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Apple's commoditization discount

When asked where Apple’s growth will come from, most analysts or observers will cite new products. As long as there are new products, then there is growth. Conversely, if there are no new products, then there will be no growth. This is such a commonly held belief that it’s axiomatic: Apple is being valued based on short-term foreseeable growth.

To be more precise, analysts value the wave of growth of every new product and heavily discount the post-growth phase assuming commoditization. There is no value assigned to Apple for extending market reach to the mass market.

Consider: Analysts currently forecast an operating income (or EBIT) of $43.3bn for 2012 and $49.7bn for 2013. That implies growth of 28% in 2012 and 15% in 2013. These growth rates are modest in light of Apple’s recent historic growth and especially 84% in 2011 on EBIT level. Much of this growth has been due to iPhone which quickly captured 4% market share in four years. To suggest 15% growth in 2013 is to suggest that Apple will not increase its phone market share by an appreciable amount. The implicit assumption in that growth figure alone is that Apple will remain a niche player.

Bear in mind that 15% growth is so low as to be half the the growth in the Mac business and below the likely growth in the overall phone market. Considering the risk premium on equities, this growth forecast assumes essentially a no growth scenario. But even with no growth, Apple’s cash flows are huge and thus they should add up to some significant present value. Since we know the value as reflected in the current price, we can work backwards to determine the discount rate being applied to those future flows. In other words, we can calculate how risky Apple’s existing product cash flows are seen to be.

Based on  assumptions originating from analysts’ consensus, we can construct a simple model that will approximate the discount the stock market puts on Apple’s future cash flows. Let’s have a look at an adjusted Gordon or dividend discount valuation model on EBIT basis:

Shares are valued based on the projected future cash flows of a company. Discounting EBIT with Weighted Average Cost of Capital and subtracting growth will yield enterprise value (= market capitalization – cash).

Applying analysts’ assumption of close to zero growth to Apple’s post 2012 EBIT means EBIT stays constant for 2013 and beyond. Let’s solve for the implied capital costs. Right away we can eliminate growth (g) as it equals zero. EBIT reflects operating cash flow since in a zero growth scenario CapEx will equal deprecation and there are no changes in net working capital. As Apple has no debt but a cash surplus, WACC will be equal to cost of equity[1].

Solving for capital cost (WACC) with available analysts’ EBIT estimates reveals a discount rate of 15%.

But let’s remember that analysts have consistently and by a large margin missed Apple’s financial performance. So let’s dial in a more aggressive estimate of around $56bn of EBIT for the fiscal year 2012. The discount rate goes up to 19% and implies an EBIT multiple of 5.3x.

In other words, Apple’s cash flows for a zero growth scenario are being discounted at a rate of 15% to 19%. This places the company in an extremely risky category of investment. It is certainly not something that can be categorized as a value stock.

The discussions on this blog regarding Apple’s valuation have been insightful, but only danced around the triangle of price, earnings and growth. When the growth forecasts are considered vis-a-vis current pricing, the assumptions built into ‘consensus’ forecasts for Apple are condemnations of the company.

They present a view of a company that is extremely vulnerable and can neither preserve its current cash flows nor find new sources of growth. It is, quite plainly, a company doomed to commoditization.

Notes:

  1. Or one can even assume that cash has a positive effect lowering costs of equity (less indirect bankruptcy costs).
  • parv

    Apple has not done badly in the PC market. It has a much smaller market share but yet it makes the most profit in a commoditised pc market. Why can’t the same apply in the Mobile phone market?

    • http://twitter.com/DrErnie Ernest Prabhakar

      That’s not quite fair; many analysts are quite bullish on Apple with price estimates from $500 to $650.  The real question may be why not enough people -believe- those estimates to bid the price up…

      • Duane Bemister

        The price is determined by the seller. The real question is who is selling and why.

      • berult

        In the mind of the big sellers the pressure put on the Apple Brand by the ‘Apple-sensitized’ commodity markets is just too great. It couldn’t possibly be counterbalanced in the medium and long term by Apple’s innovative and disruptive drive and moxy. Historical precedents call the shot on a disruptor’s eventual fate. Large investors tend to heed  the muted calls of temperance …whereas small-time buyers romanticize through their savings account around perpetuating a serial innovator’s winning streak.

