Why Apple’s cheap

By Felix Salmon
December 5, 2011
original post.

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I’m going to take one last bite at the Apple valuation question, since I’m happier now about why Apple’s trading where it’s trading than I was when I wrote my original post.

The first thing to note, as pointed out by Tadas Viskanta, is that Apple’s now a megacap, and that changes quite a few things. Consider, for instance, the iPod. It was a real game-changer in the history of Apple — the thing which moved the company out of providing expensive computers to people who wore a lot of black, and into a much bigger consumer space. The iPod changed the way the world listened to music, it helped to revolutionize the music industry, and it ultimately begat the iPhone.

The story of the iPod is now pretty much over, which means that we have a pretty good grasp of how much money has been spent on iPods over the course of their natural life. The answer is about $55 billion.

Now that’s an enormous number. If you reckon that 45% of that $55 billion is profit for Apple, then Apple has made about $25 billion in profit from the iPod in the ten years since it was launched — call it $2.5 billion per year on average. On the day the iPod was launched, Apple had a market capitalization of $6.3 billion — so it’s easy to see how a new product with $55 billion in sales and $25 billion in profits would do amazing things for the stock.

Today, however, Apple’s market capitalization is $362 billion. If the company invents a new product which is just as successful as the iPod, and which makes Apple just as much money, and which is completely unanticipated by the market, how much should the stock rise? The present value of $25 billion in future profits is still substantial — but even if you put it at $20 billion, that just gooses the share price by 5% or so. If you look at Apple today, the company’s cash in the bank — its liquid assets — is a significantly larger number than the total revenue it’s made from every iPod ever sold.

If you grow to 50 times your previous size, your new products don’t become 50 times more successful. Or even 10 times more successful. Apple, like all companies, has certain economies of scale, and it has millions of people devoted to its ecosystem. But the market isn’t going to give it credit for having a pipeline filled with unknown products that are going to be bigger than the iPod. The iPad will evolve; the Apple TV will get Siri voice control; the computers will get faster and thinner. All of these things will be profitable for Apple — the company’s not going away any time soon. As Horace Dediu puts it:

The consensus is that the value of future, unknown products is zero. Not only that but the probability that there will be any products at all is equally zero. Not only that but whatever Apple does to create new products is not perceptibly valuable. The company is simply the sum-of-the-product-parts and nothing more.

Dediu reckons this is silly — “like valuing Pixar on the box office revenues of its current movie”. But as his chart shows, it’s pretty much impossible to compete with iOS devices on a profitability basis. Look at the thin yellow line for music: Apple’s the biggest music merchant the world has ever known, and music sales barely register on its P&L.


More generally, the entire market for megacaps has been utterly miserable for the past decade, and Apple’s p/e has naturally shrunk as it has joined the ranks of the dinosaurs. If you picked a member of the S&P 500 at random on March 24, 2000, it has risen by 66% since then. While the index as a whole has fallen by 19%. That’s entirely a function of the megacaps performing atrociously, even as the rest of the index did reasonably well. On average, megacaps (the S&P 100) trade on a p/e of 18.6; right now, they’re at 12.1. I’m not going to hazard a guess as to why that should be the case, but it stands to reason that Apple is just as susceptible to the phenomenon as any other megacap.

And then there’s the question of what kind of asset Apple stock really is. Equity is permanent capital, of course, and the best stocks are the ones you buy and forget about and leave to your grandchildren. But it’s frankly hard to imagine that Apple is going to be one of the most valuable companies in the world in 50 years’ time. It has a lot of room to grow, to be sure, but it just doesn’t feel like the kind of company which lasts forever. On top of that, Apple doesn’t pay a dividend.

Put those two things together and you have a trading vehicle, rather than a long-term play. Buy now, and sell when it reaches X. But the problem here is that no one has a clue what X might be. And if Apple is fundamentally a stock for speculators, rather than a buy-and-hold investment, then at that point things like p/e ratios cease to matter: all anybody cares about is momentum, and whether it’s going up or going down.

Apple never made it as a computer company; its big resurgence took place when it became an iPod/iTunes company. And just when that revenue stream started looking tired, the iPhone came along to turbocharge everything. The iPhone and iPad will be around for a while, I’m sure. But then they’ll be gone. And that will be the end of Apple’s megacap days — unless the company can pull yet another new product out of its hat, and one which can bring in billions of dollars of profit every quarter, at that. I wouldn’t bet against it. But I can see why the market might be reluctant to bet on it, before anybody really knows what that product might be.


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“On average, megacaps (the S&P 100) trade on a p/e of 18.6; right now, they’re at 12.1. I’m not going to hazard a guess as to why that should be the case”

Translation: “I have identified the key issue — quick, let’s change the subject!”

FWIW, I agree that you have identified the key issue: once a company has grown to a large market cap, the market will penalize it on a per-share basis. Your decision to assume that the market understands something about big companies (&/or Apple in particular) and try to figure out what is wrong with big companies seems to me to be a large logical leap. Shouldn’t you first ask why the market resists letting capitalization grow beyond a certain point without jumping to the conclusion that it must be based on canny judgement?

WRT Apple not having anywhere to go: the world market for cell phones is about 1 per adult. Apple currently sells one per 1,000 adults, give or take. As Horace notes, they sell them profitably as fast as they can make them. There is every reason to expect continued explosive growth until they reach, say 1 per 50 adults.

