60% of Apple's sales come from products that didn't even exist 4 years ago. Imagine the effect on future sales if today's launches would fail to beat the competition.
The same mechanics that allowed Apple to rise from the ashes in 2007, and Nokia to fall from grace*, are a constant threat to Apple's hegemony. *Nokia had a 35% market share of smart phones in 2010. Only two years later it had fallen to 5%. Five years from now, Lenovo, Huawei or Xiaomi are likely to have dented Apple's and Samsung's lead and possibly taken over. The industrial history of the last 50 years is littered with corporate corpses of indisputable champions and technological leaders like Kodak and Xerox. The survivors are the (temporary) exceptions, not the rule.
Global and digital collaboration is affecting more and more industries - not just cell phones. Just three companies remain on the FT global top ten list from 2008; 70% dropped off the list in just 5 years and that churning process is accelerating. During the 10 years 1998-2008, a mere 60% disappeared. Always ask yourself why the investment you select should survive longer than its competitors.
Valuing Apple, step by step
I'm writing a book for beginners on how to make the hard art of investing easier: Sprezzaturian Investment. All my subscribers will be offered the book for free sooner or later. For now, I'll just share a couple of thoughts on how to make quick but still thoughtful investment decisions.
1. Get the latest company earnings report (here is Apple's Q4=fourth quarter report from its own website. You can also get historical numbers from sites like Market Wach - if you trust them) and make the simplest model possible for the last two fiscal years (the fiscal year is the 12 month perod that the company uses for its accounting. For most companies the fiscal year and the calendar year are the same)
Sales, a.k.a. revenues or turnover
Costs (including cost of goods sold = COGS and operating expenditures = opex)
Profit before tax or Operating profit
Taxes = paid taxes (or possibly normalized taxes)
Earnings after tax = net income or simpy the result
Number of shares (this one can be tricky due to outstanding personnel options, convertible bonds, but start with what the company calls diluted number of shares; the highest number of shares reported)
Earnings per share = EPS (Earnings divided by the number of shares)
Revenue per share = RPS (Sales / #shares)
| 2013 | 2014 | |
| Sales | 170,910 | 182,795 |
| Cost of sales | 106,606 | 112,258 |
| Opex | 15,305 | 18,034 |
| Operating profit | 50,155 | 53,483 |
| Income tax | (13,118) | (13,973) |
| Earnings | 37,037 | 39,510 |
| Diluted nr of shares | 6,521,634 | 6,122,663 |
| Earnings Per Share | 5.68 | 6.45 |
| Revenue per share | 26.2 | 29.9 |
I have highlighted sales, earnings, EPS and RPS, because those are the most important numbers.
2. Calculate the valuation based on Earnings and Sales respectively (or just rip them off some market information site you trust. I just picked the first one I came across: Market Watch)
- First, get the share price (e.g., from Market Watch). Yesterday it was 109.28 USD per share
- Then divide the share price by the EPS to get the P/E ratio (also called PER): 109.28/6.45=16.9 (for 2014)
- Then do the same for RPS; Share price/RPS = P/S =3.7 for 2014
| 2013 | 2014 | |
| P/E | 19.2 | 16.9 |
| P/S | 4.2 | 3.7 |
You can find all of these measures and more on Apple's Profile Page on Market Watch or any of a number of market information sites.
3. Compare the valuation to some benchmark (anything that can serve as a fix point) to decide whether Apple's valuation is cheap, reasonable or expensive. This kind of valuation approach is called Relative Valuation (as opposed to Absolute Valuation)
- Compare Apple's P/E and P/S to the market's average valuation. Which market? Choose the most relevant market; in Apple's case the Nasdaq, Dow Jones or S&P 500.
- Compare the valuation to the market's historical average valuation or the market's historical valuation range. You can find one measure of the market valuation here.