        Apple is a freak of market-driven economics. Or so it appears to secular economic views. In short, it has no traceable precedent therefore …an untrendy, questionable future. Apple’s cultural ancestry draws, in the mind of the classic shareholder, the lifeline of its anticipated progeny. Of dubious origin, hence …with nowhere to go other than to a spontaneous combustion storyline in a straightforward doomsday scenario. 

        The present does not, by definition, translate well into a valuable and equitably priced non commodity, if it happens to be lived through the prism of fiction. A novel …a short story has to be internalized through the overhanging promise of its constantly evolving but always apprehensible conclusion. But conclusive it ought to be constantly assumed to be. The stock price of Apple trends towards an institutional assumption of fiction-like finite exemplarity. It simply is too good to be …consistent with past market predicaments.

        Apple’s ‘fate-holders’ equity rests in its potential to foresee and capitalize the future through the lens of its forefather’s true to form, honest-to-goodness ingenuity…
        …and the actual financial chips will fall wherever in the black they may…

      • http://www.asymco.com Horace Dediu

        What this analysis shows is that the analyst assumptions about growth are disconnected from their price targets. If one were to believe their estimates then there is no way one could believe the price target. The share price will collapse if there is no growth and a stop to growth is precisely what they are forecasting. What’s more, they know this. So what they need to tell us which number is a lie.

      • Anonymous

        But it also seems that with up to 70% of Apple’s stock being held by institutions that already hold the maximum they can, by charter, it’s one of the biggest reasons the stock isn’t moving sharply higher.

        Yet, the value groups have little of it because it’s priced TOO highly. And individual traders with just several thousand shares, hardly count, as we are often long, so we’re not really moving the market either.

        I would like to see some of that discussed.

      • Anonymous

        I think you’re right, in that these are factors that are helping to drive Apple’s P/E down. But frankly, anyone who thinks Apple is over-valued hasn’t done their homework, whoever they are. Which is, of course, Horace’s point.

        Every individual trader should be taking advantage of this huge opportunity to load up on Apple stock at bargain-basement prices. As the years pile up, Apple is pretty much destined to be incredibly valuable, just on the basis of its present fractionally commoditized products. And it’s a fair bet that it’s not through creating breakthrough products which it will in turn be able to commoditize.

      • http://www.opineapple.com/ Mark Newton

        I think this point nails it – institutional investors are already in. The problem is that retail investors are still hiding under the bed with a shoebox containing whatever cash they saved from the GFC. Until they come out, AAPL appears doomed to a rear-view mirror valuation of 13-15 times earnings.

      • http://www.asymco.com Horace Dediu

        This reduces to an argument that the shares are not liquid: Apple shares face a liquidity crisis stemming from a reduction in the number of market participants. This quickly becomes absurd when you think about it. The suggestion that there could be no more buyers for equities in the most visible, most rapidly growing and most valuable company on the planet is preposterous.

      • Anonymous

        Exactly. How much money is stupidly sitting there on the sidelines? It’s a vast amount, a veritable ocean of liquidity.

      • Keith Doherty

        I disagree, the shares are obviously liquid, but we have been shown how stupidly institutional entities can behave. Many institutional buyers cannot hold more than 4% of an individual stock. I.E. no new net buyers of substance. Some bright undergrad might be able to quantify this effect, but the fact remains that the large capitalization of Apple is the apparent number one factor in the shrinkage of it’s P/E ratio. There is no other variable that seems to so obviously coincide.

      • Anonymous

        There is a large amount of institutional money sitting in funds which can’t invest in Apple, such as funds focusing on companies that pay dividends, and funds that track the Dow 30 (which apple isn’t in). It would require changes by Apple to free that money up to invested in Apple stock.

      • http://www.asymco.com Horace Dediu

        So this argument implies that the more valuable the company, the less valuable the company. In other words, if a company becomes infinitely valuable then nobody will own it and thus its price will be zero.

      • berult

        Food for thoughts perhaps:
        The amount of capital needed to sustain breathing and drinking is demographic dependent. Air and water cannot be priced according to their utility …for they are essential to life itself. They are indeed …for all intents and purposes priceless non commodities. Every debate about their price structure is a sustainability non sequitur, therefore academic and a matter of political strategy.

        We could hypothesize Apple requiring a purely demographic-dependent amount of capital to expend its supply of products and services in as much as those become essential to life itself. I believe the prospect of such a quantum evolutionary leap could very well be fueled by revolutionary advances in artificial intelligence.

