Picture Source: Hybrid Image, James Emanuel
Apple Inc. (NASDAQ:AAPL) is the darling of the stock market. It is the first company that Mr. Market has priced at over $2 trillion. So, is Mr. Market correct or not?
Apple had an exceptional Q2 2020. Its revenue increased 11% to $59.7 billion for the three months ended June 30, while analysts had broadly expected revenue to drop 2% to $52.6 billion. And earnings per share were up 18% to $2.58, which smashed the average forecast of $2.07. But does this justify a market capitalization of over $2 trillion and a share price of over $500?
This is a question that you ought to be asking because investing is about two critical decisions. The first is knowing when to get into an investment. The second is knowing when to exit that investment. Most people are reasonably competent at the first, but are very bad at the second.
Benjamin Graham sums this up nicely. He said that an intelligent investor is a realist who buys from a pessimist and sells to an optimist. I will show that the market of Apple is so full of optimists that an intelligent investor ought to view this as a great selling opportunity.
While, in the short term, the price and intrinsic value of a company can diverge, over the long term, the two are mean reverting, and the gradient of the curve demonstrates the company’s growth rate. On this basis, looking at the chart below, in recent months, can a vertical – almost 100% gradient – be justified for a company the size of Apple? I deliberately say “the size of Apple” because a new company with a single customer can double its revenue easily by winning a second customer, but when a company is generating $273 billion in annual revenue, as Apple does, doubling in size is not nearly so easy! So, how can the share price double in such a short period of time?
Fig.1 – Apple share price. Source: MacroTrends
Valuation against Sales and Earnings
Let us examine the income statement first. Top line revenue is as follows:
* Annual numbers except for 2020 which is TTM until 30 June 2020
Fig.2 – Apple Revenues, Source: Apple
Extrapolating annual numbers from a single quarter is a dangerous game. So, we know that Apple sales were up 11% in Q2 2020, but that does not mean that sales will be up 44% for the year!
As the table above demonstrates, the TTM (trailing twelve month) revenue for Apple, including Q2 2020, is $274 billion, which is a change of +5.72%. That gives us a better perspective.
Zooming out further to look at a four-year average demonstrates that Apple is achieving average annual sales growth of 6.46%. Does that justify a 100% share price spike? I think not.
The average Price to Sales multiple for Apple over the past decade has been approximately 4x. On $273.86 Billion sales, that suggests fair value around $1.1 trillion, which is little more than half of where it trades today.
The U.S. smartphone market contracted over the last year according to research firm Counterpoint, and Apple is not immune from the downturn as the following chart demonstrates:
Fig.3 – Source: Counterpoint Technology Market Research
Apple volumes grew during Q2 and were especially helped by iPhone SE volumes. The launch was understated by Steve Jobs’ historical standards, but COVID-19 changed the way in which we all behave! However, the device has been successful and selling above expectations in both postpaid and prepaid channels.
The iPhone SE launched via national retailers which saw large promotions being run when business was permitted to re-open at the end of the first wave of the pandemic in order to draw shoppers back to stores. This was especially true within Walmart (NYSE:WMT), Metro by T-Mobile (NASDAQ:TMUS), and Boost.
The big question is in relation to the September launch of the new 5G iPhones. If a large number of the Apple faithful have recently upgraded to the iPhone SE, will that result in less demand for the iPhone 5G? Only time will tell, although data suggests that, over 30% of iPhone SE buyers came from using an iPhone that was four years old or older, suggesting that it is a different segment of demand to those customers that always want cutting edge technology. However, one point worthy of note is that 5G is primarily about higher speed connectivity, the Internet of Things, but the infrastructure simply is not in place yet. Huawei was the primary source for 5G infrastructure, but the Trump administration has blown that ship out of the water, and this has undoubtedly slowed down the 5G roll-out. As such, will consumers hold off from upgrading their cell phone until the full benefits of 5G may be enjoyed? Only time will tell, but a stellar performance from Apple in Q2 on the cell phone sales side does not guarantee strong Q3 and Q4 numbers.
Apple has expanded some of its other offerings, through services such as Apple TV+ and Apple News, which bring in monthly subscription fee revenue that can be steadier than those from device sales. Services revenue jumped 15% to $13.2 billion. Again, a word of caution. During the pandemic lock-down, many people subscribed to streaming services for want of something to do. Now that life is returning to normality, it is very possible that subscriptions will be cancelled, and these revenues may go into reverse.
Of particular note is that, when Apple announced its Q2 numbers, it did not offer a forecast of its next quarter’s results. Is it possible to read something into that?
So, if sales cannot justify the market valuation, what about earnings per share?
* Annual numbers except for 2020 which is TTM until 30 June 2020
Fig.4 – Apple Earnings per share, Source: Apple
Well, earnings per share are growing at twice the rate of top line revenue, which is encouraging, but with an average of 13.01% over the last four years and the most recent twelve months missing that average, this still does not justify a $2 trillion market cap.
