Valuing Companies: Apple Edition
So I am considering a long position in Apple. This post will serve as my investment case, an attempt to apply the mindset of Graham and Dodd. I have a shares Isa, in which I hold a portion of my savings. I try to find undervalued companies and sectors, and aim to hold for a longish time period. My current holdings are BG Group, Man Group, Lamprell, Schroder’s Real Estate Investment Trust, and a hedged Nikki positions through the MSCI Sterling hedged ETF, Cazenove Smaller Companies Fund, and Standard Life Equity Unconstrained.
Firstly, I will set out how I think about valuing companies in the abstract. As a shareholder, you live in a gray area of the investing landscape. You have a share in the assets and liabilities of the company, and also a share in current and future profits. I like to think about how a share price reflects a company as a going concern, which means I need to strip out of the market capitalisation those assets and liabilities that are independent of daily operations. Most commonly this involves bond issues. Bonds are more senior than equity, so they get first bite at the profits and also, in the event of bankruptcy, first claim on the assets. Thus, to understand how the market is valuing a company, we need to add its liabilities to its market cap. Similarly, in the unusual event of a company having a very strong net cash position, we should subtract it from the market capitalisation.
We can imagine, as it were, that the “market value of a business” = Market Cap + Liabilities – Non productive assets. We should not include such things as factories or offices, or those assets that are necessary for the daily operations of the company. The reasons for this are laid out in Graham and Dodds weighty tome “Security analysis”. When one comes to value a productive asset, its value is usually how much it produces. A company usually only sells such assets when they are no longer profitable, in which case there is no reason to think another company could profitably employ your factory, so its value drops to its land value. As an investor, we cannot know for certain how a company is valuing its productive assets, so in the interests of safety, assume you will get nothing from them that is not fully factored into the profit expectations.
Apple produces an interesting test case for this way of thinking, as its strong cash position materially affects its market cap, despite having almost no debt. According to its most recent 10-Q (interim statement for UK readers), it has around $68.7bn in liabilities, and around $158.6bn dollars of non productive assets, mostly in long dated securities and cash. The enterprise value of Apple is therefore its 400bn market cap, less $70bn in net non productive assets, for $330bn. This is the value that should be used for PE ratios. Last years apple earnings were around $41bn consensus estimates suggest it will be around $45bn this year and $50bn the year after. This gives an effective PE ratio of around 8. To put this in perspective, Google is valued at around 24 times earnings, Microsoft and Oracle are measured at around 15 times earnings. (In fairness, these are just the values from the FT website, not the adjusted values I laid out above for apple). This suggests to me that Apple is pretty cheap for a Tech company. Mean reversion is the most powerful force in market dynamics, so I would expect to see this valuation gap resolve itself one way or another.
As is often pointed out, the stock market is a forward looking vehicle, so let us ask what this stock price is predicting. To me this suggests that the Stock market is expecting Apple earnings to halve. If they did so then Apple would be fair valued as a tech company at around 15 times earnings. This does not seem plausible to me. It is true that as smart phones have become a commodity margins are likely to come under pressure, and that Google is at a huge premium because the market is very excited about driverless cars and Google glasses. Apple has always been extremely secretive about product development, are we certain that Apple does not have another game changing device up its sleeve? Apple has a fantastic brand, and huge brand loyalty. Smart phones are a fast growing market, and so we could easily see Apple maintaining earnings even with falling margins. Moreover, the corporate culture of excellence that Steve Jobs built is likely to persist.
So we have set out a value case for Apple. However, market sentiment is a strange beast, and its clear that Apple is in a monster downtrend. Do you fight the trend? Do you catch a falling knife? Well, this is an area in which it helps to look at the big picture.
So the question is, are we going to break through the support at $420? If it does, we are likely to see another big move lower, down to 380 or so. At the moment the chart looks squeezed between the top of its down trend and the support line. Over the next few days it will break out either higher or lower. The risk of buying now is that it might go lower. The risk of not buying is that it might break out to the up side by some 20% or so.
In such situations my inclination is not to bother too much with the charts. I intend to hold for a long time (two years at least), and so a temporary downwards movement is not such a big deal. Apple is a strongly cash generative company disconnected from its fundamentals (in a good way), so I see a buying opportunity. If your plan is to ride a short move, you have been warned.
Disclosure: I will probably initiate a long in Apple later today.