The Obvious Case for Buying Apple


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Jae Jun

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Apple’s growth in China isn’t high enough!

Consumers aren’t upgrading their iPads!

Tablets are dying like the netbook!

I could try to squeeze out something about Apple’s direction with Apple Pay, developments with iCar, their lack of innovation by following the footstetps of the Microsoft Surface, the new iPhone 6S and something about their other product lines.

But for the biggest company in the world, everything is already discussed everywhere and anywhere.

I actually get more insight and information by looking at the numbers. Believe it not, most people don’t look at or discuss numbers in detail.

And that doesn’t make sense because accounting is the language of business.

It speaks to you if you go through the numbers.

The other day, Goldman came out with a 12 month price target of $163 per share.

I have no idea how Goldman can confidently guess that Apple shares will go up in 12 months and hit $163 to the dollar. It assumes that all the variables will align with the stars and their selected scenario will be chosen.

On the other hand, Prof Aswath Damodaran is one of the best at valuation and if you read his last valuation, you’ll see a very different approach.

He takes a range, or distribution of intrinsic values, to come up with the most likely scenario.

Apple Valuation Simulation Range

Apple Valuation Simulation Range | Credit: Aswath Damodaran

From his last update on Apple in July 2015, the most likely scenario according to this bell curve puts the value of Apple at around the $130 mark.

From the highs of $134, Apple hasn’t fallen that much, but the current price of $113 does offer value. Previously I went through my favorite stock analysis ratios and techniques and I want to specifically cover some of them again here for Apple and then work out a valuation.

Apple Has a Mega Cash ROIC (CROIC)

It’s not surprising that ROIC is a great indicator of company performance.

CROIC is a variation that focuses on Cash Return on Invested Capital. It’s also labeled as CROCI (Cash Return on Capital Invested).

CROIC = FCF/Invested Capital

Invested Capital = Shareholders Equity + Interest Bearing Debt + Short Term Debt + Long Term Debt

Basically, it shows how well management is generating cash returns from the capital it is investing.

Any stock that can consistently maintain a number over 13% is a strong indication of a moat.

In Apple’s case, no problem here. 

Fantastic CROIC Numbers

Fantastic CROIC Numbers | Enlarge

If you zoom out more, the average over the past 10 years is 32.6% and the 5 year median is 35.4% which is astounding.

At the peak in 2011, the CROIC was 43.4% but consider that an outlier.

Takeaway: when analysts and investors are crying about slowing growth, check CROIC and see whether management is still performing at the same level. CROIC shows that Apple generates 35c for every dollar of invested capital. That’s nothing to cry about.

Why You Shouldn’t Blindly Trust ROE

In general ROE works fine. It’s better than other metrics like P/S, but if you don’t know what you are looking at, you can be misled.

AAPL ROE Good or Bad?

AAPL ROE Good or Bad? | Enlarge

Those are some impressive numbers. But that’s only on the surface.

Howard Marks says that to be successful in the stock market, you need second level thinking. i.e. go deeper and beyond what everybody else hears, sees and thinks.

Anybody with an internet connection can find the ROE for AAPL from Google Finance or Yahoo Finance and will immediately assume that a 40% ROE is kick ass.

But the second level analysis of ROE shows something different.

5 Step DuPont analysis for AAPL

5 Step DuPont Shows ROE Increased Due to Leverage | Enlarge

By breaking down each component that makes up ROE, you get much more insight.

Remember, accounting is the language of business and this example of ROE is speaking to you.

Operating margins is down compared to 2011 and 2012, yet the ROE is higher.

Why?

Because the increase in debt also increases ROE.

Bingo.

Takeaway: Some numbers look good at first, but dig deeper to get the true picture and stay ahead of the herd.

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Free Cash Flow is King with FCF/S and FCF Yield

Earnings are sexy.

It makes for a great girlfriend, but not a good wife.

When you focus too much on earnings and not what’s underneath, the relationship won’t last long.

That’s where the importance of FCF shines.