Let us look at the progression of the Apple share price next. The average share price of Apple Inc. in 2006 was $10.12, and by 2019, the average share price had increased to $208.26. This is a cumulative average growth rate of 26.19%. So, the share price has grown well in excess of both revenue growth and EPS growth, but the price to earnings ratio has been stable in the 10 to 20 range for a decade. That is until now as the chart below demonstrates. Suddenly, the shares are trading at over 35 times earnings, which is double the 10-year average. Why the multiple expansion?
Fig.5 – Apple Price to Earnings ratio, Source: MacroTrends
If we look at the EBITDA for Apple, there is nothing in the numbers, either quarterly or annually, which would suggest that suddenly the fortunes of the company have changed warranting a doubling of the price to earnings multiple.
Fig.6 – Apple EBITDA (TTM, Quarterly and YoY change), Source: MacroTrends
So, we know from Fig.4 that the unadjusted EPS is $13.19. The long-term earnings multiple is x20, which implies a share price of $263.80. That is a long way short of $467 which is where the shares are trading at the time of writing.
There are 4,649 billion shares outstanding which implies a market cap of £1.23 trillion. This is in a similar ball park to the number that we calculated against sales above, both of which are well short of $2 trillion.
Valuation on the Basis of Cash Flow
Free cash flow cannot explain the high share price either. The chart below shows that the price to free cash flow curve is exactly the same shape as the price to earnings curve. This demonstrates that price has run well ahead of both earnings and of free cash flow generation.
Fig.7 – Apple Price to Free Cash Flow ratio, Source: MacroTrends
Valuation on the Basis of the Balance Sheet
Is the answer to be found in the balance sheet? Let us look at the book value of the company to see if that justifies the stratospheric increase in the share price.
Fig.8 – Apple Book value and Change in Book Value, Source: MacroTrends
Fig.9 – Apple Price to Book multiple, Source: MacroTrends
No, that’s not it either. In fact, we can see that the book value is in steep decline and has been that way since 2017. While the price to book multiple has been under 10x for a decade until June 2019, since that date, it has climbed rapidly, meaning that price is running way ahead of the equity value of the company. The current price to book ratio for Apple as of August 19, 2020, is 27.38, which makes my eyes water just thinking about it.
Why is the price to book number so important? Well, Apple has been generating an average return on equity of 45.41% over the past 5 years, which is an impressive number. However, an investor paying a premium of 27.38x for his equity stake in the company today is having the corporate return on equity diluted by the same amount. Said differently he will generate an earnings yield of 1.66%. Does that meet any rational investor’s hurdle rate? Again, I think not.
Destruction of Shareholder Value
You can see from the table below that Return on Equity for the trailing twelve months stands at almost 70%, which on paper looks fantastic. It is well ahead of the long-term average. So, is this good news for shareholders?
You will note that the neither Return on Assets nor the Return on Invested Capital has increased by the same extent as Return on Equity. And there is a good reason for that. Apple has been sitting on a huge cash pile for some time and, in the absence of sufficient new investment opportunities, the company has been using it to buy back its own shares.
Fig.10 – Apple Operating performance, Source: MorningStar
The chart below shows how, from 2013 until now, the number of outstanding shares has reduced from 6.5 billion to 4.3 billion. So, what’s the problem?
Well, as explained above, the return on equity generated by a company is diluted by the equity premium reflected in the price to book multiple. While the average ROE for the company over the past five years has been 45%, the earnings yield available today for anyone buying the shares is only 1.66% due to the price to book multiple standing at over 27. And this applies to Apple itself when it buys back its own shares! So, Apple executives are de-facto allocating corporate capital at a return of 1.66% through share repurchases.
This means that, contrary to the assertion that share buybacks are good for shareholders, at high price to book multiples, they destroy shareholder value. If you look at Fig.8 above, it shows how book value has been destroyed by the share repurchase program. More particularly, Fig.11 shows that the repurchase program commenced in 2013 as the number of shares outstanding were relatively constant until that time. And Fig.8 demonstrates how the equity value of the company grew sharply until the repurchase initiative started. Since 2013, the book value of the company has fallen sharply.
Shareholders ought to insist on a return of capital in the form of special dividends at these multiples because share repurchases make no sense. I cover this topic and more in great detail in my book “Success in the Stock Market“, so if you are interested, please take a look.
