Apple is worth $744 b now; just 34.41% away from becoming a $ trillion company. Next in line are Google at $588 b; Microsoft at $502 b; Berkshire Hathaway at $447 b; Amazon at $408 b; and Facebook at $400 b. Since Apple is already 27% ahead of Google in the run, we can assume that it could the first company to hit the $ trillion. Much credit goes to Buffett and Munger for not falling behind the technology companies in today's times.
The discussion is on Apple; so let me stick to that. The question is whether Apple would make sense for an investor at its current price.
The business
For the year ended September 2016, Apple had revenues of $215 b, on which it earned $45 b for its shareholders.
For the year ended September 2016, Apple had revenues of $215 b, on which it earned $45 b for its shareholders.
Over 60% of its revenues come from one product, iPhone.
Units are in thousands:
The key for this business is growth. Can its revenues, operating profits, and free cash flows grow at a meaningful rate in future? The law of large numbers is impending, although it enjoyed extraordinary growth in the past decade. Where can it possibly sell more?
Of course, the return for the investor is directly based upon its growth rate. iPhones are not going to be changed every year, although certain geeks engage in doing just that. iPhones, iPads, and Mac are not cheap. Growth in China and India is some possibility; yet, there is enough competition in the emerging markets. Fighting the price war is not going to be easy. Average price of iPhone is $645, iPad $452, and Mac $1,235. A large base and high price are a serious impediment to the growth story.
In the current interest rate scene, 10-year treasury is yielding 2.48%, and 30-year treasury, 3.07%. For an investor then the choices are: pick treasury at these rates, or look for something that is higher than that. I am not checking real properties, or high-yield bonds; that is a separate business. So let's stick to equities in the public market. And I am not going to calculate the cost of equity to precision with the academic formula.
I reckon, any rate that is higher than 3% should be sufficient, unless the investor is predicting higher interest rates. Even then how much higher? We can add an equity risk premium of say, 5 points to get to an expected rate of return of 8%.
Apple is a weird business. It is currently earning ridiculous amount of cash on virtually insignificant capital. It had $237 b of cash from $128 b equity and $87 b debt. That amounts to a negative operating capital employed. Yeah, it is a weird business.
The intrinsic value
In order to estimate intrinsic value of Apple, obviously, we cannot assume that such weirdness should continue. We have to assume that Apple will have to reinvest in order for it go grow. So there are assumptions regarding the revenue growth rates in the next decade, and beyond that, there is a cap on the growth rate until perpetuity. How much the revenues would be say, in a decade, $325 b? Tim Cook has a story, and so do you and I.
Apple has shown remarkable improvement in operating margins from 12.70% in 2006 to 27.84% in 2016, all thanks to the brand iPhone. Net margins gained from 10.30% in 2006 to 21.19% in 2016. Again, return on equity increased from 19.92% to 38.28%. For the reasons mentioned earlier, it is not meaningful to calculate return of capital. However, we cannot expect these margins and returns to improve any further or even remain unchanged in future. Apple has become truly large to sustain further improvements is a reasonable assumption. How far down will these be in a decade is anybody's guess. Are 20% operating margin and 15% return on capital until perpetuity defendable? Time, not Tim, should tell us.
As a consequence of higher reinvestment rate, lower growth rate, lower margins, and lower return on capital assumptions, Apple's free cash flows to firm should also be lower in the coming decade. How about $37-40 b for the stable business growth?
Based upon its intrinsic value calculated considering a myriad assumptions, Apple might even be successful in giving the investor a 7.50% return at its current price. However, following it has its pitfalls.
Perpetual cash flows
We can even assume that Apple has already matured, and can value it on a perpetuity basis. At $40 b of free cash flows growing moderately forever, I see that the rate of return to the investor based on its current price is about 7%.
The pricing effect
Pricing is relatively easier. Apple had an EPS of $8.31 in 2016, which grew 16% (in 5 years) and 38% (in 10 years) annually; exceptional. From now on, though, there would be bumps on the road; but how high to obstruct growth? At 5% annual growth, its EPS in 2026 should be $13.50. Apple has been trading at an average high PE of about 15, and a low PE of say, 10 in the last five years. If we mark its high of 15, its estimated price will be $202.50 in 2026. That is a return of 3.78%.
Then there dividends. If we assume that Apple will fall short of innovation and moves to return much of its cash back to the shareholders, and further assume that $200 b of cash, net of repatriation taxes, will be used up in the next ten years, the dividend per share should be $5.40 at year 10 without any equity dilution. The aggregate investment return (price appreciation and dividends) will then be just about 6%.
If we assume that Apple realizes its size and acknowledges that it can no longer innovate, and further assume that, consequently, it chooses to distribute all cash back to the shareholders, at $435 b of cash return during the decade, the aggregate investment return will be about 8.60%. At this rate, the dividend per share should be $10.40 at year 10 without any equity dilution.