- Compare with Apple's industry peers (i.e., similar companies, you can find a list of similar companies on the Profile Page as well: Key Competitors. Just note that often these are not the most relevant companies so think for yourself; Samsung or Google, e.g., are more relevant than Blackberry or Nokia); their current, average and historical valuation range. Click on the respective competitor and check its valuation multiples (P/E and P/S etc). Google's P/E according to Market Watch is 31 and its P/S is 6.25, so compared to Google Apple is much cheaper. However, they are not directly comparable in my opinion, since Google mainly runs a search engine while Apple is developing internet access devices, including smartphones.
- Compare Apple to itself, to its own historical valuation range. This can be done under the Charts tab, where you can choose P/E ratio or P/E range for the Lower Indicator. Over the last two years Apple's PER has ranged from 9 to 17 (and before that it reached 34 in early 2010 and almost 100 in 2005. If you ask me the P/E valuation seems to be trending downward and the last year's doubling of the PER is an anomaly. On the other hand the entire market's valuation measures have trended upward the last few years (from P/E 14 to almost 20, and from P/S 0.8 to 1.8, for the S&P 500. Note that the long term median P/E is around 14.5. In addition, reported earnings were more robust in the good old days, before today's practice of adjustments and one-offs).
4. Compare share price trends. There is an alternative (much easier) to comparing valuations. Compare (recent) share price movements. Assume that Apple and other companies were correctly priced a year or a couple of months ago. If nothing important has changed since then, their share prices should have moved in a similar fashion since then. If they have diverged more than reasonable, given company specific news warrant, the share prices should converge again
- Compare Apple's share price movement the last three months to the market or to one or more close peers (similar companies). There is a function for this at Market Watch on the Stock Overview tab (just click Compare Indexes in the chart) and many more under the Charts tab.
Over the last three months Apple's share price has outperformed the Nasdaq by almost 10 percentage points. That might indicate it's time to sell Apple versus the market. In addition, over three years, Apple and Nasdaq have performed similarly, with Apple pulling away just the last half year. Unless there are really good reasons for the latest outperformance (what do you think; is Apple improving significantly vs. its competitors?) it could be time for a setback.
To the future and beyond
Now let's forget about all the relative fun you can have on sites like Market Watch and focus on the Apple model and forecasting again.
Start with sales. What will Apple's revenues be next year, and 2016 and 2017 and onward? You will have to guess one way or the other. How much have they grown before? Go back and check Apple's annual and quarterly reports or get them off some website. On Market Watch you can click the PLUS signs in the tables on the Financials tab to see historical growth rates.
Unfortunately it's not all that helpful to see the hyper growth for Sales, Earnings and EPS in 2011 and 2012, followed by slower sales growth in 2013 and 2014, not to mention negative EPS growth in 2013 and little more than a recovery in 2014 of that drop.
So what next? Tou have to guess, like everybody else. You can base that guess on anything you deem plausible. The level of detail and sophistication is all up to you. Sell side analysts try to look smart by including everything. You on the other hand need only include whatever you think is relevant:
5. Sales forecasts:
- Last year's growth rate
- The five year (or any arbitrary period you think is relevant) average growth rate
- Global GDP growth (historical, last year's, long term average, some economist's forecast)
- Volume and pricing of individual products (collect historical numbers [units sold and price per unit] for iPhone 1,2,3,4,5,6, iPad, iPod, iMac and their variations like S and plus. Then model similar progressions for coming products. Don't forget iTunes and app sales or new products like iTV or iAdvertising)
- External factors (recessions, competition)
Your guess over the coming 5 years probably won't be any better or worse than anybody else's. A professional sales side analyst might have an edge over the common man for the coming quarter or year. Over longer terms however, they really have no clue. Nobody saw the iPhone coming and nobody sees its coming demise.
A good guess is often to assume any company's growth rate gradually tapers off from whatever it is now toward the nominal GDP growth rate, give or take a couple of percentage points.
Don't forget to add acquisitions to your sales forecasts if the company is likely do do any (or recently has).