Fig.11 – Apple Shares Outstanding, Source: MacroTrends
You may be saying to yourself, why should I care about erosion of equity value if the share price is at an all-time high? The answer to that question is simply that the share price is a temporary indicator of sentiment, while the equity value is an absolute measure of net shareholder assets. Within a couple of months of Apple breaching the $1 trillion market cap threshold, the share price had collapsed by 40% valuing the company at $600 billion. Throughout that period, the equity value of the company was unchanged. Said differently, shareholder equity at June 30th, 2020, was $72 billion. We know that the long-term Price to Book ratio is 10x as Fig.9 suggests, but even if you wanted to be generous and said that Apple deserved a multiple of 16x, then that would still only imply a market cap of $1.15 trillion. You will note that this is a similar value to the number that we calculated earlier against sales and against earnings. Either way, it’s a long way short of the $2 trillion valuation of Mr. Market today!
Of greater concern is that, as explained earlier, shareholder equity is in rapid decline due to share buybacks at ridiculous price multiples. The table below demonstrates this perfectly. So, ask yourself this, if Apple continues with an insane policy of buybacks at current levels, what will be the book value of the company next year or the year after. Multiply that by a reasonable long-term price to book multiple of 10x and that will be the value of Apple.
* Annual numbers except for 2020 which is TTM until 30 June 2020
Fig.12 – Apple Revenues, Source: Apple
The moral of the story is that the ROE of Apple has increased not because the numerator, its corporate earnings, has spectacularly increased, but because the denominator, its equity book value, has significantly been eroded. As such, the increase in ROE cannot be used to justify the recent spike in the share price, and more particularly, it ought to be a major concern for existing shareholders.
Share Price Analysis
Apple has achieved a cumulative average shares price growth rate of 26.19% since 2006. This is nothing short of impressive. But know this, if you start a new company and you go from having one customer to having two customers, then you have instantly achieved 200% growth. But as your number of customers grows and the value of your sales grows, it becomes increasingly more difficult to grow, and so your growth rate necessarily slows. Apple has annual sales worth $274 billion each year. From here it certainly cannot double in size easily if at all. Even maintaining a 26% growth rate from here will be nothing short of miraculous particularly when you consider the tables at Fig.3 and Fig.4 which show that both sales growth and earnings growth are well below this level.
So, against that backdrop, consider the chart below. If Apple were able to continue growing at 26% year on year, then its share price would follow the red dotted trend line. Instead, it has pivoted along the green arrow, and the share price has increased by 122% relative to the average share price in 2019. Really?
Fig.13 – Apple share price, Source: MacroTrends, James Emanuel
I have a number of theories for why price has become so disconnected with reality, and those are covered in another Seeking Alpha article S&P 500: Flying In The Danger Zone, so I shan’t rehearse those same arguments here, but I would encourage you to read that article if you are interested in learning more.
Benjamin Graham in his 1949 book “The Intelligent Investor” said that a great company at the wrong price makes for a poor investment.
There can be no doubt that Apple is a great company. Of that, we are in agreement.
So, why has the price spiked? Well, the answer to that question is truly astonishing. Investors seem to believe that if you take a $10 pie and then you cut that pie into four pieces, then the pie is suddenly worth $20. It defies belief. On July 30, Apple announced a four for one split of Apple stock. Trading will begin on a split adjusted basis on August 31, 2020. So, now the $1 trillion Apple Pie, split into four pieces suddenly has a market value of $2 trillion – despite the underlying economics of the company remaining unchanged.
Rather ironically, following the +11% Q2 sales increase, Apple’s CEO Tim Cook said at the congressional antitrust hearing about Big Tech.
“We’re conscious of the fact that these results stand in stark relief during a time of real economic adversity…in times like this we’re focused on growing the pie”. However, as set out in this article, I would suggest that the share split is evidence that the focus is primarily on growing the market price of the pie!
Goldman Sachs analyst Rod Hall called the Apple share price rally “unsustainable,” while recommending that investors avoid the stock. He predicted the price would drop to $299 in a year compared to $515 at the time of writing. Of interest here is that a share price of $299 implies a market capitalization of $1.25 trillion of Apple, which is very much in line with the valuations that I arrived at earlier in this article.
Of course, neither Rod Hall nor I is saying that the market price of Apple will collapse imminently. The same investors that pushed it this far could well push it further. And sometimes a share that has an inflated price simply stagnates for a few years while its intrinsic value catches up.
The other point to note is that the market is not functioning at all rationally at the moment – just consider Tesla (NASDAQ:TSLA) as an example which has a market valuation that suggests it is worth more than the value of Toyota (TM), VW [Volkswagen (OTCPK:VWAGY)], Porsche, Ducati, Bentley, Bugatti, Audi, Lamborghini, Scania, Seat, Skoda and Man combined!
And on that basis, I am not advocating shorting Apple, or Tesla, either. As John Maynard Keynes said, “Markets can remain irrational for longer than you can remain solvent!”
What I am saying is that the share price of Apple has moved way too far ahead of its intrinsic value and I would argue that it is unsustainable at these levels. If you are a shareholder in Apple, then you have done very well this year. You have effectively won the jackpot. Cash in your chips before the house takes back all of your winnings! A stock market correction may be on its way, see my article linked above on S&P 500.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.