Having a balance sheet filled and growing with more cash offers the following thesis for an investment in Apple:

  • Downside protection – when many companies acquire debt to work through difficult seasons, Apple has the flexibility to enter new markets (payments, cars).
  • Better than the S&P: Apple already makes up a large portion of the S&P, but with its industry leading position, it’s a bet that the company will perform better than the market over the long run.
  • Better than cash sitting in my account: I started the year with about 20% of cash in my portfolio and it has grown this year as I took profits. Instead of holding too much cash, I’m happy to transfer my US dollars to AAPL dollars when valuations are reasonable (like now). With their management, pricing power and business strength, they are able to invest money in ways I cannot dream of.

Here are the FCF numbers that back it up.

Cheap Compared to FCF

Cheap Compared to FCF | Enlarge

FCF/S = Free Cash Flow / Sales

FCF Yield = Free Cash Flow / Price per Share

FCF/S greater than 15% is considered excellent.

Apple’s median FCF/S over 5 years of 27.3% is “out of this world” awesome.

Again, it shows the strength of Apple’s business in being able to generate profit and cash. Despite all the competition and cheap competitive products, their ability to maintain their bottom line is magician like.

When FCF yield is greater than 10%, it has always been the best time to buy Apple.

See what I mean below.

AAPL Opportunities Based on FCF Yield

AAPL Opportunities Based on FCF Yield | Enlarge

Throughout these 4 periods, the same worries and fear surfaced.

  • Slowing sales
  • Lack of innovation
  • Competitive pressures

In hindsight, it was media noise and fear mongering each time. I don’t see anything different today.

Takeaway: Each company has a specific metric that works really well. For AAPL, it’s FCF and FCF Yield. Focus on the fundamentals and ignore the noise.

My Valuation Range Gives an Intrinsic Range of…

Before getting to my range, here’s how I came up with my numbers.

FCF Yield at 10% or higher is a great time to buy. On average, Apple offers a FCF Yield of around 8.6%.

Do some simple algebra to see what the stock price has to be in order to fetch a FCF yield of 8.6%. Using the current FCF per share, the price comes out to $140.

$12.05 FCF per share / 8.6% = $140 fair value

I also don’t stop with one valuation number because I like to look at valuation from different viewpoints.

Using the EV/EBIT multiple to work through the income statement is another simple way of seeing the range of possibilities.

Here’s the valuation using a conservative, normal and aggressive case.

AAPL Still Cheap at EBIT Valuation of 10x

AAPL Still Cheap at EBIT Valuation of 10x | Enlarge

Sticking with the current 10x EV/EBIT multiple with current numbers, the normal case comes out to $147.

Lowering expectations to 8.3x EV/EBIT (5 year minimum) gives a value of $126.

Still above today’s prices.

So my intrinsic value range is between $126 to $147 but my senses tell me it’s in the $140 range.

Note that I don’t have an estimate of when the intrinsic vale will be reached. It could take 12 months like Goldman Sachs, 3 months or 4 years.

Trying to predict when a stock will hit intrinsic value isn’t important.

Stick with Ben Graham’s philosophy.

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

Just focus on the price you pay and you’ll do just fine.

Valuation and Analysis Isn’t Difficult. It’s Just Tedious.

Valuation isn’t difficult.

It’s just tedious and time-consuming. That’s why most people don’t do it and buy things based on what they’ve heard or by following their “gut instincts”.

The only difficult part of investing is knowing what is noise and what is important. Most stuff you read on the news is unimportant.

If you’re reading the news and worries sink in about China, you can’t look at a company objectively.

Start with the numbers first and then move onto documents and filings. By starting with fundamental analysis, you’ll eliminate a lot of noise and be able to focus on making better decisions.

Why waste hours going through articles and news only to realize that the company is a crap shoot.

That’s why I use the Old School Value Analyzer as an initial filter. I’ve now got a process in place where I can load a stock, look up certain important metrics and then decide whether to proceed or not.

After all, it’s built to present you with deep second level analysis and cold hard facts that will debunk the noise out there.

It’s a tremendous advantage to have compared to the majority of people and analysts who are satisfied with sticking to the first level of analysis and thinking.

So try it yourself. But instead of Apple, try out the same exercise and techniques with another stock and see what insights you can gain.

(Click to download this PDF summary sheet of AAPL)

 

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