My guess for Apple? I think last year's sales growth of 7% is representative of the coming five years. It might be a bit on the high side, given the likelihood of a recession during that period, as well as increased competition. On the other hand some of their new products might boost sales. Global GDP is likely to growth around 4% per year and Apple should be able to beat that unless Apple's competitors get lucky with their new products.
On second thought, maybe 5% is a better guess after an initial year at 6%, not least considering how seldom a consumer electronics company remains in the lead for as long as Apple has:
| 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | |
| Sales | 170,910 | 182,795 | 193,763 | 203,451 | 213,623 | 224,305 | 235,520 |
| Cost of sales | 106,606 | 112,258 | |||||
| Opex | 15,305 | 18,034 | |||||
| Operating profit | 50,155 | 53,483 | |||||
| Income tax | (13,118) | (13,973) | |||||
| Earnings | 37,037 | 39,510 | |||||
| Diluted nr of shares | 6,521,634 | 6,122,663 | |||||
| Earnings Per Share | 5.68 | 6.45 | |||||
| Revenue per share | 26.2 | 29.9 | |||||
| 2013 | 2014 | ||||||
| P/E | 19.2 | 16.9 | |||||
| P/S | 4.2 | 3.7 | |||||
| sales growth | 9.6% | 7.0% | 6.0% | 5.0% | 5.0% | 5.0% | 5.0% |
6. Cost forecasting:
What about costs, margins and profits?
- Either you make it really simple and assume Apple can manage its costs to keep its margins steady (or progressing according to some trend)
- Or you make stand alone cost projections, based on number of produced units (input costs in terms of material, components etc), number of employees, marketing campaign costs, premises (rent), cost of debt and so on.
I suggest you do a little of both if you have the time and the energy. However, start with historical margins (at least the last five years, but if it's an old economy company like a car manufacturer, get as many years as you can find to see how the margin has behaved in various economic environments). Just rip the numbers from an annual report or a website you trust.
Below you see Apple's historical margins and then my first stab at forecasting them for the coming five years:
| 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | |
| Sales | 65,070 | 108,600 | 155,970 | 170,910 | 182,795 | 193,763 | 203,451 | 213,623 | 224,305 | 235,520 |
| Cost of sales | 106,606 | 112,258 | ||||||||
| Opex | 15,305 | 18,034 | ||||||||
| Operating profit | 18,540 | 34,210 | 55,760 | 50,155 | 53,483 | |||||
| Income tax | (13,118) | (13,973) | ||||||||
| Earnings | 37,037 | 39,510 | ||||||||
| Diluted nr of shares | 6,521,634 | 6,122,663 | ||||||||
| Earnings Per Share | 5.68 | 6.45 | ||||||||
| Revenue per share | 26.2 | 29.9 | ||||||||
| 2013 | 2014 | |||||||||
| P/E | 19.2 | 16.9 | ||||||||
| P/S | 4.2 | 3.7 | ||||||||
| sales growth | 9.6% | 7.0% | 6.0% | 5.0% | 5.0% | 5.0% | 5.0% | |||
| Operatingmargin | 28.5% | 31.5% | 35.8% | 29.3% | 29.3% | 29.0% | 29.0% | 29.0% | 29.0% | 29.0% |
Apart from Apple's banner years of 2011 and 2012, around 29% profit margin seems "normal". We'll check later if that leads to reasonable numbers for Apple's profitability (e.g., Return On Equity; if it's too high it will attract competitors). You can also get clues from similar companies. Google's operating margin, e.g., was 24% in 2013 and 27% in 2012. Not too dissimilar. Note that Walmart's margin last year was just 5.2%, so make sure you compare similar companies in similar industries, when looking for clues to what's normal.
7. Fill out the table with operating profit (=margin * sales), tax rate (Income tax/operating profit), tax rate forecasts (similar to historic numbers or to the tax regimes where the company operates) and tax costs (tax rate * operating profit).
