Monday, September 9, 2013

Love the company! Love the product! Love the stock? An Update on Apple

My first computer was a Mac 128K. I was a budget-constrained doctoral student from UCLA, teaching my very first class at UC Berkeley. At $2,500, in 1984 dollars, it consumed all of my discretionary income for that year, but it was love at first sight. Having sampled what the PC world had to offer, with its collection of geek speak and inscrutable illogic, I was dazzled by the human interface of the Mac and impressed with the creative spirits that ran the company (Steve Jobs & Steve Wozniak). Suffice to say, I was a Jobs fan, before it was fashionable to be one.

As I watched the evolution of the Mac through the decade, I learned some lessons that I have tried to hold on to in my investing and that came to mind last week, as I read some of the comments on my Tesla valuation.
  1. Even great CEOs have their blind spots: The success that Steve Jobs had at Apple, in his second coming as CEO, had made us forget his missteps in his first iteration as Apple's head. His creativity and focus were still there in the 1980s but I think that his zeal to put his personal imprint on style and features overwhelmed any sense of what the market wanted or needed at the time. The Mac Lisa, in my view the most ungainly of Apple computers ever, stands as testimonial to that era and to Job's lack of market discipline.
  2. The best technology does not always win: Much as I would like to believe that the best technology wins out in the market place, I learned to my consternation that this was not always the case. After all, not only did Microsoft win the operating system battle against Apple, with a vastly inferior system (in my biased view) but VHS beat out beta in the videotape stakes. Success in the market place requires a lot more than a good product: a recognition of what it is the market wants, good timing and good luck!
  3. Good companies are not always good investments: When I an enamored about a company, I have to remind myself to separate my views of a company from my views of its stock as an investment. After all, the evidence from history is sobering. As I noted in this earlier post on value investing, the better regarded a company is by the market place, the worse it is as an investment. 
  4. It is difficult to maintain distance when you love a company and its products: Much as I would like to be objective and unbiased, I am human. When I value a company, I start with preconceptions and views that find their way into my numbers, no matter how hard I try. As I noted in this very first post I had on Apple from early last year, all that I can do is be transparent about my biases and let you make your own judgments on whether you buy into my assumptions.
I have a long and complicated relationship with Apple, both as a user and as an investor. As a user, I have bought almost every version of the Mac (except for the Lisa) that has come out since 1984 and will probably add the new version of the Mac Pro to the list this fall. As an investor, I steered away from Apple as an investment through the much of the 1980s and 1990s, partly because I knew that my bias would blind me to the facts. In 1997, I succumbed and bought Apple stock (the split adjusted price was just over $5) just as the company faced its darkest days, as questions mounted about whether the company would make it in a world where Microsoft seemed to have won the PC wars. I would love to tell you that I bought the stock for intrinsic value reasons (because it would make me look good) but as I noted in a post from a little over a year ago, I did not. Instead, I bought the stock out of compassion and loyalty, the former driven by the feeling that the stock may not make it and the latter by the joy its products had delivered to me over time.  That “charitable” contribution turned into my best investment ever, a fact I remember whenever I have moments of hubris about my valuation skills. 

That investment stayed in my portfolio until April 2012, when the company’s stock price hit $600 and the market cap looked like it would climb inexorably towards a trillion, I revalued the company (as I am wont to do with every company in my portfolio, at regular intervals). While the value I obtained was close to $700, I decided that it was time for me to cash out, even though the company was undervalued (at least based on my assessment). I justified  that decision in my post on Apple at the time, arguing that the momentum investors who had come into Apple had made it a pricing play and that I was not skilled at that game. In late August 2012, as the hype for the iPhone 5 built up and the stock price hit $700, I posted a valuation of just the iPhone franchise and argued that it was the most valuable franchise in history. 

Early this year, as Apple’s stock price converged on $450, I revisited my Apple valuation to see if I could justify the sudden and dramatic loss of almost $200 billion in market capitalization from a value perspective. Even allowing for the tighter margins and the stronger competition (from Android phones) my assessment of value for Apple was about $600. Arguing that the price drop had driven some (but not all) of the price and momentum players of the game, I made the decision to become an Apple stockholder again. As I made that decision, I wondered how much of it was driven by my residual bias towards the company and its products.

