What Should I Do With My Apple Shares?

Summary

• Quantitative analysis of Apple shares using the power of free cash flow.
• Analysis of Apple from a Main Street vs. Wall Street perspective.
• Shows the reader how to do a similar analysis on their own portfolio holdings.
• This idea was discussed in more depth with members of my private investing community, Friedrich Global Research. Start your free trial today »

On Jan. 2, 2019 Seeking Alpha reported the following - Apple cuts Q1 revenue guidance - which not only shocked Apple (NASDAQ:AAPL) shareholders, but resulted in traders doing this to its shares the following day.

Obviously we believe that this selloff was way overdone and that investors were not only throwing the baby out with the bathwater, but were actually throwing the entire maternity ward out with the bathwater in outright panic selling. In this article, I will not discuss the various operations of Apple and how each is doing, as you can read many such articles on Seeking Alpha, both pro and con. What I will simply do is a quantitative analysis of Apple’s results on Main Street and then relate them to what an investor should do on Wall Street, using zero emotion.

Let us now go and analyze Apple and find out what our Friedrich algorithm has to say about all this.

Main Street vs. Wall Street

In analyzing Apple, we will present some unique ratios that our Friedrich Investing System uses and will present a real-time quantitative analysis that will demonstrate the power of free cash flow in the investment process. In doing so, we also will teach everyone how to analyze one's portfolio holdings on Main Street vs. Wall Street. At the same time, we will explain how the methodology involved in this analysis came about.

Main Street is where Apple operates and Wall Street is where its shares trade. The Apple shares that one can purchase on Wall Street are traded publicly on exchanges and the company has little control over how each share will trade. Apple is required to release its earnings reports each quarter and, from time to time, it also provides press releases to its shareholders (and the general public) giving updates on how its operations are doing on Main Street.

Main Street is where Apple invests in its own operations and sells to its customers. How well CEO Tim Cook and his management team do in selling those products determines how profitable the company will be. Wall Street then reacts based on the success or failure of management to meet its goals. Main Street and Wall Street are thus interlinked, but because anyone with a computer (or even just a smart phone), an internet connection, and a brokerage account can buy or sell any stock at any time, expertise is not a requirement in order to invest on Wall Street.

This results in Wall Street being a very dangerous place to operate as many investors tend to invest through emotion or follow the herd in and out of stocks. During bull markets, investors feel like they can do no wrong as "the rising tide lifts all boats." But when a bear market suddenly shows up, these same investors tend to panic and like lemmings stampede over the cliff. Thus, we have the classic case of "greed vs. panic."

Creation of the Friedrich Algorithm

Having noticed this problem some 35 years ago, I spent the last three decades building an algorithm called Friedrich. Our algorithm was designed to assist all investors (both Pro and Novice alike) and give them the ability to quickly compare a company's Main Street operations to its Wall Street valuation (Overbought or Oversold condition). Friedrich can do this on an individual company basis or assist users in analyzing an entire index like the S&P 500, an ETF, Mutual Fund, or individual portfolio with the use of our Portfolio Analyzer.

Many years ago, while reading Berkshire Hathaway's ( BRK.A) ( BRK.B) 1986 letter to shareholders, I discovered a ratio, which Mr. Buffett called "Owner Earnings," or what we may consider to be Mr. Buffett's version of FCF, or "free cash flow." To my amazement, in that little footnote, Mr. Buffett explained how to use it and basically states that it is one of the key ratios that he and Charlie Munger used in analyzing stocks. In that article, he defined the term "owner earnings" as the cash that is generated by the company's business operations.

"(Owner earnings) represent [A] reported earnings plus [B] depreciation, depletion, amortization, and certain other non-cash charges… less [C] the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume."

We have used the free cash flow ratio for decades, using data from the Value Line Investment Survey, whose founder was Arnold Bernhard. Mr. Bernhard was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. I know this as I was able to calculate the FCF ratio using old Value Line sheets for my 60-year backtest of the DJIA from 1950 to 2009.

The backtest mentioned above demonstrated that if one can purchase a company whose shares are selling for 15 (or less) times its Price to Free Cash Flow Ratio, that the probability of success will dramatically increase in most cases. I have renamed the ratio the Bernhard Buffett free cash flow ratio in honor of both men. The following is how that ratio is calculated.