8. Forecast number of shares (check historical progression and make an assumption. Then double check that what those buy backs would cost in USD [number of shares bought back * current price] and see if it is reasonable compared to annual earnings [buyback cost/earnings]). I settled for 3% reduced share count per year, costing about half to a third of Apple's annual profits. Maybe 4% is a better number for buybacks, maybe not. maybe they will make a huge buyback to clear away cash next year, maybe not. They are issuing a lot of debt these days so they definitely have a lot of cash at hand for something.
9. Then calculate EPS, RPS, P/E and P/S given today's share price. The model now looks like this without too much work:
| 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | |
| Sales | 65,070 | 108,600 | 155,970 | 170,910 | 182,795 | 193,763 | 203,451 | 213,623 | 224,305 | 235,520 |
| Cost of sales | 106,606 | 112,258 | 137,572 | 144,450 | 151,673 | 159,256 | 167,219 | |||
| Opex | 15,305 | 18,034 | ||||||||
| Operating profit | 18,540 | 34,210 | 55,760 | 50,155 | 53,483 | 56,191 | 59,001 | 61,951 | 65,048 | 68,301 |
| Income tax | (13,118) | (13,973) | (14,610) | (15,340) | (16,107) | (16,913) | (17,758) | |||
| Earnings | 37,037 | 39,510 | 41,581 | 43,661 | 45,844 | 48,136 | 50,543 | |||
| Diluted nr of shares | 6,521,634 | 6,122,663 | 5,938,983 | 5,760,814 | 5,587,989 | 5,420,350 | 5,257,739 | |||
| Earnings Per Share | 5.68 | 6.45 | 7.00 | 7.58 | 8.20 | 8.88 | 9.61 | |||
| Revenue per share | 26.2 | 29.9 | 32.6 | 35.3 | 38.2 | 41.4 | 44.8 | |||
| 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | ||||
| P/E | 19.2 | 16.9 | 15.6 | 14.4 | 13.3 | 12.3 | 11.4 | |||
| P/S | 4.2 | 3.7 | 3.3 | 3.1 | 2.9 | 2.6 | 2.4 | |||
| Market cap at current share price | 669,084,613 | 649,012,074 | 629,541,712 | 610,655,461 | 592,335,797 | 574,565,723 | ||||
| sales growth | 9.6% | 7.0% | 6.0% | 5.0% | 5.0% | 5.0% | 5.0% | |||
| Operatingmargin | 28.5% | 31.5% | 35.8% | 29.3% | 29.3% | 29.0% | 29.0% | 29.0% | 29.0% | 29.0% |
| tax rate | -26.2% | -26.1% | -26% | -26% | -26% | -26% | -26% | |||
| Share count evolution | -6.1% | -3% | -3% | -3% | -3% | -3% | ||||
| cost of share purchases at current price | 20,073 | 19,470 | 18,886 | 18,320 | 17,770 | |||||
| Buyback cost as proportion of earnings | 48% | 45% | 41% | 38% | 35% |
Finishing touches to forecasting and modelling
Now you have a decent starting point. Now you know what you know and with a little thought, what you don't know. Tha latter is more important because that is where the risk (and opportunity) of an investment lies:
- What might happen to sales in a recession or after a poor product launch. Change the numbers in the model to see for yourself
- What happens if consumers don't want to pay as much for a phone/tablet/song or if telecom operators stop subsidizing phones in the future? Reduce revenues accordingly
- What if iTV hits big? Make an assumption about volumes and pricing and ad that to your sales forecasts
- What if Apple's costs rise for real estate, for employees, for commodities and components? Find a way to increase the costs of doing business in the model and adjust forecasts accordingly
- A large buyback? Reduce cash at hand (in the Balance Sheet) and reduce the number of shares in the model
But that's just forecasts, what about valuation?! And, by the way, what did you say about "reducing cash"? Where? Where is the Balance Sheet? What is it? And what about "Cash Flow" that everybody always talk about?
The value of Apple
We will get to Balance Sheets, cash flow, DCF-valuation, Return on Equity etc. in a future post, but for now this is enough modelling.