In May 2013, after feeling some outside pressure from activist investors and their proposals for enhancing price (with David Einhorn’s well publicized push for the company to issue preferred stock, which I responded to in this post), the company announced its intentions to borrow money for the first time in its history and to augment its stock buybacks. I argued at the time that while these actions would have a relatively small impact on value, which I estimated to be $588 at the time, they might be the catalysts that caused the price to move towards the value.

I was clearly way too optimistic, since the stock continued its descent hitting a low of $385 in April. As the price dropped, I did hear from a lot of the readers of my blog post, asking me whether I was reconsidering my decision. The essence (and appeal) of value investing to me is that if you buy a company for its capacity to deliver cash flows to you as an investor, the fact that the market moves against you should change nothing. I would be lying if I said that I was unaffected by the price moving in the wrong direction, but Apple stayed in my portfolio. In the last few weeks, we have seen a piling on of big name investors (Carl Icahn, Leon Cooperman) into Apple and the stock price has risen back to close to $500. To those who have asked me how that has affected my value, I would argue that nothing that Mr. Icahn had said since he took his stake in the company is a revelation that changes my fundamental assessment of value.

Apple’s big announcement date is tomorrow, at 10 am. If you are investor (long or short, potential or current), here are my suggestions. 
  1. Ignore the lead-up to the announcement, with the rumors, stories and opinion that you will see thrown around. Much of it is hot air with no effect on value. 
  2. If you can avoid it (and it will be tough to do so), don’t watch or listen in on the Apple announcement and try not get caught up in the frenzied trading that will inevitably follow. 
  3. I updated my valuation of Apple to reflect the financials as they stand today. Incorporating the information in the last annual report and markets (US treasury bond and equity) as they stand today, my estimate of value is $617, about 4% higher than my estimate in April 2013. A factor contributing to the increased value per share is the decline in the number of shares outstanding from 939.6 million to 908.4, a logical consequence of Apple's aggressive stock buyback program. 
Once you have the details of the announcement, go through the news stories with a singular focus on how they will impact Apple’s revenue growth path, operating margins and investment requirements for the future. The key is to not only separate the wheat (information) from the chaff (distractions) but also to work out the consequences for value.

As an Apple investor, I will be doing the exercise as well to see the implications for my Apple holding. While it is always dangerous to prejudge a news story, I don’t think that anything that comes out tomorrow will be game changer when it comes to value, though it may very well move the price (and I have absolutely no idea in which direction), especially if, as is rumored, it will revolve primarily around the iPhone and the iPad. As I noted in my last post on Apple, I believe that Apple’s value creation over the last decade has come from its capacity to disrupt existing businesses and that Apple is now too large a player in both the smartphone and tablet businesses to be a disruptor. In fact, I think that they face a bigger risk in both businesses of someone else disrupting their cash cows. It would be exciting and potentially value changing if Apple announced a new market that they were planning to enter that no one expected them to. In my last post on Tesla, I argued that one of the potential positive scenarios for a Tesla bull was a strategic buyer who would be able to pay a premium over $20 billion. While I named automobile companies as potential buyers, there is no reason why that buyer cannot be a technology company with a large cash balance. Apple clearly has the cash and if it can figure out a way to bring Elon Musk on board, it may have found a new market to disrupt. The Tesla iCar? Probably no chance of it happening, but I can still dream, can’t I?

26 comments:

Spartacus said...

First, thank you for a very interesting blog.

Second, why invest at all in stocks one is biased to or has feeling towards. Wouldnt it be better (for long term performance) to stay with the dull and boring ones?

Aditya said...

Hello Sir,

I thoroughly enjoy reading your blogs.
I have a small doubt regarding the sales to capital ratio that you use to arrive at the invested capital for young growth companies. Can you please elaborate on the rationale behind keeping that number constant for the firms, because by using a constant Sales/Capital ratio we are implicitly making the assumption that irrespective of the changes in every other characteristics of the company(changing operating margins,moving towards stable growth rates,lower Cost of capital), we are still maintaining the sales to capital ratio as constant. Why doesnt there be a change in sales/capital ratio as the young firm matures or declines for that matter?
Kindly do reply Sir

Thanks
Aditya

suman equitytips said...

This blog provides really great tips for Fabulous ideas.. To get Free Stock Tips
stock tips
equity tips

Anonymous said...

