It would seem an odd thing that the most famous company over the past decade, and today’s market cap leader, could be seriously undervalued versus related, somewhat similar investment opportunities.
The first sections run through some simple arithmetic and the underlying assumptions to show that a rational investor (yours truly, I hope) can easily justify $300+ right now for AAPL shares for new money looking at related alternative homes for the money. The second part of the article provides my take on how and why this intensely-studied company with a narrow product line could end up being so undervalued, and why Mr. Market is wrong here.
I use Warren Buffett’s somewhat recent large stake in AAPL and comments he made more than once on the stock this year to discuss what I think that he, as an example of the mythical Mr. Market, gets right about the stock and what Mr. Market may still be getting wrong. This is important to me, because if I’m bullish on an asset, I want to know why the asset is misperceived and therefore mispriced.
One small note before the meat of the article: this was written on Sunday night, with Friday’s closing prices. I was on the road and did not have time to submit this until Tuesday, pre-open. AAPL is up a little to $159.75 at this time, versus $157 when the article was written. The S&P 500 (SPY) is up marginally from Friday, as well. Please adjust for this if you want to be precise.
I doubt this is necessary, as the real point of this article is not to say that AAPL is worth some specific number, rather that if it’s reasonable to calculate that its fair value is about double its current price, it’s a strong contender to be A) owned and B) overweighted in an investment portfolio.
First, the basic math that shows the undervaluation, and the assumptions that are used to get there.
Estimating AAPL’s earnings yield
AAPL is a good stock for an earnings yield approach, because its free cash flow is similar to its EPS. That’s as opposed to companies with high capital spending needs, such as IaaS companies or oil producers.
The earnings yield is the reciprocal of the P/E, expressed as a percentage. So, a 20X forward P/E would translate to a 1/20 = 5% forward one-year earnings yield.
What is AAPL’s forward earnings yield? Of course, we don’t know the future, but AAPL has enough stability that allows a guess to be made (that’s my first assumption). Just going with consensus, which shows $11.05 as FY 2018’s EPS, and at Friday’s close for AAPL around $157, the following earnings yield can be projected in a way that makes AAPL comparable to most of its large cap peers.
Namely, AAPL has so much extra cash and a high profit, high-FCF business model that it could lever up a bit and then have a balance sheet much more like its peers in SPY. Except for a small number of other tech giants, AAPL’s other comparators in SPY or Dow 30 (DIA) and general large cap sector have already levered up. So I first subtract about $14/share of value from AAPL’s stock price.
This $14 number is computed using AAPL’s 6/30/17 balance sheet that shows the following assets that are cash-like or otherwise liquid:
- $77 B in cash and short-term investments
- $23 B in receivables
- $10 B in other current assets
- $185 B in long-term investments
These total $294.5 B including rounding.
From this, I subtract all liabilities, which total $213 B.
This leaves $81.8 B of excess financial assets, or close to $16/share. When thinking about the availability of this to shareholders via either dividends or share buybacks, tax must be paid first, so I haircut this to $13/share. That leads to an adjusted share price of $144, or 13X consensus forward EPS. That comes to a 7.7% earnings yield, which is likely to be similar to AAPL’s FCF yield.
There are at least two small adjustments to think about regarding that earnings yield. One is that without all those balance sheet assets, AAPL would earn a little less in interest income. The other is that to simplify thinking about forward earnings with those of peers such as Alphabet (NASDAQ:GOOG) (GOOGL) and Amazon (AMZN), it’s reasonable to think of CY 2018, not AAPL’s FY 2018 that ends at the end of September next year.
There is a larger potential adjustment, namely that the trend of consensus FY 2018 EPS estimates has been moving up. Over many years of AAPL-watching, that trend has been the investor’s friend, and I expect the same this fiscal year as well.
So I’m going to go with a forward adjusted earnings yield of 8% for AAPL based on CY 2018 EPS. It’s approximate, but good enough to use for further analysis.
The next section contains some comparisons of AAPL stock with alternatives. I’m using a 10-year time frame, assuming that major companies and major investments are best thought of that way rather than worrying about what happens this quarter or this year. It is going to take many years for a share of any stock to pay off in reality (as opposed to trading it for capital gains).
The assumptions are twfold.
One relates to the market as a whole:
According to a spreadsheet that Standard and Poor’s maintains, S&P 500 GAAP EPS have risen at a 5.5% annual rate since the calendar year ending 12/31/88. This assumes $107 EPS for the S&P 500 (SPY) for Q3, for which earnings are just now being reported.
I’m going to assume that 5.5% remains the CAGR for EPS of SPY for the decade ahead.
The next assumption is that AAPL will beat SPY by about 2.5% per year, i.e. grow EPS at an 8% CAGR over the next 10 years, due to its leading positions in the tech sector and in the consumer products sector. AAPL products are changing the world more than those of any other company, and the change is just getting going (think Apple Watch and Apple Pay along with the iPhone).
AAPL as an absolutely undervalued stock (not a comparison)
Basic math: If AAPL’s 1-year forward earnings yield is 8%, and EPS compound at 8% per year, then AAPL’s share price will rise to $192 by year 10 if AAPL’s earnings yield (P/E) in 10 years remains the same as it is now.
This would be more than OK from a zero coupon bond or a junior biotech, but in addition, shareholder returns include the actual earnings that AAPL will be making over the 10 years and which it will either retain or deliver to shareholders via dividends and/or buybacks. Since we do not know the precise path of the assumed 8% growth rate (it’s unlikely to be steady as compound interest is), I assume 10% per year as a conservative average annual total return, probably more like 11% if the growth path is relatively steady or (better) front-loaded.
Thus, total returns in this situation would be in the range of 8% price appreciation just from EPS growth, plus an average of 10% or more earned and returnable to shareholders along the way each year. This implies a high-teens annual total return if the terminal P/E stays the same.
This is clearly “too high.” the question is, what is an appropriate forward earnings yield?
My answer is 4%, which would provide a 7.7% yield in year 10 at 8% compounded annually. The average yield is around 5.5%, which is similar to the yield on many junk bonds. I would rather have AAPL, but the comparison is not easy.
This implies a TTM P/E for AAPL right now around 35X, similar to that of Facebook (FB) and Alphabet, and an AAPL price around $300 per share.
A 4% forward earnings yield right now also implies that at the end of year 10, investors would be looking at a forward earnings yield of 8.3% at an unchanged stock price and the same 8% growth rate. So, the predictable return in this case would be the actual earnings. The unpredictable part would be whether AAPL’s price would be higher than $157, giving a lower forward earnings yield, or lower than that, trading at a higher forward earnings yield.
I would think this is a fair choice, and that AAPL’s forward earnings yield of 4% “works” by this general analysis. Even requiring a 5-6% as a starting earnings yield would mandate a sharp repricing of AAPL much higher right now to get to that fair value.