This assumption also has its perils; the market might mark its PE down to lower levels; and Apple may not be able to generate another $200 b cash in the next ten years. Just imagine a return of $435 b of cash in dividends! That would be a voodoo. That would even be the end of story.
Buybacks
Apple could expedite share buybacks. $200 b can be used up to buyback 1.3 m shares from its shareholders. Sure, it would trigger market pricing if done at one go. Nevertheless, that should leave approximately 4 m shares outstanding. This should have an immediate effect of increasing EPS to $11. If this grows at 5% annually, EPS in 2026 would be $17.91. The estimated price at 15 PE will be $268 in 2026. That is a return of 6.72%. With increased dividends, the annual return could be in the region of 9%; much better.
All this assumes that Apple will be able to retain its existing earning power. Yet, is 9% a cap on Apple's returns for the investor?
The benefactor
Warren Buffett has been piling up on the Apple stock. That should say all is well for its business. Is that so? Buffett has also been piling up on the airlines stock. Yeah, that is the same person who said, if a capitalist had been present at Kitty Hawk in the early 1900s, he should have shot down Orville Wright. Yeah, the same airlines that grow rapidly, require significant capital to grow, and earn little or no money. Yet, Berkshire's purchases have been like there is no other time. This time there is no 800 number to dial either.
Never mind, Buffett bought 61 m shares of Apple for $6.75 b as of December 2016; that is about $110 per share.
Subsequently, he also bought more shares of Apple, because he liked it.
These 133 million shares might have cost him at least $15 b, which makes the average price per share at about $113.
Well, these are worth over $18 b now; so he has already earned book profits of $3.5 b. The Buffett factor is also imminent in the market.
So what is it that he saw in Apple now that he did not see before? From a technology-hater to the 2.50% owner of a technology company, sure, there must be something. One could be the law of large numbers staring at him.
But here's the bizarre reason that he chose to give; some enlightenment I suppose.
Of course, the product is sticky; otherwise it would not have enjoyed the growth rate that it reported. It has been there since 2007, when iPhone was first launched. Granted, 2007 was too early to feel the stickiness; but, last five years would have told something.
Even Microsoft's windows and office have been sticky products since a long time. What stopped him from buying its stock, conflicts of interest due to friendship?
The enterprising Apple
What else Apple could do to please its shareholders? With $200 b cash and growing, it can create an investment portfolio with some high-quality stocks. It can acquire certain high-growth companies. There is no other business, presently, in the world that matches cash generating capacity that Apple has. That cash has to be employed such that its shareholders get a meaningful rate of return. Tesla is selling at $40 b; What about some of Google and Facebook? A diversified portfolio of high-growth technology, and high-quality stable business stocks, and some of the index itself will not be a bad idea. Then Apple will have two divisions, iPhones, etc. and company, and investments business. Tim Cook will have to look for a worthy capital allocator.
The trillion
If the $ trillion is what matters, here's what it takes Apple to reach it.
While irrationality knows no bounds, Apple is a 7.50% return stock. That's not bad considering the alternative opportunities available at this time. But, even the broader markets are capable of delivering that return, give or take some points. That leaves us to choose between a low-cost S&P-500 index fund and say, Apple. A comfortable, low stress market return, or an exciting Apple return.
That is the question.
In the current interest rate scene, 10-year treasury is yielding 2.48%, and 30-year treasury, 3.07%. For an investor then the choices are: pick treasury at these rates, or look for something that is higher than that. I am not checking real properties, or high-yield bonds; that is a separate business. So let's stick to equities in the public market. And I am not going to calculate the cost of equity to precision with the academic formula.
I reckon, any rate that is higher than 3% should be sufficient, unless the investor is predicting higher interest rates. Even then how much higher? We can add an equity risk premium of say, 5 points to get to an expected rate of return of 8%.
Apple is a weird business. It is currently earning ridiculous amount of cash on virtually insignificant capital. It had $237 b of cash from $128 b equity and $87 b debt. That amounts to a negative operating capital employed. Yeah, it is a weird business.
The intrinsic value
In order to estimate intrinsic value of Apple, obviously, we cannot assume that such weirdness should continue. We have to assume that Apple will have to reinvest in order for it go grow. So there are assumptions regarding the revenue growth rates in the next decade, and beyond that, there is a cap on the growth rate until perpetuity. How much the revenues would be say, in a decade, $325 b? Tim Cook has a story, and so do you and I.
Apple has shown remarkable improvement in operating margins from 12.70% in 2006 to 27.84% in 2016, all thanks to the brand iPhone. Net margins gained from 10.30% in 2006 to 21.19% in 2016. Again, return on equity increased from 19.92% to 38.28%. For the reasons mentioned earlier, it is not meaningful to calculate return of capital. However, we cannot expect these margins and returns to improve any further or even remain unchanged in future. Apple has become truly large to sustain further improvements is a reasonable assumption. How far down will these be in a decade is anybody's guess. Are 20% operating margin and 15% return on capital until perpetuity defendable? Time, not Tim, should tell us.