        Could the market be anticipating having to provide exponentially growing capital to life-sustaining human metamorphism? Could the market indulge as we all do from time to time in socio-economic anthropomorphism, and pay Apple the supreme tribute of trending towards the infinite-value, the priceless, the ever sapient non commodity?

        We could hypothesize Apple being immensely valuable out of being impounded with a void of market capitalization; too heavy to be weighed by market anticipations… just like water, air, homo-sapiens-economicus  emancipation…

      • Keith Doherty

        That is overstating the argument a tad. The obvious point is that there is a definite negative correlation, a natural drag on the stock appreciation as it becomes a mega cap stock. The reasons are logical in the sense that stock fundamentals run into portfolio science, risk management principals etc. What I do not know is, if we are running into those ceilings at present, or if there is more capacity for institutional ownership. You must agree that if Apple’s capitalization continues to grow, the factors I have mentioned must inevitably come into play. 

      • http://www.asymco.com Horace Dediu

        I don’t disagree with your observations, I just point out that they are absurd. If we can reduce portfolio science and risk management principles to absurdities then the prudent thing to do is to abandon them.
        Put another way, those who will persevere with these principles will be easy prey to those who won’t.

      • Keith Doherty

        I love the way you think, it is a learning experience. 

      • Anonymous

        So a ludicrous suggestion would be that apple split itself into different companies to theoretically enable its value to be unlocked, due to some artificial limit imposed by fund rules? (So each individual company could then be included at full value in a fund managers portfolio as seperate companies beneath their maximum threshold?)

        This seems absurd, but if this theory is true, then apple could just split itself into 4 holding companies, all of which simply have a 25% share in Apple inc. So instead of a hypotheical fund limit of 4% value for one company holding back AAPL shares from being valued correctly, funds could instead hold 4 companies worth up to 4% each, with a total of up to 16% of the portfolio being able to be made up of Apple Inc. Problem solved.

      • http://openid.aol.com/makesmelaughhard AppleKilledMobileFlash

        Their price targets are an outright lie and they should be lowered considerably.  Don’t try to fool investors with target prices that can’t possibly be reached.  Not that anyone is being fooled because hardly anyone is buying Apple stock.  No one is falling for those outrageous target prices, so why do analysts continue to raise them?  When all is said and done, next year Apple will probably be up another 25% to 30% and shareholders should consider themselves lucky.  $550 in a year is merely a crack pipe fantasy of overzealous analysts.  Wall Street will not allow it to happen.

      • Anonymous

        Please remember you said this a year from now.

      • Anonymous

        25-30% handily breaks $500. As with everyone here, I would like to see that sooner; but a 25-30% gain is going to at least quadruple the S&P. I am still down 30-50% on my oil and potash stocks from the crash but up 400% on Apple. Google and Amazon both doubled Apple’s %age increase today and Samsung seems poised to blow the doors off of their own quarterlies. I think I will just be happy for all of us.

      • Anonymous

        It would be helpful if Walt were to chime in on this.

      • gbonzo

        I agree 100%. If I use analyst consensus estimates for valuation, I will come to conclusion that Apple is correctly priced or a little overpriced. Where those high targets come from is a mystery to me.

        Many analyst reports do contain the numbers they have used. It could be that analysts use a lower cost of equity. It would be intriguing to have such a report at hand, but I don’t have any.

      • Chris

        I think one thing we should keep in mind is that analysts’ price targets are generally 1 yr price targets, that is, prices they suggest that are going to be realized within the next twelve months, not at some point during the lifetime of the company. Are they offering a price of what they think the company is worth or what they believe the market will believe it is worth during the next year? 

         In other words, I am suggesting the price target may be offered as the realization of an expectation’s game. So long as Apple’s growth continues, the price will keep pushing north, but none of the analysts are willing to offer a price of what the company is really worth. 

        I actually think this is too hard with a company like Apple. All I know is that its worth is considerably higher than what it is here, if we believe that valuation is merely the present value of all the cash that can be taken out of a company throughout its lifetime.

  • Gregg Thurman

    Dell is a commodity player.  Lenovo is a commodity player.  Handset manufacturers like SamSung, Sony, HTC are commodity players.  MSFT is a commodity player to the extent that it permits its product to be sold via commodity players.  The same is true of hard drive, memory and processor manufacturers.

