Wednesday, April 4, 2012

Is a $ 1 Trillion Market Cap in Apple's Future?

There have been some recent headlines made by analysts who are predicting that Apple (AAPL) stock will hit $ 1,000/share.

Brian White of Topeka Capital Markets said he expected it to happen within 12 months while Gene Munster of Piper Jaffrey said it would be more like by 2014.

Apple May Be World's First Trillion Dollar Company

Are these predictions at all similar to the kind of price targets that happened during the tech bubble?

Well, I doubt we are there yet but I readily admit to not being a fan of the whole price target game. Never have been and never will be. I also realize the price target folly that goes on is not going away anytime soon.

So I'll leave the guessing what a stock will do over a shorter time frame like 2 or 3 years to others.

To me, it has always made more sense to to buy what I understand at a discount to a conservative estimate of hopefully well-judged worth, then let it compound for years to come.

Other than that, just monitor the strength of the core franchise and sell only if something fundamental materially breaks (and occasionally, if reluctantly, when it gets extremely expensive or the capital is needed for a clearly superior alternative).

Well, that's true for most investments I've made but, as I'll get to later in this post, it's not easy to do with something like Apple (at least not easy for me).

So will Apple soon be intrinsically worth $ 1 trillion? More importantly, will it be able sustain and increase that value for a long time?

Let's look, somewhat simplistically, at the kind of assumptions that are needed to get Apple to a $ 1 trillion valuation.

Assumptions
15% earnings growth in 2013 and 2014 (I think many are expecting more than that)
Dividends and buyback plan is executed as announced
15x enterprise value/earnings
Shares outstanding remain roughly the same (per Apple's recent announcement, buybacks are to neutralize share dilution)

With 15% growth in earnings through 2014, by my math Apple will have over $ 200 billion in cash after paying the dividends and executing the buyback. That 15% level of growth suggests Apple will be earning roughly $ 55 billion in 2014.

15x that amount of earnings results in an enterprise value/earnings of $ 825 billion.

Add in the $ 200 billion of cash and you get a $ 1 trillion market cap.

For those willing to buy the above assumptions the stock may not seem expensive now. Yet, while I own shares of Apple (disclosure: purchased at less than 1/3 of yesterday's closing price), the risk/reward of buying near what it sells at now is far less comfortable for me.

It's not that the stock is expensive compared to current earnings. Certainly not at roughly 12x enterprise value to 2012 earnings even after this most recent run up in the stock price.

It's that, unlike most other things I own, it's difficult to judge what Apple's normalized earnings are likely to be longer term. There is a wide range of outcomes (seemingly now more on the upside than downside these days, but that's often the time to start being skeptical) and the safety margin seems either too small or not knowable.

I can see why others will likely still see the stock as still a good opportunity and they may turn out to be right. Apple's near term prospects are hard to argue with and, considering their track record, will probably even continue to surprise on the upside.

I just have no idea and I'm not willing to risk additional capital based upon the assumption that $ 50 billion plus in earnings, if achieved in 2014, will be a sustainable number that can be built upon for years to come. (Apple very well may prove it is more than sustainable, but no one gets to invest in retrospect.)

In other words, I'm being conservative in my estimate of intrinsic value by not assuming that $ 50 billion plus will be sustainable.*

What's the normalized earnings for a company like Apple that has seen its recent earnings explode higher?

Maybe still a lot higher but who knows in an industry as dynamic as the one Apple competes in. Among other scenarios, it's also possible this is a temporary explosive spike in earnings that, as competition pressure margins somewhat, eventually settles in at a lower level and then Apple grows from there. Apple would remain a terrific business if that happened, but the stock would seem a whole lot less cheap.
(Of course, this was also a possibility a few years back. It's just worth considering that Apple has gone from earning just under $ 5 billion in 2008 to a current estimate of ~$ 40 billion this year. So while, with the benefit of hindsight, this concern may also prove to be too early at least some caution seems warranted considering how dramatically the earnings picture has changed in a short time.)

When earnings capacity changes this much in a relatively small window of time (both a large percentage change and a large absolute number by any measure), it seems wise to at least start considering some of the less desirable scenarios instead of blindly extrapolating into what now seems a blissful future.

I don't doubt the stock could go up from here but eventually an investment gets to the point where, at least near the current price, it's not clear to the owner (me) what the longer run downside risk is (again, even if it turns out to be a wrong judgment after the fact).

So, while I may not be selling the shares I already own anytime soon, what seemed a clear margin of safety when I initially purchased Apple's stock is, to me, much harder to see.

Can Apple can become worth $ 1 trillion and make it stick longer term? As good as Apple is, that's still too hard to figure out. I mean, the durability of any company that resides in a dynamic industry is difficult to figure out but, of course, Apple is not just any company.

Over the next five years or so, Apple's upside is or at least seems just fine compared to just about any large cap. I don't doubt they may get to $ 1 trillion or more in market value. They may even seem worth it for a while (Or end up actually being worth it. Remember: I'm not selling yet...I'm just not buying!).

The math required to get there isn't aggressive.

Having said that, I know of some great (if far more boring) business franchises in less dynamic industries that, if bought at the right price, still have a far easier to gauge long-term risk/reward for my money.

That's my comfort zone.

Apple's business is not. As I've explained here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment.

Of course, few can probably match Apple's potential near-term (and possibly even longer-term) term prospects. 

I have owned Apple's stock the past three years or so for the simple reason that the price became ludicrously low compared to its rapidly growing intrinsic value. Its cash generation and net cash on the balance sheet provided a margin of safety. That margin of safety seemed large and turned out to be even larger than could have been known at the time (at least by me). As always, the price paid relative to likely value dictates the risk one takes on an investment.

Eventually, the discount to value gets so low that something I normally would not like to own becomes attractive.

Apple's business has a far wider range of outcomes than I usually like so it's kept on a shorter leash than most other things I own. The underlying economics are terrific now, but the durability of it's economics over many years will never be easy to judge. In contrast, selling something like Coca-Cola  (KO) would never be a consideration just because it became somewhat expensive (Though if it ever becomes late 1990s expensive again I certainly will be selling some shares!)

The fact is, I never will be the best candidate to own Apple's shares long-term (others are more qualified), but I wouldn't want to be betting against the company's future prospects either.

It's always about price versus value and I've just decided to think more conservatively about Apple's likely intrinsic value. As more evidence comes in, I will adjust accordingly.

Adam

Established a long position in AAPL at much lower than recent market prices

Related post:
Technology Stocks

* Others, of course, can do whatever they want but, for me, capital preservation is paramount. Apple may continue to do very well but missing that kind of opportunity doesn't bother me. I like certain attractive returns...not risky ones. It's not difficult to understand why value-oriented investors sometimes buy "too early" and sell "too early". What seems to be a bargain becomes an even bigger one. When something becomes expensive it ends getting even more so.
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