Apple, Inflation and Valuation

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In light of Mr. Cook’s revision of expected fourth quarter revenue for Apple, it is worth revisiting the question of whether the stock is overpriced.  To examine that question, I made the following assumptions.  To begin, the four quarters from Q4 2018 to Q3 2019 will show a year-over-year decline of 5% in revenue and EBIT from the same period a year before.  After that, Apple will have no real growth into perpetuity.  That is, revenue and EBIT will grow at the rate of inflation.  As an assumption for long-run inflation, I use 2% which matches the Fed’s long-run target and is consistent with current inflation rates.  For a cost of capital, I use 8.2% initially falling to 8% in the long run.  This discount rate is slightly greater than the discount rate used by my colleague, Aswath Damodaran, in his valuation of Apple.

It is worth stressing that assuming growth at the rate of inflation means that Apple will not grow in real terms, even as the real economy expands.  This is a very conservative assumption.  It means that in the years ahead Apple will become a progressively smaller part of the overall economy.  Prof. Damodaran uses what is arguably a more reasonable assumption that Apple will grow at 3%, about equal to the long-run growth rate in the overall economy.

The bottom line is that with the initial 5% drop and growth at inflation after that Apple has a fundamental value of $163.52.  If I retain the 5% drop and use Prof. Damodaran long-run growth rate of 3%, the value rises to $170.47.  If I used Prof. Damodaran’s cost of capital, the number would be even higher.  At $143, the stock looks like a buy, not a sell, even considering Mr. Cook’s revision.

Finally, Apple can help its own cause by stressing innovation.  The company did not upgrade its iMac line at all in 2018.  The standalone Mac Pro has not been upgraded since 2013.  It is time to get moving.  These are, of course, small steps compared to the iPhone, but they are a signal to customers and investors that Apple is pushing ahead on all fronts.

Enough is Enough?

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For over a year now, we have been banging the drum saying that equities, particularly the equities of high-flying tech companies like Netflix were overpriced.  Today we say, enough is enough.  We are not ready to say that stocks, particularly tech stocks, are cheap across the board, but the extensive overpricing has disappeared, and some high-profile tech companies look downright attractive from a valuation perspective.

To start, the table below updates the results for the ten bubble stocks we called out on October 3.  The ten are down an average of 33.2% as of the close today.  They are down 36.9% if Tesla is excluded.  The ten are down 40.6% from their 2018 highs.  The table also shows the results for Apple and Goggle.  Apple is off 36.5% from its price on October 3 and 37.1% from its high.  Google has held up the best.  It is down 18.8% from its October 3 price and 23.4% from its high.

In our view, these large price drops were not accompanied by a corresponding decline in fundamental value.  Apple is a poster child in this respect.  Though iPhone growth may be slowing the company is the same cash generating machine it was on October 3.  On September 21, 2018, our colleague, Aswath Damodaran, posted what we believed was a conservative valuation of Apple taking account of the slowing iPhone growth.  Over the next ten years, Damodaran projected a rate of revenue growth below that of the overall economy and barely above the rate of inflation.  Using this low growth rate, he arrived at an estimated value of $201, below the then stock price of $220.  He also undertook a simulation analysis and concluded that $176 was the cutoff for the 10th percentile.  As the table shows, the price is now $146.83.  At that price, the company is trading below the average price at which Warren Buffett acquired his shares.  All of this points to a unique buying opportunity.

Apple is not the only example.  General Motors at less than $33 appears to be trading well below its fundamental value.  In our view, this is no longer the time to “get defensive,” but to start looking for opportunities.

Company Information Releases and Stock Prices

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            I don’t often disagree with Warren Buffet, but his position on companies providing guidance was one example.  In a previous post, I argued that the more information companies give investors, the more accurately they will price stocks, on average.  Perhaps there will be instances where investors might over- or under-react to certain information releases, particularly if it is vaguer information like guidance.  But that possibility should not make executives the paternalistic managers of investor sentiment.

            The problem is a good deal worse if companies decide to withhold value relevant historical information as Apple has now decided to do regarding the number of units it sells.  Withholding that information clearly makes it more difficult for investors to value Apple accurately.  Remember that the fundamental social role of the stock market is to move funds from savers to investors.  That task requires accurate pricing so that funds are allocated to the companies with the best opportunities.  If companies withhold information and pricing becomes noisier, the capital allocation process is impeded, and everyone loses.