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.

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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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