    Valuing Apple as a commodity player ignores that its products are differentiated by proprietary technologies that are patent protected.  While Apple’s products are sold into commoditized markets, because of its product differentiations, Apple derives non-commodity prices and profits.

    For the life of me, I don’t understand why analysts view Apple so narrowly.

    • Anonymous

      For the life of me, I don’t understand why analysts view Apple so narrowly.
      Perhaps the Dilbert™ definition of the word analysis strikes again:

      The word analysis is formed by the root word anal and the Greek suffix ysis which means “to pull numbers from”.

      More seriously though, I share in your quandary: why is it that people who are paid big bucks to prognosticate about Apple’s future performance don’t look at the company from all angles? This doesn’t seem like an unreasonable think for at least one analyst to do and statistically there should be a handful of analysts that are viewing Apple through this lens. Why the lack of this point of view from the “professionals”?

      • Wwoxuk

        Why do analysts have such a narrow ‘sphincteral’ view on AAPL? Maybe there should be a penalty in playing safe and missing opportunities.  

    • http://wmilliken.livejournal.com/ Walter Milliken

      The problem with “proprietary” and “patent protected” is that the market analysts view neither as effective in anything but the short term. Proprietary will be reverse-engineered and copied, in their view, and patents are only held to exchange with other mega-corps and to keep small-timers out of the market.

      Note the continued bogglement of analysts that Apple is actually asserting patents against another player in the same market *to actually protect their inventions*, rather than to milk a bit of extra cash from competitors. Normally, patents in large corporations are seen only as defensive (mutual deterrence) or as an extra cash cow (see Dolby and Microsoft).  I think this is partly why Samsung seems so surprised that Apple is actually trying to bar them from markets due to copying — this isn’t the way the game is normally played at this level, normally a patent suit is simply a prelude to a shakedown.

      • Anonymous

        Yes, and it also explains the virulent explosion of anti-patent rants, as supporters of the pirates leap to their defense. Hmm. I can’t remember the last time I saw a patent war on this level. How unprecedented is this?

  • http://twitter.com/DrErnie Ernest Prabhakar

    When I did stock valuation back at BCG/HOLT, we’d always assume that above-average returns would eventually “fade” back to average (since otherwise they’d eventually take over the economy!). Certainly it seems reasonable to assume that Apple’s stratospheric growth would eventually settle down to 3% at some point. The question is, can we use the data to infer *how fast* the market thinks that will happen?  We used to use a five-year fade…

    • http://www.asymco.com Horace Dediu

      The assumption that complex systems such as large companies reach some sort of equilibrium is provably false. By using an innovation theory view of business shows that companies are either in phases of exponential growth or terminal decline. There is no such thing as steady state. Unfortunately innovation-based modeling is neither taught nor practiced and the myths persist.

      • simon l

        Ok. I’m interested. Prove it.

      • Anonymous

        Apple is already proving it. I’ve followed it since 1984, and it has NEVER stopped innovating, even under some of the dried grass that served as CEO’s.

      • http://www.asymco.com Horace Dediu

        The proof is elegant: Equilibrium in company growth implies at least two things. First that companies exist in perpetuity because they have earnings in perpetuity. Second that there are no opportunities for new companies to emerge since the market is served by the incumbent cohort. In other words, an equilibrium view of large companies implies they are immortal and that they are irreplaceable. Both of these are false. In fact, you can measure company longevity (de-listings, mergers, acquisitions, bankruptcies show that the average life span of a company is less than the average lifespan of a human being) and you can measure the rate of entrants (IPOs). You can even measure the creation and destruction of entire industries. Company mortality and the birth of large new companies disprove the notion of equilibrium which assumes both company immortality and irreplaceability.

      • Chris

        It is unfortunate, but most business schools teach valuation of  companies as businesses with perpetual cash flow. I know I am a product of one of them.
        What they should also teach students is how they are actually projects that come to an inevitable end. This will eventually be the fate of Microsoft and Intel, though Intel has a good long run because they kept finding new markets for their technnology.

      • Anonymous

        I’m intriqued. Where would you categorize Intel and Microsoft?

      • http://www.asymco.com Horace Dediu

        Terminal decline.

      • http://www.facebook.com/lee.penick Lee Penick

        Hasn’t Microsoft had a steady stock price for the past 10 years.   They seem somewhat of a candidate for a steady state large company.

