549 Billion Reasons to Buy Apple Stock

Apple (AAPL -0.13%) has grown to become one of the most relevant and influential companies in the modern economy. But it's also one of the most important U.S. stocks. Apple makes up 7.6% of the S&P 500 and 13.2% of the Nasdaq Composite. It alone can move the market.

The tech giant's size and wide range of products and services give it an advantage over smaller companies that aren't as diversified. And that's especially true in tough economic times. Apple also has plenty of cash to outlast a downturn in the business cycle, and can use that cash to take market share. Although it's harder for massive companies to grow as quickly as smaller ones, Apple has an impeccable track record for growing its top and bottom lines, as well as its free cash flow (FCF).

Apple stock is up 248% in the last five years and a mind-numbing 879% over the last decade. But it hasn't grown its profits nearly as fast. When a company's stock price outpaces its earnings growth rate, that usually means the stock is going to be more expensive.

Yet, Apple stock isn't all that expensive for a blue-chip company with one of the most powerful brands in the world. The secret is that Apple has spent the last 10 years deploying its FCF arsenal toward buying back its own stock. Here's why that's great for investors, and why Apple stock is worth buying now.

Image source: Getty Images.

Apple's Dual Recipe for Growth

Earnings per share (EPS) is one of the most important financial metrics. Take a company's trailing 12-month earnings and divide it by the outstanding share count, and you get EPS. If you have one share in a stock, you can look at EPS to see how much profit your one share generated. For example, if there are 100 shares outstanding and a company made $100 in profit, then EPS is $1. And if the price of the stock is $10, then that stock would have a price to earnings (P/E) ratio of 10. The P/E ratio is widely used to determine how expensive or cheap a stock is.

There are two ways for a company to grow its EPS over time. The first and most common is to make more money. The second is to reduce the outstanding share count by buying back stock.

Apple has done both. It has grown its earnings (the numerator of the equation) and reduced its outstanding share count (the denominator) at a rapid pace. In fact, Apple has spent a staggering $548.8 billion buying back its own stock in the last decade alone -- often at prices far lower than the current price of the stock. And it's been able to do so because it generates gobs of FCF.

Here's a breakdown of Apple's FCF and stock buybacks by fiscal year (FY) over the past decade.

Data source: Apple. 

Apple stock is a good value

There are multiple benefits to Apple buying back its own stock. The shares are much higher today than the average price they traded at over the last 10 years. So buying back stock was an excellent use of capital for Apple. Secondly, Apple has reduced its outstanding share count by 40% over the last 10 years. As a result, Apple's diluted EPS has grown at more than double the rate of its net income.

AAPL EPS Diluted (TTM) data by YCharts

What that means for Apple shareholders is that the pie itself -- the market capitalization of Apple -- has gotten bigger because it's making so much more money and the stock price has gone up. But there are also fewer slices of that pie because there are fewer shares, making each slice much more valuable.

Apple's earnings growth and timely buybacks have kept its valuation from getting lofty. And while it's true that Apple's P/E ratio of 26.3 is far higher than its 10-year median P/E of 17.3, it's still not too high of a P/E ratio compared to the S&P 500 average P/E ratio of 20.9. Since Apple is a higher quality business than the vast majority of S&P 500 components, it makes sense why it should trade a premium to the market.

"Price is what you pay, value is what you get"

Since Berkshire Hathaway's (NYSE: BRK.A) (NYSE: BRK.B) largest public equity holding is Apple stock, it makes sense to quote Warren Buffett's famous line: "Price is what you pay, value is what you get." What he means is that the price of a stock doesn't tell you if it's a good deal or not.

A quick look at the three-, five-, or 10-year chart of Apple stock might lead one to think the stock has gone up too much and isn't a good deal anymore. But Apple has done a masterful job at expanding its services by branching into new markets across media and financial services.

By widening its moat, it has made its business more sticky, leading to growth and customer retention. That dynamic sets the stage for FCF growth, buying back more stock, rinse, and repeat. Generating consistently high FCF and using that FCF to back its own stock allows Apple to ride a virtuous cycle that compounds its efforts.