Apple (NASDAQ:AAPL) is the world's largest publicly traded company and for good reason. With a market cap of $740 billion, a company needs a large profit base to backup its stock price and Apple has exactly that. Apple boasted profit of $39 billion in 2014, $53 billion in 2015, and $45 billion in 2016. These numbers are hard to grasp as they exceed the GDP of some countries.
Apple's valuation is reasonable on the surface
On the surface, Apple's valuation is not unreasonable. With 2016 earnings of $45 billion, the current market cap of $740 billion only represents a 16.4 trailing P/E ratio. With stalwarts like Coca-Cola (NYSE:KO) trading at a P/E ratio approaching or exceeding 30, a sub-20 P/E ratio sounds like a bargain.
However, it is important to evaluate each company on an individual basis and look at absolute valuation measures instead of relative measures like a simple P/E ratio. For now though, let's continue addressing Apple's P/E ratio.
One of the common refrains from Apple bulls is that Apple holds an extremely large amount of cash on the balance sheet, and that you need to subtract this cash before calculating valuation ratios. Let us perform this exercise to explore its true effects. As of Q2 2017, Apple has $257 billion in cash and cash equivalents on its balance sheet. Apple also has total debt of $99 billion. This gives a net cash of $158 billion.
However, you can't simply subtract debt from the total cash pile to determine net cash. $240 billion of Apple's cash sits overseas and has yet to be taxed by the United States federal government. We need to discount the value of this cash by an estimate of the repatriation tax rate. We could use the US corporate tax rate of 35%, but I will be generous to the Apple bulls. Let us assume that United States President Donald Trump manages to pass tax reform that includes a 10% repatriation tax on foreign corporate earnings. This is what I would consider a 'best case' scenario for Apple bulls.
Under this scenario, we'll assume Apple repatriates all of its foreign cash, which is not likely because it needs some portion of it as working capital. Apple's net cash would then be $134 billion. If we directly reduce Apple's market cap of $740 billion by this $134 billion in cash, you end up with an enterprise value of $606 billion. Using the net income of $45 billion per year, you end up with an ex-cash P/E ratio of 13.46.
This is a much more rosy look at Apple's valuation. However, this is where it is important to recognize the limitations of using the P/E ratio for valuation purposes. The P/E ratio can only give you a snapshot based upon current earnings. If there is a substantial change in the earnings component, then the P/E ratio can change dramatically.
One technique I use to consider whether a company is trading at fair value is to reverse engineer the assumed growth rate which the market is assuming for a company. I define "fair value" as the stock price at which purchasing a company will result in a long-term return of at least 10%. This 10% return is chosen as it represents the long-term return of the stock market as shown by the research of Jeremy Siegel.
To calculate Apple's assumed growth rate, we begin with the calculated ex-cash P/E ratio of 13.46. If you take the reciprocal of the P/E ratio, you end up with the earnings yield. Apple's earnings yield is 7.4%. Therefore, we can determine a simple long-term growth rate of 2.6% is necessary to provide a long-term return of 10%.
It's important to remember that the price you pay for a stock directly impacts your future returns. If you believe that Apple can achieve earnings growth of 2.6% or more each year forever, then Apple is priced at fair value. If not, then you must understand that Apple is overvalued.
AAPL's stock price tends to move in cycles
The easiest way to illustrate the concept of higher returns at lower prices is to show you a chart of the cycles which Apple's stock price has gone through over the past 6 years.
When looking at a price chart on the surface, you can only really see the blue line. Apple has increased in both price and value significantly over the last 6 years, but it has also gone through interim highs and lows. Buy and hold investors who bought the stock 6 years ago in June 2011 have done quite well. However, astute speculators watching the valuation metrics would have been able to increase their returns by either selling when the earnings yield reached relative lows and only buying when the earnings yield reached highs of over 9.5%.
I do not currently own Apple stock, but have owned it a few times in the past. I chose a six-year time frame for this chart because I have owned shares in Apple through each of the past three cycles of Apple's stock price. I would buy at the lows and sell near the tops. The most lucrative for me personally was certainly the cycle from the 2013 low to the 2015 top.
Most recently, I played the current run-up from below $100 per share and sold out not long ago.
Apple is most definitely a great company with great products, but AAPL the stock does not trade based exclusively on the underlying business. The fluctuations tend to be cyclical and this is in large part influenced by its standing as the largest company in the world.
It is important for investors to understand that although Apple is a great company, this might not be the right time to buy shares when the earnings yield is at a relative low. Instead, it might be a time to consider simply holding or selling shares and waiting for the next cyclical opportunity to buy in.
