Apple Inc.’s (AAPL) stock price has underperformed the NASDAQ by roughly 30% over the last four months. To many investors this makes it a very attractive buying opportunity. I agree. Apple is attractive from a behavioral finance standpoint and from a fundamental valuation standpoint.
What Does Apple Do?
Apple makes iPhones, iPods, iPads, and Macs. More broadly speaking, and according to their annual report, Apple “designs, manufactures and markets mobile communication and media devices, personal computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications” (annual report, p1). Apple was co-founded by Steve Jobs. After leaving the firm in the 1980’s, Jobs returned in the 1990’s and lead the firm from near bankruptcy to one of the most successful companies in the history of the world. Apple’s current market capitalization is approximately $470 billion. Simply put, Apple is absolutely enormous.
The iPhone generates a little over half of Apple’s total revenue. Here is the revenue breakdown and more information by product:
-iPod: 3.6% of Apple’s total sales was generated by the iPod in 2012. The Company’s iPod line of portable digital music and media players includes iPod touch, iPod nano, iPod shuffle and iPod classic.
-iPhone: 51.4% of Apple’s total sales was generated by the iPhone in 2012. The iPhone combines a mobile phone, an iPod, and an Internet communications device in a single handheld product.
-iPad: 20.7% of Apple’s total sales was generated by the iPad in 2012. The iPad is a multi-purpose mobile device for browsing the web, reading and sending email, viewing photos, watching videos, listening to music, playing games, reading e-books and more.
-Mac: 14.8% of Apple’s total sales was generated by the Mac in 2012. The Company offers a range of personal computing products including desktop and portable computers, related devices and peripherals, and third-party hardware products. The Company’s Mac desktop and portable systems feature Intel microprocessors, the OS X operating system and the iLife suite of software for creation and management of digital photography, music, movies, DVDs and websites.
-Other Music Related Products and Services: 5.5% of Apple’s total sales was generated by this segment in 2012. This segment includes revenue from sales from the iTunes Store, App Store, and iBookstore in addition to sales of iPod services and Apple-branded and third-party iPod accessories.
The remaining 4% of Apple’s total sales in 2012 comes from peripherals, other hardware, software, services, and other.
36.7% of sales are in the US, 23.2% are in Europe, 6.8% are in Japan, 21.3% are in Asia-Pacific, and the remaining 12% are from other retail sales.
What Is Behavioral Finance?
Warren Buffett’s mentor, Benjamin Graham, is widely credited with long ago saying the stock market is a voting machine in the short-term, and a weighing machine in the long-term. I believe this is a description of behavioral finance before the term behavioral finance even existed. According to Wikipedia, “behavioral finance highlights [market] inefficiencies such as under- or over-reactions to information as causes of market trends (and in extreme cases of bubbles and crashes). Such reactions have been attributed to limited investor attention, overconfidence, overoptimism, mimicry (herding instinct) and noise trading.” Basically, the market may ignore fundamentals in the short-term and price stocks based on popularity (a voting machine), but fundamentals are the ultimate long-term driver of a stock’s price (a weighing machine). As a long-term investor, I’d suggest ignoring short-term prices and instead focusing only on long-term fundamental valuations, except for the universal truth that the market can stay irrational longer than you can stay solvent.
One of my favorite behavioral finance investment management firms is Fuller &Thaler Asset Management, Inc. because I like Fuller’s research. There’s a really good paper on the firm’s website called “Behavioral Finance and the Sources of Alpha.” I particularly like the section of this paper called “Heuristic Biases and Errors in Expectations” because I believe it is applicable to Apple’s stock price over the last several years. Especially the points on “saliency” (for events that occur infrequently, people tend to overestimate the probability of such an event occurring in the future if they recently observed such an event) and “anchoring” (psychologists have documented that when people make quantitative estimates, their estimates may be heavily influenced by previous values of the item). I believe both saliency and anchoring are applicable to Apple earnings estimates and its stock price.
How Has Behavioral Finance Impacted Apple’s Stock Price?
Behavioral finance impacted Apple’s stock price on its historic rise to the largest market cap stock in the world, and during its significant decline over the last four months. With regard to Apple’s historic rise, equity analyst’s actually started to believe Apple’s earnings could continue to grow at an enormous rate for a really long-time. It was a classic example of saliency and anchoring as described above. And when visionary leader, Steve Jobs, passed away, rather than taking their foot off the gas, the analysts misinterpreted the “tribute effect.” For example, when Michael Jackson died, Michael Jackson songs immediately shot to the top of the sales list on iTunes as a tribute to the tormented genius that created some of the best music in the history of the world. Similarly, when Steve Jobs died there was an unprecedented outpouring of support for his contributions to the world, and one big way in which it manifested itself was through sales of Apple products. With regard to paying tribute to Jobs upon his death, I certainly won’t soon forget images like this one which popped up all over the world:
In recent months, Wall Street analysts have slowly and reluctantly been lowering their earnings estimates for Apple. And I say reluctantly because I believe the behavioral finance heuristic known as anchoring (described above) has prevented them from lowering them sooner. A quick view of Yahoo!Finance shows that over the last 90 days analysts have significantly lowered current quarter, current year and next year earnings estimates. Also, Apple missed earnings estimates the last two quarters. The market is slowly admitting it was overly optimistic about Apple, and Apple’s stock price has come down significantly.