As regards TESLA, you are not alone, PROF. Porter Stansberry Associates
(a much maligned group where some subscribers leave as soon as they put up sth. like this) twice alerted their subscribers as early as one month back about this EVOLVING shorting opportunity but the timing signals haven't come yet due to the ongoing "tulip mania syndrome." In fact, 2 more "will-never-go-down" darlings of the market too are on their "death watch" list. To think Enron too was a rising
"will-never-fall" star once!

Jay said...

I really like to see your valuation of Steve Jobs! It looks like you don't give him much credit for Apple's success?

Anonymous said...

> as they stand today, my estimate of value is $617...

Nice to know.

I hope Apple can crack the Chinese market. People believe that those cheap, iPhone-look-alike Androids are a threat. It's hard to value such a threat.

What's your take?

Anonymous said...

I have a query on sales to capital too:

You use that ratio for calculation of reinvestment requirements for all types of firms (large and small, technology and other).

While I understand its use as a pretty good measure of reinvestment, I would like to know the reason why you don't use the traditional way of calculating reinvestments,i.e.,Capex less depreciation plus working capital. For instance, this growing at similar rate as sales growth.

Is there a particular reason you don't calculate using this method?

In your valuation book, in fact, you have mentioned the traditional way of calculating reinvestments for all firms, and sales to capital for only those which are young and money losing.

Your explanation would help me understand the concept better.

Thanks.
sunny














Anonymous said...

I have a query on sales to capital too:

You use that ratio for calculation of reinvestment requirements for all types of firms (large and small, technology and other).

While I understand its use as a pretty good measure of reinvestment, I would like to know the reason why you don't use the traditional way of calculating reinvestments,i.e.,Capex less depreciation plus working capital. For instance, this growing at similar rate as sales growth.

Is there a particular reason you don't calculate using this method?

In your valuation book, in fact, you have mentioned the traditional way of calculating reinvestments for all firms, and sales to capital for only those which are young and money losing.

Your explanation would help me understand the concept better.

Thanks.
sunny

Aswath Damodaran said...

Lots of questions on the use of sales to capital ratios. Here is the key. It is a general measure but how it affects your valuation will depend upon what you are assuming about margins over time and the level of the ratio. If you leave margins unchanged and set the company's sales to capital ratio at its current level, you are essentially assuming that the company's current return on capital will continue for the long term and that reinvestment will be based off that return on capital.
Reinvestment rate = Expected growth rate/ ROC
If you increase margins over time and keep the sales to capital ratio fixed (as I did for Tesla), you are assuming that returns on capital will improve over time as the company matures, before settling into a steady state.
If you decrease margins over time and keep the sales to capital ratio fixed (as is the case with Apple), you are assuming that the return on capital will decrease over time.
Generally speaking, the level of return on capital in year 10 is a good indicator variable as to whether you have invested enough. In the case of Apple, the presence of an astronomically large cash balance makes the invested capital computation moot and I don't pay as much attention to it.

Anonymous said...

Prof Thanks for this.

Should we use the traditional way (net capex + wc) or use sales to capital?

Which is more efficient?

sunny

Anonymous said...

Great post! In particular, I appreciate the mix between personal story and valuation fundamentals.
Professor, you said that your new estimate of value was $617, about 4% higher than your estimate in April 2013. A factor contributing to the increased value per share is the decline in the number of shares outstanding from 939.6 million to 908.4, a logical consequence of Apple's aggressive stock buyback program.
I have trouble understating the argument. EPS may be up, but intrinsic value should remain flat.
Many thanks.
Mustapha

Aswath Damodaran said...

The intrinsic value of the operating assets does not change, but the value of the firm actually drops by the amount of the shares bought back. If you buy back the shares at less than their intrinsic value (as I think Apple did during this period), the value of the intrinsic value per share of the remaining shares will increase.

Anonymous said...

Professor,

Thank You for sharing your insights. Just wanted to get your thoughts on Apple's media event yesterday. Does it significantly impact your valuation of Apple?

Thanks!

Dexter Louis said...

Yes, the best technology doesn’t always win, there’s also require some efforts and guidance before investing in any stock business.
VCT

tr33hug33r said...

Love the strategy !

C stands for CALM + COOL + CALCULATED = Mr. Cook !