      • http://www.asymco.com Horace Dediu

        There is no such thing as a steady state large company. Companies can be in one of two states: disrupting or disrupted.

      • http://www.facebook.com/profile.php?id=644846198 Ron Smith

        What, no dynamic homeostasis? 

        Katz D & Kahn R L. The social psychology of organizations.

      • http://www.facebook.com/lee.penick Lee Penick

        You have me curious Horace.  I could see Apple sometime in the future with multiple produce lines, but perhaps only one or two providing rapid earnings growth.  (Others would be like when the iPod business matured).  

        The sum total of all the product lines providing a more normal growth of 10-20%.  Why would this be out of line?

      • http://www.asymco.com Horace Dediu

        The reason “normal growth” does not exist is that commoditization and value chain evolution are constantly changing the definition of what the market is.
        The only way companies will survive past adolescence is if they completely re-define themselves.

      • http://twitter.com/DrErnie Ernest Prabhakar

        > Unfortunately innovation-based modeling is neither taught nor practiced and the myths persist.

        So what’s the alternative, Horace? Can you use  innovation-based modeling to do a future cash-flow analysis based on more rational assumptions about growth and decline, and then discount that back to get a less “myth-based” stock price?  How many free parameters do you need to fit actual historical performance in a reasonable way?  

      • http://www.asymco.com Horace Dediu

        Let me get back to you on that.

  • Canucker

    I know this column is tongue in cheek, Horace, but the market has never understood Apple as you have quite clearly illustrated over the past year or so. When presented with a beast you do not understand, you treat it gingerly – even penalizing it for your inability to comprehend its inner workings. This inversion is perfectly healthy if the outsider is stung in the tail and learns his/her lesson but that doesn’t seem to be happening. Rather the market seems to be in perpetual doomsday mode over Apple, transiently acknowledging its performance for a few days after earnings before receding into “the next quarter will be flat” mode. In a world where it is only too easy to take a misstep, you are rewarded for predicting the downside. There are few rewards for the opposite for it is better to be a pessimist proven wrong than an optimist proven wrong.

  • http://twitter.com/zzbar Joe Zou

    Buying AAPL at current level is so much LESS risky than buying it when the stock was at $10 10 years ago. 
    If other investors don’t believe it, it’s their problem.  it’s time to load up trucks. don’t use leverage and no short-term options, reward will come sooner or later.  Happy New year  investing in AAPL.  

  • Anonymous

    Personally, I would rephrase your last sentence. I’d say:

    It is, quite plainly, a company that is GENERALLY PERCEIVED TO BE doomed to commoditization.

    Many people, including Horace, have posted why this is a false perception. Some, like Andy Zaky, have posted why it can’t last, that the compressing P/E ratio will eventually hit a floor. And while I think that’s true, I’m not so sure when that’s going to happen.

    To me, owning Apple stock is like being in an elevator falling in a vacuum. You can’t stand on the floor because it keeps moving out from under you. That is, the P part of P/E can’t keep up with the E part, simply because the E part is growing faster than potential investors think it can. They keep telling themselves that this can’t go on – and then it does. Quarter after quarter after quarter.

    Apple has shattered the paradigm, but most investors aren’t ready, or maybe even able, to admit it.

    • http://twitter.com/zzbar Joe Zou

      yea, but if you bought the stock Jan 2011, you’d still be up 25% while the rest of the market was flat and go-go names like AMZN (down), GOOG all underperformed. I already forgot all the noises of 2011 about AAPL (ok, may be not entirely, NDX rebalance, supply chain disruptions, etc, etc…).  I’ll take 25% return anytime. on the other hand, weekly option speculators probably got screwed and i shed no tears.  

    • http://twitter.com/zzbar Joe Zou

      yea, but if you bought the stock Jan 2011, you’d still be up 25% while the rest of the market was flat and go-go names like AMZN (down), GOOG all underperformed. I already forgot all the noises of 2011 about AAPL (ok, may be not entirely, NDX rebalance, supply chain disruptions, etc, etc…).  I’ll take 25% return anytime. on the other hand, weekly option speculators probably got screwed and i shed no tears.  

      • Anonymous

        Over the last three months, the Dow, the Nasdaq and the S&P500 all handily outperforned Apple. That is, frankly, nuts.

      • Anonymous

        You can handpick any short period in time to illustrate whatever you like. But three months is not a useful period unless you are a day trader. The point is that for the year, Apple did quite well.

