When I was much younger, my father taught me that it was never safe to catch a falling knife. "Just let it fall," he would say. Somehow, this logic has seeped into investing strategies. If a stock price is climbing, climb aboard! If it's falling, abandon ship. And then we tend to go one step further and use the current share value (or its recent trend) to make commentary and analysis on the status of the underlying company. Think about it, 12 months ago, Apple (NASDAQ:AAPL) had a market cap of over $650 billion. Today, it is $372 billion. In the last year, Mr. Market has halved his valuation of the company. If you only knew the last two sentences, you might assume that the company had a huge crisis, lost half of its earnings, or perhaps was at the epicenter of a meteorite strike. In reality, Apple's revenue is up year-over-year and its book value per share has climbed by 15%.
So, what happened? Well, Apple had a monster 2012. It generated its highest Return on Equity (RoE) in 10 years with 35.30% and pushed its Earnings Per Share up by almost 60% over 2011 with revenues of $156 billion. Mr. Market responded favorably and pushed Apple to $705/share and a Price to Earnings (P/E) ratio of 15.97 (still well shy of Google's, by the way).
When we fast-forward into this year we see that for the quarter ending in Dec 2012, Apple had static earnings over Dec 2011 and dropped from $12.30 to $10.09 year-over-year for the quarter ending in March 2013. But, its revenues increased over those same quarters. So Apple is churning a still impressive 28% RoE this year. And the market response? Pandelerium (if you'll pardon my Jeff Foxworthy-ism)! I recently watched two talking heads discussing whether Apple has a future. The bear cited 3 reasons why the company was the next Microsoft, aka dead in the water, while the bull referenced some technical jargon about 50-day moving averages and 'support' at $435. (As a caveat, beware of guys who draw lines based on stock histories and then predict a price at which a share will 'bounce'...they are notoriously bad at predicting the number of bounces before the bottom falls out.) To my delight, neither of these guys could muster a strong argument in favor of Apple's historical returns on equity, profit growth, shareholder value growth, and of course, an ability to pump out some of the most incredible technological products that any generation has ever seen.
I write all of that as a precursor to my calculations on Apple's long-term growth potential and to demonstrate that if Apple can do half as well in the next 10 years as it has in the past 10, then it is a bargain today. As with my last article, I will be looking at Apple through the lens and formulas of famous value investor, Warren Buffett. That means we are looking for a durable competitive advantage and a history of producing consistent earnings, growth, and shareholder value. Let's take Buffett's word for it and agree that looking backwards 10 years can give us a very strong indicator of the next 10. In that vein, Apple is rock solid. But does it have a durable advantage over its competitors? Absolutely. Apple has made no attempt to hide that it believes in quality products that cannot (and will not) compete on clearance racks and in the marketplace of the thrifty. If you want an Apple product, you pay more for it. This, along with an incredibly loyal customer base distinguishes the firm and it is something that sets it apart from its competitors in a very unique way. Apple does not engage in price-competitive behavior. Remember that because it will help you better understand their unbelievable returns as we go through the numbers.
1st Look: Better than a Government Bond?
You have to put your money somewhere, right? As a savings account is barely better than the underside of your mattress, let's see if Apple can beat out the safest place to put your money, the US Treasury. Begin by dividing Apple's trailing twelve month EPS, $41.89, by the current 10-yr Treasury rate, 2.5%, and you will get a relative value of $1,675.60. This means that you would have to pay $1,675 for a share of Apple in order to earn the same return on investment as a government bond.* That's a clear win. But no one considers 2.5% to be anything to write home about. So let's compare Apple against a fictional 8% bond. Dividing the EPS by that rate gives you a relative value of $523.63. That is still 25% above Apple's current price. At $420/share, Apple offers you a 9.9% initial return on investment with a coupon that is slated to grow annually. I'll take that deal any day.
(Remember that Buffett looks at corporate earnings from a business perspective and considers earnings as a return on his investment. With an average RoE of 21.63% in the last ten years, you know that Apple is going to use those earnings to generate more growth and value.)
2nd Look: It's All About the Equity
As stated above, Apple's long-term RoE is 21.63% (that includes 2003 and 2004 that saw RoEs of 1.6% and 5.4%, respectively). It has traditionally retained about 100% of those earnings. With Apple's new dividend program, it will be retaining about 73% of those earnings for 2013. Multiplying these values shows that the firm will add approximately 15.79% (73% of 21.63%) of equity per year. Apple's Book Value per Share (BVpS) at the end of 2012 was $125. Increasing annually at 15.79% yields a book value of $627.04 in 2023. At a 21.63% RoE, that would generate an estimated $135.63 in earnings for that year. The below table shows an estimated price and 10-yr return based on historical price-to-earnings ratios. (Note: these estimates do not include the potential $327 in dividends potentially paid out during that same period.)
*I stayed very conservative and used 20 for the high-end P/E. Apple has actually seen historic P/E ratios in the 30's, 40's and even 50's.
*CAR - Compound Annual Return
Last Look: EPS Valuation
Now there has got be some modicum of excitement in the above numbers. If not, let's bring it home with a projection of the next 10 years worth of earnings. Traditionally, Buffett would use the historical EPS rate of growth to project outwards. For Apple, however, we are talking about a climb from $0.10/share in 2003 to $41.89 in the TTM. That's an 82.9% annual growth. It is highly unlikely that can be sustained. The past five years have seen a 50.81% annual growth; slowing down, but still too high for me to keep any credibility here. Instead, I will ratchet down Apple's earnings growth potential to 18%; well below their past performance. If the firm's per share earnings trend upwards at 18%, and dividends continue to flow at 2013's projected level of about 27.2%, we can calculate the projected earnings and dividends for the next 10 years.
The projected earnings for 2023 would be an impressive $219.25. Re-using the above table, we are able to lay out a range of the company's 2022 value based on historic ratios.
Look, I understand that these projections are daunting and that this article will likely drum up some controversial feedback/comments. But this is a company that is not going anywhere. Apple has become a market unto itself. It has created and dominated the niche market of 'not-Windows' and it has flourished as a provider of quality products that earns fiercely loyal customers. I would re-evaluate my position if I saw drastic management changes/turnover and if 2013 and 2014 passed without any product refreshes. Apple has strong competitors in Google, Samsung, Netflix and Amazon. These and a number of others are capable of chipping away at some of the company's customer base. But, Apple is in a great position to defend its territory. It employs a tremendous workforce that has literally changed the world with its innovation and it has more than enough cash lying around (and no debt) to weather some pretty serious storms.
I have enjoyed the recent slide in Apple's stock. I do not know if that trend will continue or if the bounce these past few days will hold firm. But I am confident in where the company is going. The turning point for me was a mix of the recent dividend offerings, stock buyback increases (to $60 billion) and the now bargain prices. In the last week, I have increased my portfolio position of Apple to 22% with plans to add more during any future sell-offs. Happy Hunting!
Now bring on the criticism. I can take it...and I know Apple can, too.
Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As with any investing advice, ensure that you take the time to conduct your own due diligence. There is no good substitute or short cut.