Apple strategy as I see it:
================
What did Wall Street pick up from the announcement?
a new iPhone 5S & new iPhone 5C

Expected Sales of iPhone 5S, 5C for the next 4-Qs
110 – 125Million units in North America, Europe and Japan
4-8 Million units Rest of the World
Profit margins 45%-53%

Who is the target audience for iPhone 5C?
It’s not China, not India but young adults (13-25yrs)
C is not for Cheap, C is not just for Color, C is for COOL!

Wall Street does not get the significance of the Apple In-Store trade in program
Expected Sales for 2013 Q4 and 2014 Q1-Q3 of Apple Certified Pre-Owned iPhone 4, 4S
40-60 Million units in China, India and other Emerging Markets
Profit margins 30%-45%

Wall Street does not get the significance of the iOS 7
iOS7 is a complete re-write available to iPhone 4 and up.
the refurbished phones with the iOS7 update are as good as new!

The new features to the iPhone 5S
Touch id : huge impact, technically very difficult to replicate. big impact in simplifying online purchases and password management. Big big usability win !
64 bit processor: huge architecture overall, big performance improvements
M7 Chip: separate health chip allows always on mode while not being a drain on the battery

CH868 said...

Does anyone knows how the professor get 30% for Apple's standard deviation.

andrea said...

i read you since 2 years.
for many reasons i consider this your best article ever.

one of the reasons being the last lines when you suggest Elon Musk to become the new CEO.

since long i m thinking whether an entrepreneur/founder should leave the company to his long standing CEO/CFO (tim cook, steve balmber, and 100 other examples all other the world) OR, as i believe, he should leave the company to another like minded entrepreneur.
Your last lines make me think i might not be alone in this way of thinking

Angel said...

Hi Aswath,
Great work as usual.
I was reading through the Apple valuation and noticed that your spreadsheet is calculating the revenue growth in the most recent year using the trailing 12 months against the last 10k. The problem with this is that both figures share one quarter. I mean, the trailing figure was created by adding 3 new quarters but leaving 1 quarter as it is in the 10k. So this approach should be underestimating the growth rate in case Apple can generate revenues higher for this following quarter. I believe that in the case a calculated trailing figure is used, it needs to be compared against a calculated trailing figure from the previous period. Much more work but a more precise rate.
I calculated the compounded revenue growth for the last 3 years (10K) and it is higher than 50%. Is it accurate to estimate a 5% compounded revenue growth for the next 5 years? I know it is the future and it is really hard to estimate but a drop of 45% in this rate seems as too high. I know that these are your estimates and that we are encouraged to change them. I just wanted to understand the reasoning behind it.
Just wanting to learn.
Thanks and congratulations on your work once again.

Anonymous said...

Hi Professor,

Enjoy and appreciate your analysis as always.

I am an Apple investor and would like your thoughts on the following article:

http://seekingalpha.com/article/1692232-apples-huge-ecosystem-blunder

I wonder to what extent you would reconsider your scenario analysis as the long-term effect of premium pricing and loss of market share could greatly damage Apple's long-run value and Apple's strategy is starting to remind of the PC battles.

China Telecom's decision to cut subsidy seems to underscore the point.

sunil malviya said...

Copper prices were almost steady on Friday amid mixed data from western countries, the United States and weak US Dollar. Upcoming Chinese holidays were also seen pressuring the base metal prices to certain extent in the global market.
Equity Tips

Anonymous said...

Hi Guys, I found a Website to perform Discounted Cash Flow Model calculations, no need to do those calculations on the Excel file anymore, check it out:
http://turnkeyanalyst.com/2013/09/19/cloud-based-discounted-cash-flow-analysis-tool/

Sara said...

We have to love this kind of things we need to know about about our products, but we need to know about the operating systems first like the new ios 7

Anonymous said...

I did the same daydreaming yesterday. I was thinking about what great things Apple and Elon Musk could do together.

Natalie Tijan said...


I made that decision, I wondered how much of it was driven by my residual bias towards the company and its products.

Stock Market

Natalie Tijan said...

lows to you as an investor, the fact that the market moves against you should change nothing


Stock Market

Elizabeth harville said...

sampled what the PC world had to offer, with its collection of geek speak and inscrutable illogic
Unitedhealth Group Stock Price