Image source: Apple.
It might seem odd to put the words Apple (AAPL +0.94%) and "value stock" in the same sentence, especially with the meteoric growth it has experienced over the past decade. Yet as growth has slowed, and the stock has underperformed the market and its peers, it makes sense to see how it stacks up as a value investment. What better way to determine this than to go back to the father of value investing himself?
The quick and dirty method
Benjamin Graham loved to buy securities that were underpriced compared to their estimated intrinsic value. Graham had a relatively simple equation to do a quick sniff test to see if a stock had potential as a value investment. Often referred to as the Ben Graham Formula, it is as follows:
The intrinsic value of a stock = Trailing-12-Month EPS * [8.5 + (2 * EPS Growth Rate)] * (4.4/AAA Bond Yield)
It's a bit confusing at first, so let's break it down. The 8.5 figure is a number Graham used as a multiple of earnings he was willing to pay for a company with zero growth, which he then adjusts by the expected long-term growth rate. The 4.4 is the minimum rate of return Graham required, as it was the average yield of high-grade corporate bonds in the '60s when he introduced the formula. Dividing by the current AAA bond yield adjusts this to the present.
For Apple, the trailing-12-month EPS is $9.40; analysts are expecting the next five-year EPS growth rate will be close to 12%. Triple-A bonds are currently yielding 3.9%, but using a long-term average, especially in today's low interest rate environment, is safer. The average AAA corporate bond yield going back to 1919 is approximately 6%.
Doing the math gives us a whopping stock value of $345 per share! Is Apple really that undervalued, or are we missing something? First, the formula is very sensitive to the expected growth rate. Ideally you want to use as long of a growth rate as possible, such as 10-year forecasts, but Wall Street analysts typically only go out five years. If we assume long-term growth is closer to 6%, which is closer to what the smartphone market will be slowing down to, then the value declines to $217 per share -- but that's still a large undervaluation.
Second, the 8.5 number and multiplying the growth rate by 2 is somewhat arbitrary. Some value investors prefer to adjust these numbers to something more conservative, such as 7 times for a stock with zero growth, and only multiply the growth factor by 1.5 instead of 2. Doing this would result in a value of $170 per share. So even after being more conservative, Apple still looks cheap according to Graham's formula.
The Graham checklist
Perhaps a better sense of whether Apple passes the value test is to stack it up against Graham's 10-point checklist. If you are unfamiliar with the 10-point checklist and some of the caveats, you can review it in an earlier Foolish article.
The first five points of the checklist look to see if the stock is a good value and underpriced, while the second half of the checklist makes sure you are not buying a company that is circling the drain or overleveraged and at risk of bankruptcy.
- An earnings-to-price yield at least twice the AAA bond rate. An earnings-to-price yield is exactly what it sounds like -- the inverse of the P/E ratio. Apple passes this one as its current P/E of 10.9 is equivalent to an E/P of 9.2%, more than double the current AAA bond yield of 3.9%.
- P/E ratio of less than 40% of the highest P/E ratio the stock has had over the past five years. Apple had a P/E ratio of near 20 times five years ago, so its current ratio of 10.9 is 55% of that high, not quite reaching the 40% threshold.
- Dividend yield of at least two-thirds the AAA bond yield. Apple falls a bit short on this one as well, with a dividend yield of 2.1%, which is 54% of the current AAA bond yield of 3.9%.
- Stock price below two-thirds of tangible book value per share. A big miss here, as Apple's regular book value is a quarter of its share price. Granted, this metric doesn't work well for tech stocks or companies with massive brand capital.
- Items 5 and 8 on the list deal with net current asset value (current assets less total liabilities). This one also doesn't work well for today's tech stocks, and it really doesn't work for Apple as most of its massive cash hoard is classified as a long-term asset. Because of this we get a negative value when trying to calculate this metric. Note that very few companies pass this criterion these days.
- Total debt less than book value. Even though Apple has utilized the debt markets a number of times, its total debt of $63 billion is well below its book value of $128 billion.
- Current ratio greater than 2. If you look this up you will find Apple's is 1.0 for the most recent quarter, but this also falls victim to the fact its massive cash hoard is classified as long-term investments. If we include this cash, the current ratio is a very safe 3.3.
- See item number 5.
- Earnings growth of at least 7% in the past 10 years. You might have to have been living under a rock to not notice the massive earnings growth Apple put up over the last decade.
- No more than two years of declining earnings of 5% or more over the past decade. Check! However, Apple did have one year -- a 10% decline in 2013.
How did Apple do? For the first half of the checklist Apple only hit one valuation metric, but wasn't too far away from No. 2 and 3. This falls in line with a stock that seems attractive, but may not be at a rock-bottom price.
However, this is countered by the company's financial health and earnings stability. Most companies that look like a steal are priced that way for a reason, so Graham wanted to make sure people didn't fall into a value trap. Criteria 4, 5, and 8 should either be discounted or updated for today's world and tech stocks.
Overall, I think Apple would certainly show up on Graham's radar today. It might not be a dirt cheap bargain, but remember that even Graham distinguished between "defensive" investors and "enterprising" investors. Based on some of his metrics, it appears Apple could be a great play for an enterprising investor. But as always, these are only guidelines to help, and more homework should always be done.