The current price does not compensate adequately for the risks
As a value investor, it is critical to remember that your first goal with investing is to not lose money. Therefore, you must consider the risks inherent in any investment. With Apple, there are many risks that go along with the many potential rewards. Below, I will highlight a number of the risks which I believe give Apple a SELL rating at these current elevated prices.
1. Donald Trump fails to pass his tax reform proposals and a reduced repatriation tax is not available for Apple.
Remember that earlier we assumed that Donald Trump would be successful in passing tax reform. If in fact he's not able to reduce the repatriation tax, then you must consequently assign a lower value to Apple's stock.
2. Apple chooses to repatriate only a small portion of its overseas cash.
In this scenario, current shareholders will realize a lower benefit from the available resources of the company than they otherwise would. You would need to then value each $ of cash on Apple's balance sheet at a reduced rate and take this into account in your valuation.
3. Apple's earnings fail to grow at a 2.6% long-term growth rate.
This scenario is not only a risk but quite likely. Apple earns more profit than any other publicly traded company. $45 billion in annual earnings puts a major target on the back of Apple, and everyone is going to want a piece of this Apple pie. Apple currently has a sustained moat and competitive advantage from its iPhone and related ecosystem. The question is, can that advantage be sustained?
It would be a tremendous success to simply sustain a long-term earnings rate of $45 billion per year through perpetuity. If you assume that it grows earnings on top of this, you're building a lot of risk into your stock choice. It's certainly possible, but be careful about putting your money at risk when you make assumptions.
4. Supplier risks
Apple has a tremendous supply chain management system. It sources components to produce and sell millions upon millions of iPhones every month. It not only has to find suppliers with the capability to produce top of the line hardware, but those suppliers also have to be dependable enough to produce millions of components without a hitch. Natural disasters or other unpredictable occurrences can cause supply shocks, potentially impacting Apple's profitability.
5. Litigation risk
Apple is involved in numerous lawsuits requiring large outlays of resources to defend and prosecute. In addition, should it lose a major lawsuit such as the one currently with Qualcomm (NASDAQ:QCOM), its future profitability and current balance sheet could be affected badly.
6. iPhone loses its market advantage
Currently, the iPhone has an almost cult-like market advantage. Apple is able to charge premium prices compared to its competitors and soak up nearly the entire profit share for the smartphone market. This is not a normal condition for a company to sustain long term. BlackBerry (BBRY) may be the standard cautionary tale. I don't think that's a likely future for Apple, but it's quite possible. Any loss in pricing power by Apple will have a devastating effect on shareholders.
7. Augmented or Virtual Reality Device replacing smartphones in the personal device marketplace
Should Apple fail to be a leader in the next personal device category which replaces smartphones, the result could be devastating for long-term holders of Apple stock. Based upon the current P/E ratio, shareholders are relying upon at least a decade of earnings growth to receive a positive return on investment. I consider it likely that AR or VR devices could come into play in that time frame, so there is a definite risk that Apple could fail to be the leader in that new market.
8. Apple's ecosystem fails to find accretive earnings in related categories such as iWatch, Apple Pay, and the new Home Pod.
I disagree with most Apple bears who say that these accessory products to the iPhone are not contributing positively to Apple's earnings. They certainly are, and add up in the aggregate. However, there is no guarantee that this situation will continue perpetually.
9. Large exposure to a general stock market crash
As the largest component in the S&P 500, AAPL stock is the largest current beneficiary of the massive influx buying of passive investment instruments such as ETFs and index funds. This situation would be effectively the reverse in a broad based market sell off. I believe current stock market prices make it likely that a stock market crash could come soon. If that occurs, index funds would be forced to sell a large number of shares of Apple which could negatively impact the short-term price of Apple shares.
10. Apple management ineffectively manages the share buyback program
Apple has for the past couple of years engaged in a massive stock buyback program. This has led Apple to be one of the largest net buyers of its own shares. So far, this has led to a higher stock price for the company as the program has been fairly well managed. However, this won't necessarily always be the case. If large amounts of stock are bought back by Apple above intrinsic value, then this would be value destructive from the perspective of long-term shareholders.
This list of risks is by no means exhaustive for Apple, and I encourage everyone to do their own due diligence before making any investment decisions. Apple's management outlines their own thoughts on potential risks in their annual 10-K reports.
Based upon the above risks and Apple trading above my definition of fair value, while at the same time being near a cyclical top, I consider Apple to be a SELL at this time. I find it difficult to believe shareholders making an initial purchase at current prices will earn a 10% annualized rate of return over the next 25-year period.
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Disclaimer: I am not a financial adviser, and none of the information presented in this article is financial advice. I explicitly disclaim any responsibility for investing decisions made by others. Always do your own due diligence when making investments.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.