market participants do feel that buybacks are a signal that the company does not know what to do with the cash, the impact on stock prices could be negative. Excess cash can therefore be negative for the company as much as it is positive.
Further, one is generally near the peak when there is too much optimism and excitement surrounding a stock or product. This is an observation from historical evidence and does not involve any financial analysis. From this perspective, one needs to be cautious about Apple. It also remains to be seen if Mr. Tim Cook has the ability to surprise everyone as much as Mr. Steve Jobs. If yes, Apple can remain the apple of investors' eyes for relatively long.