Wall Street Analysis

Price to Bernhard Buffett Free Cash Flow Ratio = Sherlock Debt Divisor / [(net income per share + depreciation per share) - (capital spending per diluted share)]

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding))

The above are the ratios I use when analyzing a stock on Wall Street, and below are the ratios I use when analyzing a stock on Main Street.

Main Street Analysis

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) - (Capital Spending)]

FROIC = (Forward Free Cash Flow)/(Long-Term Debt + Shareholders' Equity)

The FROIC ratio tells us how much forward free cash flow we can expect the company to generate on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow it, therefore, has a FROIC of 20%, which we consider excellent. This is just one of the key ratios (66 in total) that we use to identify how a company is performing on Main Street, as it is our belief that if a company is making a killing on Main Street, Wall Street will eventually take notice.

So, let us begin our analysis and at the same time try to teach everyone how to do a similar analysis on one's own portfolio. In analyzing Apple's Price to Bernhard Buffett FCF ratio, we must first adjust Apple's Wall Street Price to account for its debt using our Sherlock Debt Divisor. Below is a detailed definition of that ratio and how we use it.

Sherlock Debt Divisor

A major concern that we have these days in analyzing companies is the debt burden relative to its operations and whether management is abusing this situation by taking on more debt than it requires. Debt, when used wisely, allows for what is called leverage, and leverage can be extremely beneficial within certain parameters. On the other side of the coin, the use of debt can also be excessive and put a company's future in jeopardy. So, what we have done to determine if a company's debt policy is beneficial or abusive is to create the Sherlock Debt Divisor.

What the Divisor does is punish companies that use debt unwisely and rewards those who successfully use debt as leverage. How do we do this? Well, we take a company's working capital and subtract its long-term debt. If a company has a lot more working capital than long-term debt we reward it but punish those whose long-term debt exceeds its working capital. So, if this result is higher than the current stock market price, then leverage is being used and the more leveraged a company is the worse the results of this ratio will be and the less attractive its stock will be as an investment.

Thus, having successfully defined the Sherlock Debt Divisor, we need the following four bits of financial data in order to calculate it for Apple's TTM (trailing twelve months) which is as close to real-time data as we can get, based on when each company reports. The current analysis is taken from the Apple’s Sept. 30, 2018, filing with the SEC (except the Market Price per share).

Market Price Per Share = $142.19

Working Capital = Total Current Assets - Total Current Liabilities

Total Current Assets = $131,339,000,000

Total Current Liabilities = $116,866,000,000

Working Capital = $14,473,000,000

Long-Term Debt = $93,735,000,000

Diluted Shares Outstanding = 4,871,400,000

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/ (Diluted Shares Outstanding))

Sherlock Debt Divisor = $142.19 - ((14,473,000,000 - $93,735,000,000)/4,871,400,000))

Sherlock Debt Divisor = $142.19 - ($-16.27) = $158.46

Since Apple has more Long-Term Debt vs. Working Capital, we, therefore, must punish it and use the new $158.46 as our new numerator in all our calculations.

Wall Street Analysis of Apple

Price to Bernhard Buffett FCF Ratio = Sherlock Debt Divisor/[(net income per share + depreciation per share) - (capital spending per diluted share)]

Sherlock Debt Divisor = $158.46

Net Income per diluted share = $59,531,000,000/4,871,400,000 = $12.22

Depreciation per diluted share = $10,903,000,000/4,871,400,000= $2.24

Capital Spending per diluted share = $-13,313,000,000/4,871,400,000 = $-2.73

$12.22 + $2.24 - $2.73 = $11.73

Price to Bernhard Buffett Free Cash Flow Ratio = $158.46/$11.73 =13.50

Now, if one goes to our FRIEDRICH LEGEND (on what is considered a good or bad result), you will notice that our result of 13.50 is considered excellent and a bargain.

We last ran our data file for Apple on Ja. 3, 2019, and our Friedrich Algorithm gave a recommendation to our subscribers that Apple is a "Strong Buy" as our Friedrich Data File and Chart below shows. There you also will find the last 10 years of Apple’s Price to Bernhard Buffett Free Cash Flow results.