      • Anonymous

        I understand your point of view. And BTW, it’s not up 25%, it’s up 32%. A year ago, Apple was at $310.50. Today it’s at $411.23, or about a $100 gain.

        “Quite well” is a relative term. From one point of view, 32% is doing “quite well”, as you put it. But at the same time, Apple’s revenue and EPS completely blow away that gain. Between FY 2010 and FY 2011, Apple’s revenue increased 66%, and its EPS increased 83%.

        So from another point of view, 32% is falling woefully short. Now that wouldn’t be a problem, if it hadn’t been falling woefully short for several years now, resulting in an accelerating P/E compression.

        The larger point is that Apple, which demonstrably is going to continue growing its earnings at a feverish pace, should not be undergoing P/E compression. Microsoft, yes. They’re not growing. But Apple has no business at its present P/E, let alone the P/E it’s going to be at in a couple of weeks, when its earnings utterly slam that ratio into the basement. Because at this rate, Apple’s P/E is going to be less than Microsoft’s before the year is out!

      • http://openid.aol.com/makesmelaughhard AppleKilledMobileFlash

        Yeah, three months is three months.  Apple is up 25% for the year and that’s what matters to me.  My satisfaction is that my portfolio excelled with Apple, while my friends’ portfolios sucked for other stocks.  The rest of the market underperformed horribly.  That’s what I don’t get with Wall Street.  All those jerks constantly betting against Apple, now and in the future.  They’re fools.  Surely they see Apple seriously kicking butt, yet they ignore it and say it’s not possible and it can’t last.  I wouldn’t trust analysts or firms to decide they know what’s best for me.  25% may not be Apple bull territory, but it’s decent, damn decent returns by any financial measure.

        To me, the commoditization of Apple is like saying Porsche, BMW or Mercedes-Benz will be commoditized by Nissan and Toyota.  That’s pure crap.  You either want an elite vehicle or you don’t.  Haven’t any of those analysts driven a Porsche or Bimmer and then driven a Toyota?  Is Tag Heuer or Movado being commoditized by Timex and Casio?  I swear, these analysts are truly stupid when it comes to consumers’ spending habits.  Apple has become an elite brand equal to any other elite brand.  Maybe not on such a grand scale as Cartier or Rolls-Royce, but still there is something that exists that doesn’t become diminished overnight.  I’m not sure about features, but Apple’s product quality and consumer service definitely does exist.

      • Anonymous

        FWIW, the market as a whole seems little prepared for the tsunami that will be Apple’s winter quarter earnings. And like a tidal wave, the water recedes just before it comes rushing in. That’s the way I look at the last three months.

      • Anonymous

        Yes, and YTD RIM is killing Apple. :)

        It is disappointing that the stock hasn’t done even better, but it far outperformed every relevant benchmark over 1, 2, 3, 5, 10 year horizons.

  • Anonymous

    Horace, i know in the past you have been demonstrated a patchy return for investors when a company does a share buyback – but with apple apparently being so drastically undervalued, would it not make sense to invest in a share buyback of its shares?

    Surely apple itself recognizes its own shares as one of the best possible investments that can be made with a spare pile of cash? (assuming it has spare cash not needed for another purpose…)

    • http://www.asymco.com Horace Dediu

      The problem is with the word “invest”. An operating company does not exist to invest in equities. If it cannot find projects that make use of its unique assets and processes then it should return the money to shareholders. It’s not being hired by its owners to speculate on share prices and if it did it would be wasting its talents. Also consider that its vast cash pile is not invested in any equities. The job of its capital manager is to preserve capital, not to increase it.

      • Anonymous

        That makes sense, thanks for the lesson.

        So its more of a decision for whoever represents the best interests of shareholders then? Which would be the Board of Directors?

      • Anonymous

        The only minor caveat I would add is that it’s to Apple’s advantage to make the stock “attractive”, to the degree that it uses stock options to attract and keep to talent. Taking some stock off the market would do that.

        I’ve come around to thinking that returning a modicum of excess cash to stockholders may also be desirable from this point of view, as would creating a stock split. Personally, it wouldn’t bother me if Apple did all three simultaneously.

      • Westechm

        Horace, wish I said that.

  • MOD

    A 15-19% return on investment sounds good to me.

  • Billykunz

    Why do a byback?
    IPO price of AAPL is probably below $7 (adjusted)
    Why buy it back for $400?
    At IPO AAPL got a free loan with no maturity date.