Posted by SamPenrose | Report as abusive

Interesting analysis, but I think the point could have been made more simply by noting the market is skeptical that there is much earnings growth to be added given the current level of profits and competitive environment.

Posted by Accprof | Report as abusive

Felix, don’t confuse gross margin with profit. Apple may well have 45% gross margins on the ipod and iphone, but their operating costs, R&D, marketing, etc., have to be paid out of that margin, so their net profit on the ipod is much less than you suggest.

That being said, your valuation model may very well be a good one, but unfortunately, it is only one of maybe millions of models that people use for valuing stocks like Apple. So it’s worthless to someone who is considering buying or selling Apple stock, because the only thing that matters is what other people will value it at, and most of them don’t use your model. As evidenced by your last post on Apple’ market value, they have many different ways of deciding on what it is worth, so the only real way to decide if it is a buy is to know how people will respond to what you expect their sales will be. Even if you knew they were going to have $150 Billion in revenue and $40B in profit, you still couldn’t say with any accuracy what their share price will be, unless you have a view into the minds (I use that word loosely) of millions of traders.

But I’d rather read about you speculating on Apple than art frauds, so don’t stop writing about it.

Posted by KenG_CA | Report as abusive

Apple has lots of room for growth – and is growing – in all its sectors. The problem for the markets is that their yardstick is often a PC maker, or a software company, or a digital devices company – there really are no other companies doing what Apple does across all of these markets. In the lack of any similar companies, valuations are lower than they might otherwise be along the lines of, “If we don’t understand it or have something to measure it against, mark its value down”.

Posted by FifthDecade | Report as abusive

@SamPenrose There are now 7B people in the world, let’s say half are adults as per your assumption. So 1 in 1000 from 3.5B is 3.5m… Apple sold over 50m iPhones in the last four quarters, and over 200m since the first iPhone came out. If we say half of those 200m sales are repeat customers (ie people that upgraded once, say from iPhone2 to iPhone 4) than that’s 100m adults served, from 3.5B, or 1 in 35. SOOOO according to your logic Apple is already AHEAD of where they should rightfully be, at about 1 in 50. Sell now while you can!!!

Posted by CDN_Rebel | Report as abusive

Felix, what you are omitting is the fact that while PEs might compress for a time, they will eventually find a floor.
Once you have a stable multiple, earnings just need to grow for the stock to rise.
No new iPod, no mythical new product.
As a rule of thumb I would happily pay 10x for stable low growth megacaps.
EPS expected for Sep-13 year is $39. A better metric – cashflow per share is $45.
However the cash on the balance sheet isn’t worth NOTHING.
Take it at 50c on the dollar.
There is $88 per share today and in say 2 years that will be around $160.
So price in two years: 10x $45 + $160*0.5 = $530 or 35% upside. Not a terrible IRR.

The key (obviously) is the word “stable”
I would claim that stable is a WORST case.
I mean 50m iPhones in the last 12 months?
That’s 5% share of the 1bn unit market.
Why? BECAUSE iPhones aren’t available on every network!
Because the low end iPhone (nano?) hasn’t launched yet.

Your analogy with the iPod was weak because you think that for some reason the market size of music players is somehow comparable to the market for cell-phones or PCs…

The correct analogy would be to suggest that AAPL takes 80% global share of one or two more consumer electronics categories as it did with digital music players.
80% share of cell-phones?? You would be looking VERY much higher than a $530 stock price.
80% share of PCs/laptops/tablets? Likewise.

Oh and “one more thing” – 80% share of TVs?
Done and done.

Posted by TinyTim1 | Report as abusive

Where you could see a huge increase in value is in software. The Mac OS is far superior to any MSFT product. MSFT makes in the neighborhood of $10B of profit off OS sales. There is also lots of growth available for their Mac hardware business. Price differences have slimmed and the barrier to entry of learning a new OS is virtually zero.

Plus how many more middle class consumers will there be in 10 or 20 years? 300M in China, maybe 100M in India, lots in Brazil & other Latin American countries.
http://www.brookings.edu/~/media/Files/r c/papers/2010/03_china_middle_class_khar as/03_china_middle_class_kharas.pdf

Say the number of consumers for Apples products doubles. Will their overall profit double? Gross margin is a poor indicator because their margins are so high. Fixed costs (R&D) are significant, so growth in sales make up a quicker growth in profits. Apple’s products are not as resource intensive as some others will be from that increased size of the world middle class.

Posted by winstongator | Report as abusive

@CDN_Rebel: you’re right, terrible guesstimates on my part. Reading Horace at http://www.asymco.com should however make clear that iPhone has a TON of headroom.

Posted by SamPenrose | Report as abusive

“The iPod changed the way the world listened to music, it helped to revolutionize the music industry”

No, that would have been the many other MP3 players that existed before the ipod.

I find it odd that at no point do you mention Steve Jobs. Jobs was a maniac for quality and design, and apparently the only person in the computing and consumer devices industry who thought that industrial design should lead product development. He was well known to be dying for years. And yet, you don’t think that plays into expectations of performance at Apple? Maybe you could write us analysis of Berkshire Hathaway without mentioning that guy that people always talk about as if he runs it.

Posted by DrFuManchu | Report as abusive

* an analysis. Please add an edit feature.

Posted by DrFuManchu | Report as abusive