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Valuation

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.

Why Fundamental Valuation Matters

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First, a little humility.  When we posted our list of ten bubble stocks we were not predicting an imminent collapse.  (Though, in fact, a collapse has occurred.  The ten bubble stocks are now down an average of almost 25%, 30% excluding Tesla.)  What we were saying is that prices appeared to be well above fundamental value.  Assuming that the two are going to converge at some point implies one of two things can happen.  One, future stock returns will be low relative to fair risk-adjusted returns on equity for an extended period.  Two, there will be a sudden collapse that quickly brings price down toward fundamental value.  The fact that the second has occured was not something we could predict, but neither was it a complete surprise.  In the long-run it is fundamental value that matters, it fact it is virtually all that matters.