Post-stock split, is Apple (AAPL 0.01%) a buy?
Fundamentally, this question is, in and of itself, critically flawed. Are there more calories in a pizza once it's sliced? Of course not. Nevertheless, it's a question many investors may be asking. Getting used to seeing Apple stock trade at one-seventh of the pre-split price is going to take some getting used to. And finding the intrinsic value of the post-split share may help us find our true north for Apple stock.
Just as I concluded before the Nasdaq took the pizza wheel to Apple's abnormally large share price, I still think Apple stock is a buy.
Here's my rationale.
Valuation should begin with a screen for durability. The value of any company is ultimately equal to the present value of its future cash flows. But it's impossible to estimate future cash flows if a business doesn't possess some sort of durability.
Does Apple possess durability?
Apple's wide economic moat
Staying power: Most buy-and-hold investors would agree that it's this factor that is among the most important characteristics in qualifying a stock as a potential investment. Warren Buffett has referred to this concept as an economic moat.
"In business, I look for economic castles protected by unbreachable moats," Buffett has said.
Economic moats are built from intangible assets like network effects, pricing power, cost advantages, and high switching costs.
Apple's moat is irrefutable. Here are some of the ways Apple has carved out a durable competitive advantage for itself.
- Pricing power: Apple's no-compromise approach to user experience has solidified the Apple brand at the high end in consumer electronics, aiding in pricing power.
- Higher switching costs than its competitors: Retention is unparalleled as customers get wrapped up in Apple's "sticky" ecosystem of integrated hardware, software, and services.
- Cost advantages: Apple repeatedly wields its cash hoard and consumer demand for supplier orders in monstrous quantities to land it operational advantages that help the tech giant make significant strides in driving the cost curve down on new products.
- Network effect: Developers, end users, and Apple all benefit from the network effect in the App Store; with every new developer and iOS user, the ecosystem of Apple apps is strengthened.
Apple has first-class staying power, and I've yet to hear a rational argument to the contrary.
The numbers
Estimating intrinsic value begins with a growth estimate. Thanks to its clear economic moat, Apple is likely to continue to grow -- albeit at fairly small rates since the company is so big.
Rendering of the under-construction Apple Campus 2. The scale of the new headquarters suggests Apple believes it has an optimistic future. But some investors wonder whether it's a matter of time before size begins to haunt the company.
Considering that Apple CEO Tim Cook has promised new products in new categories to launch in the near future, and that the iPhone 6 is likely to have a larger display (a market that is already proved to be hot), Apple should be able to maintain its second fiscal quarter's 15% year-over-year growth in EPS into fiscal 2015.
Over the long haul, however, investors shouldn't expect these meaningful rates to be sustainable. I expect something along these lines:
| Year | EPS Growth Rate |
|---|---|
| 1 | 15% |
| 2 | 11.3% |
| 3 | 8.4% |
| 4 | 6.3% |
| 5 | 4.7% |
| 6 | 3.6% |
| 7 | 3% |
| 8 | 3% |
| 9 | 3% |
| 10 | 3% |
To discount Apple's future earnings to present value, I used a 10% discount rate -- high enough to take into consideration both the time value of money and the risk of investing in the stock market.
Apple's growth will probably eventually retract to a rate more closely in line with the historical rate of inflation: 3%. In this scenario, I estimated that Apple's growth will arrive at this point in year seven and stay at this rate, on average, in perpetuity -- a feat easily achievable for Apple with the help of share repurchases.
These inputs are relatively conservative. For instance, consider that the consensus analyst estimate for Apple's EPS growth over the next five years is 15% per annum.
Given these assumptions, the intrinsic value of post-split Apple stock is about $120. Of course, this wouldn't mean Apple stock is a buy anywhere below $120. Investors should also seek out a discount to fair value. Fortunately, shares are trading below $100 today. This leaves a meaningful margin of safety if my estimates turn out to be too optimistic.
There's nothing magic about $120. It's just a ballpark figure. But these conservative assumptions and the resulting price, which leave me some wiggle room, are enough to give me confidence in the stock.
I certainly won't be selling Apple stock at these levels. Trading at a price-to-earnings ratio of just 15.7, this industry-leading cash cow is still one of my favorite stocks. In fact, I'd go as far as to call Apple a buy -- even after the recent run-up.