I believe behavioral finance helps explains the way wall street analysts forecasted Apple’s earnings, and I believe these same earnings estimates where a large driver of Apple’s stock price during its historic rise, and during its significant decline over the last four months.
Why Is Apple Currently Attractive From A Behavioral Finance Standpoint?
I believe Apple is attractive because behavioral finance has driven the price much lower (albeit at a very slow pace), and its earnings power once again supports the price going higher. Put differently, saliency and anchoring effects are finally wearing off to the point where Apple is attractive at its current price.
What Is Apple’s Fundamental Value?
Free Cash Flow (FCF) is an important metric in assessing the value of a company because it’s not easily manipulated and it demonstrates a company’s ability to create value. Free cash flow is the cash flow available to the security holders of a company. Free cash flow can be calculated by subtracting capital expenditures from cash flow from operations. In Apple’s case, in 2010 -2012, free cash flow was:
$42.561 billion = 2012 FCF = $50.856 (cash from ops) - $8.295 (Capex)
$33.269 billion = 2011 FCF = $37.529 (cash from ops) - $4.260 (Capex)
$16.590 billion = 2010 FCF = $18.595 (cash from ops) - $2.005 (Capex)
$30.807 billion = 3-year average FCF (all data from annual report, p46)
Discounted Cash Flow (DCF) Model is one important technique to value a company. The model assigns a value to a company as follows:
Value = (FCF/WACC) / Shares Outstanding
WACC = Weighted Average Cost of Capital, and since Apple is financed with equity (the company has zero long term debt and zero outstanding preferred stock, annual report, p63), the Capital Asset Pricing Model (CAPM) can be used to determine the WACC:
CAPM = risk free rate + Beta x (Expected Return on Market – risk free rate)
Risk free rate = 1.84 = yield on 10-year treasury (Bloomberg)
Beta = 0.93 (Yahoo!Finance)
Expected Return on Market = 8.0% = long-term assumption
Required return on Apple = CAPM = 1.84 + 0.93 x (8.0 – 1.84) = 7.5688%
Therefore, using 2012 FCF, a zero-grown discounted cash flow model says Apple is worth:
$597.78 = (42,561,000,000/0.075688)/940,690,000
Or, using a small expected growth rate (1.84%) and the 3-year average FCF suggests Apple is worth:
$571.66 = (30,807,000,000/(0.075688-0.0184))/940,690,000
Can Apple Grow?
Apple absolutely has the ability to grow at a significant rate. Apple earned a second place ranking on Interbrand’s 2012 Best Global Brands list (behind only Coca-Cola), and this strong brand recognition will undoubtedly help the company grow earnings in existing and new products. To quote Interbrand “Few companies have captured our imagination, inspired such devotion, and revolutionized the way we live quite like Apple.” A segment by segment review of Apple’s business is helpful in explaining Apple’s growth opportunities.
-iPad has been the fastest growing product during the last two years going from 7.6% to 51.4% of total sales (annual report, p30). The growth potential of this segment remains enormous particularly as enterprise use of the iPad increases.
-iPhone is the largest product by sales, and has grown 71% and 87% in 2012 and 2011, respectively (annual report, p30). iPhone continues to present significant growth opportunities, however competition in the smart phone market is fierce.
-iPod sales decreased by 25% and 10% in 2012 and 2011, respectively (annual report, p30). The decrease is due in part from iPhone attrition (the iPhone is an iPod). Growth in iPod sales is challenging, however iPod continues to generate significant revenue for Apple.
-Other music related products and services grew 35% and 28% in 2012 and 2011, respectively. The segment continues to present growth opportunities, especially as new music is constantly developed and iPod users wish to listen to that music on their existing iPods.
-Mac sales grew 7% and 25% in 2012 and 2011, respectively. Macs have a loyal customer base, and present continued growth opportunities.
An important caveat with regard to Apple’s growth is to be cautious of anchoring. Just because Apple has achieved such phenomenal growth in recent years, doesn’t mean those growth rates will continue. In fact, Apple’s growth rate has been far better than most companies, and the concept of mean reversion becomes a risk, especially considering visionary leader Steve Jobs is now gone, and continued high growth becomes even more challenging with a company already as large as Apple. That said, Apple TV presents an enormous growth opportunity for the company.
