Tuesday, 11 September 2012

Apple Inc Valuation

The Apple Inc share (NASDAQ:AAPL) has had a magnificent run of late having increased about 65% this year and some 77% over the last 52 weeks. Since 7 September 2007 the shares are up around 407%. Despite the share price reaching new highs, the shares currently only trade at a trailing P/E ratio of 15.6 according to Google Finance. The share price ending 10 September 2012 applied in this report is USD 662.74.

Apple's financial track record for the last five years is nothing short of impressive*. On average, total revenue and net income grew at an annual pace of 50% and 66% respectively. Return on assets and equity were on average 30% and 34% for the same period, while cash earnings represented 92% of net income, indicating high quality earnings. Excess cash** as of Q3-2012 is more than USD 75 billion, or almost USD 80 per share. Removing excess cash from the balance sheet over the last five years results in an average adjusted return on equity of about 85%. And that return was achieved with no gearing (as the company has no long term interest bearing debt). I would not be surprised if this is unprecedented in corporate history for a company this size.

But for a great company it does not automatically follow that its shares are a great investment. The shares currently trade at a forward P/E of 15.1 (based on forecasted EPS of 44.21 for this year), a P/E of 24.1 based on 2011 earnings with a current P/B of 5.6. Based purely on the trailing P/E of 15.6 reported above the shares are not expensive. Based on average earnings for 2008 to 2011 however, the shares currently trade at a P/E of 46.0. Herein lies the fundamental risk of investing in the Apple share: The last five years have been extraordinarily strong operationally for Apple, but the market is pricing in a significantly better future than that delivered hereto. History shows, and economics teach us, that over the long term, very few companies manage to earn a return on equity significantly higher than its cost of capital as the high returns attracts ever increasing competition until the returns are brought down towards costs of capital. And significantly fewer (none?) manage to deliver a 85% return on equity on a sustainable basis, certainly not when having reached the size Apple now has.

Although it is challenging to argue that the Apple share has become a speculative issue as the share price increase has been backed by fundamentals, the current market price does nonetheless imply the future will be significantly more profitable for Apple than the glorious past five years. In this sense the share is therefore currently priced for perfection. One should not be surprised if such expectations are not met. And if they are not, the share price will drop accordingly. On top of this, the company's effective tax rate over the past five years of 25.9% will increase once the cash held abroad are repatriated (according to Forbes, estimated cash held overseas was some USD 64 billion in March this year). This additional tax is currently not provided for in the accounts "because such earnings are intended to be indefinitely reinvested outside the U.S." (p. 31, Q3-11 report). A chunk of Apple's reported earnings are hence not "distributable" and are therefore not real earnings for valuation purposes. If the 35% maximum tax rate is applied (possible refunds of taxes paid abroad not taken into consideration), Apple would have to pay an additional USD 22.4 billion in corporation tax currently not accrued in the income statement. This figure is the equivalent of 86.4% of the net income Apple reported for 2011 and represents about 3.6% of the current market cap. This tax on repatriating cash from abroad also needs to be applied to future earnings for valuation purposes. Another risk factor to consider is the company's investments in marketable securities, amounting to USD 109.276 billion as of Q3-2012, of which USD 38.247 billion is in U.S. treasury and agency securities. There is a substantial risk of losses on these securities when the general level of interest rates again start to increase (see here and here), which will happen sooner or later as they are artificially kept low by the Fed. And there is a limit to how much government securities it can buy and one day it will need to start selling securities to limit the expansion of the money supply (see here).

But the biggest risk to the share price remains the forecast by the market that earnings (2012 which will be a record year) can be expected to grow significantly in the future as reflected in the forward P/E ratio for 2012 of 15.1 applied to those earnings. As an example, this implies a 55% payout ratio and a perpetual growth rate of 6.02% from the 2012 expected EPS. If the expected future payout ratio is lower than this, the future perpetual growth rate needs to be higher to justify the 15.1 P/E ratio.

In conclusion, the probability of the Apple share price dropping seems significantly higher than it increasing, which is why I would not recommend the prudent investor to buy Apple shares at this price level. But look to buy the share if it drops below USD 480 if the fundamentals remain strong, a price that implies no future growth from the 2012 expected earnings. The excess cash of USD 80 a share is your margin of safety.

Source: Google Finance, Apple, EcPoFi

Source: nasdaq.com

* All income statement figures as of YTD Q3-12 has been linearly extrapolated to a full year basis.
** Excess cash is here defined as current assets in excess of 2 times current liabilities with "Long term investments" (marketable securities) being added to current assets.

Disclaimer: I have no positions in the Apple share and have no plans to initiate any positions within the next 72 hours.