What you Should Know About the Books

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By RodgerRafter
July 12, 2002

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

Here's a post from 18 months ago that made Post of the Day and stimulated some good discussion.

One basic point underlying that whole post was that corporate earnings are fickle. A company's officers understate or overstate the company's earnings to suit their own short-term objectives, and fluctuations in the economy can lead to wide swings in earnings from year to year. On top of that, deceptive accounting practices (especially when it comes to options grants) mean that the earnings of almost every company these days are grossly overstated.
With Apple trading in the mid-teens again, I think it is worth revisiting.

Most valuation models give widely varying results when economic conditions fluctuate. If you rely on price to earnings, you are likely to buy high when times are good and sell low when times are bad. Valuation models involving earnings growth or revenue growth are even more vulnerable to changes in the economy.

If you look first at the value of a company's tangible and intangible assets in relation to their liabilities, you can come up with a much more reliable measure of its value.

18 months ago, when Apple was trading at 16.38, I argued that Apple was probably worth about $20.35 per share. It's up 6% since then (as of yesterday's close) while the Nasdaq as a whole is down 44%.

I criticized LU and CSCO based on their questionable revenues back then, and the two have dropped 85% and 63% respectively.

I criticized IBM, ORCL and DELL for diluting book value to prop up share price with share repurchases. IBM cut back on the repurchases during the last fiscal year, but still spent almost $4 billion, and has fallen 27%. Oracle only cut repurchase activity slightly and is down 70%. Dell, on the other hand boosted repurchase activity by about 18%, spending more than twice as much as they earned during the year and the stock is 25% as a result. Dell now has about $1 billion less in shareholder equity and 25 cents less in cash per share than they did 18 months ago.

Relying on book value doesn't protect you entirely from dishonest executives. One big lesson from WorldCom is that book value can be misrepresented, just like earnings. (I'm sitting on 60,000 shares of WorldCom right now that have lost about 90% of their value). WorldCom was over aggressive in their accounting and took things that should have been expenses and called them capital expenditures. Earnings got a huge boost and book value got a smaller boost.

Apple, on the other hand, expenses many things that actually boost the value of intangible assets. All the advertising Apple has been doing to increase the value of the Apple brand will be expensed. I expect lowered guidance for the July-September quarter as a result, but this expense is creating value that will improve Apple's earning potential down the road. Likewise, Apple invests a great deal in research and development every quarter. This money counts against earnings but creates long-term value for shareholders, that isn't reflected in shareholder equity. On another front, Apple has been making a lot of strategic acquisitions lately. The company usually looks to write off as much of these as possible, reducing earnings and decreasing the stated value of assets, but saving cash by reducing taxes. These assets generally have much more value in Apple's hands than they did in the hands of the smaller companies.

Comparing Apple to Dell or Gateway, you'll find that Apple has a vastly superior edge in intellectual property. Consider what would happen if Apple decided to abandon the Mac OS and become a WinTel box maker. Apple could bundle its own software at no increase in marginal cost, using its own innovative form factors to create a machine much more valuable than anything the others could offer at the same price point.

Of course that won't happen because Apple has the potential to do much better if OS X continues to gain momentum. Besides there would always be the threat that Microsoft would use its own software advantages to leverage its way into the boxmaking business. Maybe that's why Dell is so intent on propping up share price in the short term...

Apple's Cash and equivalents - long-term debt per diluted share - was $10.30 18 months ago, and is $10.82. Meanwhile, Apple has been even more effectively increasing the value of its intangible assets. I figure Apple is probably worth about $25 now, and anyone buying now in the mid-teens will probably be able to get $30 for AAPL some time in mid to late 2003 (Fred and company grant themselves their next batch of options sometime around January 2003).


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