    • adam

      A buyback of an undervalued stock would create more value for shareholders.  Think of buying stock that’s worth $1 for 50 cents.  IPO price means nothing because nobody can buy appl stock at that price anymore but buying back shares undervalued market prices increases the value of the stock.

      The real question is what to do with the massive pile of cash that creates the most value for aapl shareholders.  As Joe Zou points out in a comment above, aapl is a gadget company but it is also becoming a bond fund.  So which is the better investment for aapl to make…corporate bonds or aapl stock?

  • Office

    Great article Horace,
    now it would be interesting to push this a little further and instead of zero growth dial in a few cases say 10%/20%/30%.  This will then show such humongous discount rates that is will even more exemplify how ridicule the current market valuation is.

  • http://twitter.com/zzbar Joe Zou

    Apple noted in its 10Q filing that it had invested $35 billion in corporate securities; $13.5 billion in government-agency debt (mortgage backed); $10.8 billion in Treasuries; $5.6 billion in non-U.S.-government securities; $4 billion in certificates of deposit and other time deposits; $2.9 billion in commercial paper; $3.1 billion in money-market and other mutual funds and $2.9 billion in cash.
    This looks like the portfolio of  a very large bond fund in the world. the performance of this “fund” was far better than most hedge funds last year.   Ironically some of the underperfoming hedge fund managers are now demanding Apple return the cash to them. they should feel lucky that they didn’t have the cash last year and earned a negative return on it. 
     

    • Anonymous

      That had occurred to me as well. However, if I were to get a dividend on my Apple stock, I’d buy more Apple stock with it. I daresay that would yield a far better performance than leaving the cash with Apple….

      • Wessel Kosterman

        You could do the same thing now by short-selling government bonds and using the money to buy more apple shares.

      • lb51

        That sounds difficult, considering Bill Gross didn’t get it right. A person could write options to buy the stock, it’s much simpler and less risk is involved ( overall market timing is not required ).

      • http://twitter.com/zzbar Joe Zou

        The Modigliani–Miller theorem says it is not true.http://en.wikipedia.org/wiki/Modigliani-Miller_theorem 
         But you don’t need a Nobel to see this:  Say you own a company with stock price=$100, the company has $50/share in cash. The company pays you $50 in cash dividend, the stock price theoretically drops to $50. you then use the cash dividend to buy another share (assuming zero tax), you now have two shares with exactly the same value as before. you gain nothing.  You may hope that the cashless company may grow faster than the old company, i don’t see why? in fact, without any cash on hand, the risk profile of the firm is much higher and the risk premium will expand, your 2 shares may trade lower. with 15% tax, you’ll be much worse off.  

      • Anonymous

        From Wikipedia: “The main problem with the Modigliani and Miller (1958) is that they assume shareholders are the owners of the public corporations.” As I understand it, the Modilgliani-Miller theorum has to do with financing growth. If taking the cash would mean not properly financing growth, then I would be inclined to agree with you. For example, if Apple could go out and buy mobile spectrum withou risking running up against the threat of prosecution as a monopoly, then I’d say that would be a way for Apple to use its vast sums to finance growth.

        Besides, the problem here for Apple stock is, as Horace has pointed out, one of perception. If it helps break the misperception that Apple stock is overvalued, then issuing a dividend could push the stock up, not down.

    • Gerry Croce

      Apple should split 10 for 1. It has to do with the “halo effect”. A consumer who owns Apple stock in their retirement portfolio is more inclined to purchase Apple products rather than competitors. A more affordable stock will attract retail investors and increase product sales. The increase may be small but dividends and share buybacks will do nothing to boost sales.

  • Anonymous

    This will be just another of my over-simplifications; but most of us in the world are neither technophobes nor private investors. We do what we are told by people who are smarter about money than we. If your advisor is using a Dell and a Blackberry, it is likely that they have already discounted Apple, no matter what their own analysts may say. If they don’t use Apple and they don’t suggest holding some Apple, then they have probably never done any of the analyses that we regularly see from Horace and Zacky. If they are old, they have probably formed their prejudices from the days of the Big Brother ad. If they are young, they probably trained under someone from the Big Blue world. If you didn’t know that going in, you must have figured it out by now. Put your Apple shares in a shoebox and don’t open it until you retire; and don’t keep those shares in any kind of managed accounts unless your advisor has an apple on his computer. And really don’t expect them to behave as any other investment might: we are living in Oz.