Main Street Analysis of Apple

Now that we have taught everyone how to calculate our Price to Bernhard Buffett Free Cash Flow ratio, let us now move on and teach everyone how to calculate our FROIC ratio.

This is how we calculate it:

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) - (Capital Spending)]

FROIC = (Forward Free Cash Flow)/(Long-Term Debt + Shareholders' Equity)

Sherlock Debt Divisor = $158.46

Net Income per diluted share = $59,531,000,000/4,871,400,000 = $12.22

Depreciation per diluted share = $10,903,000,000/4,871,400,000= $2.24

Capital Spending per diluted share = $-13,313,000,000/4,871,400,000 = $-2.73

$12.22 + $2.24 - $2.73 = $11.73

Revenue Growth Rate TTM = 0% (Since Tim Cook lowered the guidance, we will give Apple a zero growth rate for this demonstration, down from 16% in 2018)

[(($12.22 + $2.24) (100%)) – $2.73 =$11.73

Long-Term Debt = $93,735,000,000

Shareholders Equity = $107,147,000,000

Diluted Shares Outstanding = 4,871,400,000

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

$11.73/$41.237 = 28.44%

FROIC = 28.44%

Now, if one goes to our FRIEDRICH LEGEND again (on what is considered a good or bad result), you will notice that our result of 28.44% is considered excellent and tells us that Apple produces $28.44 in forward free cash flow for every $100 it invests in total capital employed on Main Street.

On Main Street, Apple is still doing very well despite the lower revenue guidance, while on Wall Street it is considered a “Strong Buy.”

What To Do?

Going forward, Friedrich believes that Apple is trading at "Fire Sale" prices. Whether you own Apple or not, the smart way to play it is to buy it at a later date, and that date would be after Mr. Buffett files his company’s 13-F filing and shows that he has backed up the truck, buying more shares of Apple. This, in our opinion, would signal that a bottom will have formed and would be the time to buy. Tim Cook mentioned in an interview soon after lowering guidance that Apple shares represented a bargain at current prices and that the company intended to make further share repurchases under its existing buyback plan.

As Tim Cook said in his letter that even Apple, with $130 billion in cash, cannot control the macroeconomic environment, then what hope do we have as small investors? For those fully invested in Apple it would be dumb (in our opinion) to sell one’s shares right now. Back in May 2018, just before Mr. Buffett announced that he had added another 75 million shares of Apple to Berkshire Hathaway’s holdings, billionaire investor Charlie Munger told CNBC that he wished Berkshire Hathaway had bought even more Apple stock.

"I think we've been a little too restrained," Munger told on CNBC's "Squawk Box" from Omaha, Nebraska. "I wish we owned more of it."

One would assume from that statement that Mr. Munger is pushing hard right now to buy more shares. We at Friedrich Global Research added more Apple shares at $165 and will be adding more as soon as Mr. Buffett announces that he has added more as well. We are not adding more now, because if it is announced that he has not added more shares, then we will get our shares even cheaper. Apple, in our opinion, is the greatest company in the world and it has gone from being a bargain to now being "Fire Sale" priced. It just requires patience until it hits rock bottom. We will be buying in the future and are just waiting patiently for Mr. Buffett to announce what he has done.

In the stock market there are no straight lines, but at times huge opportunities arise, such as the one coming up to buy more Apple shares. No one, even Mr. Buffett or Apple, can control macro-economic events, but both can surely buy a truckload of Apple shares if each wants to, with the $100s of billions each has at hand. This in our opinion could be the buying opportunity of a lifetime as the last thing one should ever do when investing is bet against Apple or Warren Buffett.

In conclusion, it is our belief that free cash flow analysis is the ultimate tool when analyzing companies, and our hope is that you may add these ratios to your own investor toolbox in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below.

At Friedrich Global Research, we stick to the numbers. We do analysis like what you saw in this article, but for 20,000 stocks from 36 counties around the world. We also provide model portfolios ranging from ultra conservative to aggressive growth, so you can apply our research to your investing easily.

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Disclosure: I am/we are 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.