Can Apple TV Contribute To Growth?
Apple TV currently generates an almost negligible amount of the company’s total revenue, yet it has the potential to become the single largest source of revenue if the company can execute.
In case you don’t know, “Apple TV allows customers to watch movies and television shows on their high definition television. Content from iTunes, Netflix, YouTube, and Flickr as well as music, photos, videos, and podcasts from a Mac or Windows-based computer can also be wirelessly streamed to a television through Apple TV.” Anecdotally, I increasingly come across twenty-something-year olds that seem to spend more time on YouTube and Hulu than they do watching actual TV, and this is an indication to me that the market could one day be amenable to replacing traditional television with Apple TV. That said, Steve Jobs is gone, and without him the successful execution of Apple TV seems dramatically less likely to me. However, new CEO, Tim Cook, seems apt to lead the company in that direction anyway. In a recent interview with NBC’s Brian Williams, Cook said: “When I go into my living room and turn on the TV, I feel like I have gone backwards in time by 20 to 30 years. It’s an area of intense interest. I can’t say more than that.” And if Apple TV is a success, then all of a sudden Wall Street’s ridiculously high future earnings growth estimates become much more realistic.
Graham’s Valuation Formula:
To bake expected earnings growth into a company’s valuation, I like to use a simple formula first published by Warren Buffett’s mentor, Benjamin Graham, in the 1940’s: stock price = EPS x (8.5 + (2 x growth rate)). Considering Apple’s 2012 earnings-per-share (EPS) was $44.15, and if the company grows at roughly the same rate as the market (I use a long-term capital market assumption of 8%) then Apple is worth $1,081.68: EPS x (8.5 + (2 x growth)) = 44.15 x (8.5 + (2 X 8.0)) = $1,081.68.
However, if we assume Apple’s earnings will grow simply at the rate of inflation (10-year Treasury = 1.84%) then Apple is worth only $537.75 (which is still more than it is trading at today): EPS x (8.5 + (2 x growth)) = 44.15 x (8.5 + (2 X 1.84)) = $537.75.
And if Apple TV become the success many people hope, it’s more reasonable to accept the average five-year earnings growth rate forecast of the 40+ analysts covering the stock according to Yahoo! Finance, which is 20.89%. And plugging this growth rate into Graham’s formula gives Apple an astounding valuation of $2,219.86: EPS x (8.5 + (2 x growth)) = 44.15 x (8.5 + (2 X 20.89)) = $2,219.86
Personally, I believe it’s unreasonable to expect any company as large as Apple to grow at this rate, and a valuation this high seems unreasonable, however if Apple TV is a huge success then this valuation all-of-a-sudden becomes more reasonable.
Like any company, Apple faces a variety of risks that could drastically reduce its value. Some of the larger risks are described below:
-Market Decline: If the market declines significantly, Apple will likely decline with it. A struggling economy could reduce consumers’ ability to spend, which would reduce the demand for Apple products, and reduce the price of Apple’s stock.
-Failure to Innovate: Apple has only a few products (albeit blockbuster products), and if these products fail, Apple fails. The company’s success has been driven by its ability to innovate. If Apple is unable to continue to innovate then its existing products will become obsolete and the company will not be able to develop new products to meet market demands. This risk is higher than in the past because visionary leader Steve Jobs is now gone.
-Earnings Downgrades: Many Wall Street analysts have already lowered their earnings estimates for Apple, which has put downward pressure on the stock. However, additional downward revisions could cause additional selling pressure.
-Margin compression: Apple’s high profit margins will likely decrease for existing products. Competition will drive down prices. Additionally, supplier costs may increase. Both would materially impact Apple’s ability to profit.
-Poor Management: Legendary leader, Steve Jobs, is gone. The company is already changing as is evidenced by recent dividends and share repurchase programs demonstrating Apple may be struggling to find a use for all of its cash. Excess unused cash on Apple’s balance sheet is not in the best interest of shareholders, and Apple has a huge amount of cash on its balance sheet.
-Competition: Competition is fierce, particularly in the smart-phones market- Apple’s largest business segment by revenue. Competitors may develop new products that drastically reduce demand for Apple’s products, which would reduce the company’s ability to profit.
Both behavioral finance and fundamental valuation metrics suggest to me that Apple stock is undervalued. I believe Apple is attractive and will outperform the market for the next 3 to 5 years, at least, and much longer if Apple TV is a success. However, I do not own shares. Steve Jobs was the visionary leader that grew Apple into the great success that it is today, but now Jobs is gone. And without Jobs, I have less faith in the company’s ability to extraordinarily innovate and implement as it has done in the past. Steve Jobs was one of the most imaginative, creative, visionary leaders ever. He left an indelible mark on the world, and he changed the lives of hundreds of millions of people for the better.
Steven P. Jobs