  • WFA

    The above discussion quite fascinating. I’m left wondering if the psychological effect of the current three-digit price is more powerful than one might think, even for analysts.

    Just for fun — for what it’s worth:

    Since January 1987 MSFT has split nine times. Most were 2:1, with two at 3:2.

    In the same time period AAPL split three times. Obviously the growth was quite different, but had AAPL split the same number of times as MSFT, i.e. six times (9 minus 3), and assuming 2:1 splits, its price now would be $6.47:

    413.96 ÷ 2 = 206.98
    206.98 ÷ 2 = 103.49
    103.49 ÷ 2 = 51.74

    51.74 ÷ 2 = 25.87
    25.87 ÷ 2 = 12.94
    12.94 ÷ 2 = 6.47

    Even if I know that the gains possible at any price are percentages, still the lower numbers make it easier to imagine gains. It’s way easier for me to imagine a double from 12.94 to 25.87, for example, than it is to imagine the current price doubling to $828. But Apple has managed quite a few doubles over the years.

    • http://twitter.com/zzbar Joe Zou

      why don’t you buy NOK at about $5.  or better yet  EK at $0.45. just “imagine” how much money you’ll make when EK  becomes a ten bagger and it would still be trading at $4.5. 

    • Anonymous

      There is the psychological aspect, of course. But for the small investor, there’s also the issue of risk. Let’s say you have $2,000 to invest. In order to diversify, you decide you need to buy into ten different companies. Assuming you invest evenly in each, that means you can’t buy even 1 share of Apple stock.

      • http://twitter.com/RangachariAnand Rangachari Anand

        There are fractional share purchase brokers like Share Builder. I have been using this to purchase a small fraction of an Apple share every week for the past few years.

      • Anonymous

        Thanks! I didn’t know about them. I’ll see if I can get hooked in.

      • jawbroken

        How much of an impact do you think people that cannot afford even a single Apple share, out of nearly a billion, have on the price?

  • Anonymous

    Horace – Verizon just announced that they they sold 4.2MM IPhones in the 4th Q.  How does that look relative to your assumptions?

  • frank r

    I’m going to throw a stinkbomb into this lovefest…

    Consider the possibility of negative sales growth in a few years because of disruptive technology of some sort. That is, Apple pulls a Nokia (rests on its laurels) while someone else pulls an Apple (comes up with something much better that makes the Iphone and Ipad obsolete). I’m not sure what. Maybe a major breakthrough in battery technology that obsoletes all existing mobile devices, or maybe something I’m not even able to imagine, which is why it is so disruptive. These sorts of major disruptions do happen in the tech world.

    Now combine negative sales growth with a corporate culture that isn’t concerned about shareholders, so that Apple squanders its accumulated cash hoard in a futile attempt to maintain the existing order of things, rather than paying out this cash as dividends or net buybacks.

    Final result is that shareholder never see a dime of all the earnings Apple is making right now. Plug that scenario into your Gordon equation.

  • http://www.facebook.com/lee.penick Lee Penick

    Its a dynamic and interesting situation.  There is no one universally used model for valuing stock price.  And if there were, we wouldn’t all agree on the variables to plug in.

    Apples growth rate in the next year – don’t know.  Would love to see 80% and not 20%, but we don’t know for sure.

    Competition – they seem to copy fast, and the courts seem slow.  Does Apple have an infinite supply of ideas like FaceTime, iCloud, Siri to keep the competitive advantage?  I hope so but don’t know.

    Macro Economics – what will happen with the European debt situation.  (REad or listen to Michael Lewis’ “Boomerang” if you haven’t.  What an interesting and fun read)  That could much up the growth rate for awhile.

    How sensitive will Apple be in the next downturn?  Despite performing/operating well as a company in the recent market drop, the stock went down to close to $80/share.  Will investors be that scared about Apple in the next market decline?  

    Will lose cannons like “Dear Leader jr.”  or Iran cause world troubles and scare the markets?

    People look at these variables differently and they all effect the stock price.  Some think Apple is worth $500 a share and some think maybe $300.  it all works out in a black box somewhere and Mr. Market shows us the price every working day.  

    Maybe no one thought it was worth $413 today, but that’s what the black box averaged all our sentiment out to.