As a consequence of higher reinvestment rate, lower growth rate, lower margins, and lower return on capital assumptions, Apple's free cash flows to firm should also be lower in the coming decade. How about $37-40 b for the stable business growth?
Based upon its intrinsic value calculated considering a myriad assumptions, Apple might even be successful in giving the investor a 7.50% return at its current price. However, following it has its pitfalls.
Perpetual cash flows
We can even assume that Apple has already matured, and can value it on a perpetuity basis. At $40 b of free cash flows growing moderately forever, I see that the rate of return to the investor based on its current price is about 7%.
The pricing effect
Pricing is relatively easier. Apple had an EPS of $8.31 in 2016, which grew 16% (in 5 years) and 38% (in 10 years) annually; exceptional. From now on, though, there would be bumps on the road; but how high to obstruct growth? At 5% annual growth, its EPS in 2026 should be $13.50. Apple has been trading at an average high PE of about 15, and a low PE of say, 10 in the last five years. If we mark its high of 15, its estimated price will be $202.50 in 2026. That is a return of 3.78%.
Then there dividends. If we assume that Apple will fall short of innovation and moves to return much of its cash back to the shareholders, and further assume that $200 b of cash, net of repatriation taxes, will be used up in the next ten years, the dividend per share should be $5.40 at year 10 without any equity dilution. The aggregate investment return (price appreciation and dividends) will then be just about 6%.
If we assume that Apple realizes its size and acknowledges that it can no longer innovate, and further assume that, consequently, it chooses to distribute all cash back to the shareholders, at $435 b of cash return during the decade, the aggregate investment return will be about 8.60%. At this rate, the dividend per share should be $10.40 at year 10 without any equity dilution.
This assumption also has its perils; the market might mark its PE down to lower levels; and Apple may not be able to generate another $200 b cash in the next ten years. Just imagine a return of $435 b of cash in dividends! That would be a voodoo. That would even be the end of story.
Buybacks
Apple could expedite share buybacks. $200 b can be used up to buyback 1.3 m shares from its shareholders. Sure, it would trigger market pricing if done at one go. Nevertheless, that should leave approximately 4 m shares outstanding. This should have an immediate effect of increasing EPS to $11. If this grows at 5% annually, EPS in 2026 would be $17.91. The estimated price at 15 PE will be $268 in 2026. That is a return of 6.72%. With increased dividends, the annual return could be in the region of 9%; much better.
All this assumes that Apple will be able to retain its existing earning power. Yet, is 9% a cap on Apple's returns for the investor?
The benefactor
Warren Buffett has been piling up on the Apple stock. That should say all is well for its business. Is that so? Buffett has also been piling up on the airlines stock. Yeah, that is the same person who said, if a capitalist had been present at Kitty Hawk in the early 1900s, he should have shot down Orville Wright. Yeah, the same airlines that grow rapidly, require significant capital to grow, and earn little or no money. Yet, Berkshire's purchases have been like there is no other time. This time there is no 800 number to dial either.
Never mind, Buffett bought 61 m shares of Apple for $6.75 b as of December 2016; that is about $110 per share.
Subsequently, he also bought more shares of Apple, because he liked it.
These 133 million shares might have cost him at least $15 b, which makes the average price per share at about $113.
Well, these are worth over $18 b now; so he has already earned book profits of $3.5 b. The Buffett factor is also imminent in the market.
So what is it that he saw in Apple now that he did not see before? From a technology-hater to the 2.50% owner of a technology company, sure, there must be something. One could be the law of large numbers staring at him.
But here's the bizarre reason that he chose to give; some enlightenment I suppose.
Of course, the product is sticky; otherwise it would not have enjoyed the growth rate that it reported. It has been there since 2007, when iPhone was first launched. Granted, 2007 was too early to feel the stickiness; but, last five years would have told something.
Even Microsoft's windows and office have been sticky products since a long time. What stopped him from buying its stock, conflicts of interest due to friendship?
The enterprising Apple
What else Apple could do to please its shareholders? With $200 b cash and growing, it can create an investment portfolio with some high-quality stocks. It can acquire certain high-growth companies. There is no other business, presently, in the world that matches cash generating capacity that Apple has. That cash has to be employed such that its shareholders get a meaningful rate of return. Tesla is selling at $40 b; What about some of Google and Facebook? A diversified portfolio of high-growth technology, and high-quality stable business stocks, and some of the index itself will not be a bad idea. Then Apple will have two divisions, iPhones, etc. and company, and investments business. Tim Cook will have to look for a worthy capital allocator.
The trillion
If the $ trillion is what matters, here's what it takes Apple to reach it.
While irrationality knows no bounds, Apple is a 7.50% return stock. That's not bad considering the alternative opportunities available at this time. But, even the broader markets are capable of delivering that return, give or take some points. That leaves us to choose between a low-cost S&P-500 index fund and say, Apple. A comfortable, low stress market return, or an exciting Apple return.
That is the question.
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