One good thing with the Apple model above is that Apple is already in what is called a steady state. It's key variables are reasonably sustainable and thus "steady". I'ts plausible that growth, margins, tax rates etc on average stay close to today's level for a long time. That means any year (2014, 2015, 2016...) can be used as a proxy year for Apple's entire future. In those cases P/E and P/S numbers are quite useful (which isn't as common as you might think talking to your local broker).
10. Do you think a P/E of 15.6x next year's profit is reasonable or not?
(the market is at almost 20 - but the long term market average for the just reported year is 14.5. That means that if Apple and the market both converge at the historical average P/E for the just reported annual profit, in one year's time Apple's P/E would fall from 15.6 times its 2015 EPS to 14.5x. The share price would consequently fall from 109 to 102)
On the other hand, Google is trading at a P/E of over 30 and Apple has actually been there before. Also, the market is currently trading at 20x P/E. What if it stays there? Can Apple make a PER comeback? Is it likely? Is it something you are willing to bet on? Why?
Nota bene that the change doesn't have to occur in exactly the coming year, the real question is whether you think that the change will occur sometime during your likely holding period. I always advice on counting on a return to the mean for most variables, a so called mean reversion, rather than counting on the extension of an extreme or the realization of an extreme point in the future.
Apple's share price has had a good run lately as well vs. the market. Given the somewhat stretched valuation vs. its own recent history and vs. the market's long term average, the last half year's share price surge is enough to make me a bit dizzy. In addition, the market is itself stretched - both valuation wise and price incrase-wise (at all time highs and >200% up in 5-6 years)
Other questions you must ask yourself are:
- Do you think 5% sales growth is reasonable (given history, risk of recession, competition, Apple's longevity as the industry leader etc.)
- Do you think 29% profit margin is reasonable
- Is the tax rate correct (global trends? Underlying tax rates in the company's countries of operation)
- Will buybacks continue as before (faster, slower, due to legislation, borrowing costs etc)
Refine the model accordingly, create ranges for your sales and profit forecasts, for margins and growth rates, and compare, compare, compare to peers and entire markets, to historical ranges, peaks, troughs and averages for the company itself, for peers and markets. Does today seem like a good enough opportunity, or do you think a better opportunity might arise within a few years. If the latter, put Apple on hold and move on to the next company.
My opinion on Apple's stock
The model isn't finished. I want to look at Apple's cash and debt situation and at a couple of refined valuation multiples first (EV/EBIT and EV/Se.g., which includes measures of net debt that doesn't show in P/E and P/S).
However, at this point I think it's almost a coin flip, if you just look at the numbers. It has a close to average P/E multiple and is growing in line with global GDP. Apple might surprise on the upside with a new product or it might succumb to increased competition.
In the end, I would hold off on buying Apple for the following reasons:
- I don't buy "ok-ish", "not too expensive", "could go either way" shares. I want "cheap"
- The market is stretched, and when it corrects I expect Apple to fall quite a bit too
- There are good reasons to expect Apple's reign to come to an end, just given how long it has been on the top already. It's not cool anymore and people want to be cool. Hence I think both sals and margins might disappoint. That means Apple's real valuation is higher than what the model is currently showing. If Apple makes a Kodak or Nokia there is no limit to how low it can go. Remember that; the last five years of ever rising prices for everything is not the norm.
- The operational risk is much higher than people understand. Apple is running a very fickle business, where more than half of its sales come from very newly invented products and unreliable consumer tastes. The risk of a brand disaster (losing 20% of its brand value in one month) for any company, during a five year period, has risen from 20% two decades ago to 80% today. That goes for Apple too and is not included in today's valuation.
I think Apple might be interesting at around 70-75 USD per share, or 10x P/E. To me that would take into account brand disaster risk, sales risk due to competition and be closer to its historical trough valuation. However, it's not unreasonably expensive - not enough to short it anyway (unless you dare make an assumption about a product launch failure or a general market downturn). Longer-term I don't think I would want to own Apple at 75 either, since I think some other consumer electronics company will take over Apple's lead. They have simply had it too good for too long.
