Friday, August 20, 2010

Recently I was in a discussion with Horace Dediu of and I wanted to formalize the thoughts and continue here...

To make money with stocks (beyond index fund growth) you need to take risks. The risk you should take is on companies that show an ability to surprise. I mean really surprise, as in “where did all that new money come from?” If you can predict accurately the so can everybody else. The kicker is that even the company’s own management must be surprised. Not even they can tell what’s coming. In Apple’s case I’m pretty sure that iPod and iPad were all bigger than anyone there expected them to be. They created new markets. New markets can’t be measured.

I think there is a lot of logic and value in what you are saying, but I’m not in complete agreement. Example, a simple model of Apple using your FY end, TTM earnings of $15.27, a P/E that makes the stock come out to recent levels…turns out to be about 17, then the ‘big’ assumption…I’l use 20% growth. (low by recent standards, unknown in the future and especially the out years)

As you can see, this provides very good appreciation for the stock price, and I don’t think the variables I’ve used are really over estimating the markets outlook for Apples future. But as a short term minded species, we don’t seem to look much farther than the next quarter, or perhaps year.

Personally I plan on needing money and successful investments beyond the time frame of one year, and like looking further out into the future. If Apple can do a fraction as well in the future as the current management team has done in the last few years, I don’t think the market has properly discounted the future cash flows at all.

I think Apple is significantly undervalued, and believe a P/E of 17 is undeservedly low based on the actual growth rate. I’m not saying this to wine, I’m saying it as I appreciate the investment opportunity.

Year growth rate EPS P/E ratio Share Price
2010 20% 15.3 17 $260
2011 20% 18.3 17 $312
2012 20% 22.0 17 $374
2013 20% 26.4 17 $449
2014 20% 31.7 17 $539
2015 20% 38.0 17 $647
2016 20% 45.7 17 $776
2017 20% 54.8 17 $931
2018 20% 65.7 17 $1,118
2019 20% 78.9 17 $1,341
2020 20% 94.7 17 $1,609

Factors I think the market may be missing/under valuing:

The value of the Apple management team regarding innovativeness, design, production quality and efficiency.

The value of Apple’s brand and following. (quantity, quality, income level)

The value of the OS and it’s scalability.

The value of understanding customer needs and wants. (and technical ability to meet them)

The value of the profitable portion of the market. (not simply market share)

The size of the mobile internet vs. the size of the desktop PC market. (been estimated at 10x as large)

The customer's appreciation for design and quality once they experience it.

The value of the “integrated whole” Apple provides that makes life easier for the average user who is not an IT major and doesn’t want to spend their time trying to be one. (iTunes, iLife, better security and freedom from viruses, UI, apps, etc.)

The value of the fundamental base Apple has laid in the past decade that can now be built on that is missing from other competitors operating model. (software, hardware, retail, R&D, halo effect from previous quality products)

I see these as tremendous assets, and having great value in the years to come, not only the next year. The value may well be greater 5 years from now as Apple is leading in product innovation while other competitors are trying to catch up. Apple's first mover advantage may well grow as new products are introduced that take advantage of the foundation Apple has put down in the past 10 years.

Things I disagree with:

Apples lack of financial leverage.

Not having a share buy back to support the share price and concentrate earnings.

Holding too much cash at low interest rates, especially considering the current cash generation ability.

Not offering a modest dividend to attract income oriented investors and funds, even though I do dislike double taxation.