The calculation of intrinsic value needs to pay greatattention to business' economic moat. I have spent thelast three days almost exclusively researching and thinkingabout Apple's moat - and not just how it appears right now asthe definition of a true moat requires thinking abouta changing environment many years out. You can't predict whatthe changes will be but you have to bet on the environment appearingquite different and think about the elements in place now thatallow the business to endure through the changes. Ten years ago Shareholders of Nokia talked about their company's moat owingto the incredible loyalty towards the brand, the low cost of product owing to scale dominance and exceptional management. Themoat looked wide. But the environment changes. Companies like Coketend to have true moats because their business is immuneto changing environments.Apple's moat right now looks extraordinary. On paper it isincredible, looking at it less superficially it has someproblems but is still difficult to refute. Remember that a moat needs to be indestructible in order to be a moat. Key moatcategories include:1. Low cost of product or cost advantage. - Ticked2. Network effect - Ticked owing to: - Feedback loop between numbers of users and number of app developers, similar feedback loop that MS DOS and PC software developers enjoyed. - New products joining this feedback loop so the feedback loop scales with both users, increasing product classes and increasing developers (multiplicative).3. Switching costs - Half-ticked (still good, some moat companies have it better here). - Nuisance of moving away from Mac Laptops and other products once you get used to them - note that the point about switching costs needs to be applied only to those that want to move away from Macs or iPhones for price or other reasons, not the people who still love them, but stay with the product owing to tangible or intangible switching costs).4. Intangible assets - Ticked owing to: - OS architecture (phenomenal abstraction layers being the main thing that defines and differentiates the products). If you give a company a $500B you can't necessary come up with all of this in competitive time. - Huge developer engagement on the computer OS side as well as mobile OS side. - Bubbling brand increasing demand and thus margin power. This part of the moat has staying power however it can fluctuate from decade to decade, but while it is cheery it does provide additional demand and pricing power.Often for a moat you only need two or three of these for categoriesprovided they are fairly close to indestructible.Apparent moats however can fall to pieces - such moats are by definition not true moats so one needs to think deeply aboutthem. Competitors can get through the Network Effect category of moats by dominating in a smaller niche before expanding the network outwards from that niche. An excellent example is Facebook concentrating on dominating a university, then numerous universities (still niche) while MySpace and Friendster already had the network effect huge head-start that from which they had no excuse to fail, but did. I'd be interest to hear people's ideas about serious threats toApple's moat which over the past seven years has allowed for suchsuperb margins as well as revenue growth.To emphasize, when thinking about moats we are trying to estimate threats toApple over a series of ten or fifteen years, not just threatsover the next few years. This is then combined with the likelymagnitude of sales we may expect ten years away in order to comeup with a sensible multiple of today's earnings and arrive at ourgoal of calculating the intrinsic value - the reasonable valuewhich the share price will be expected to deviate around overa series of five or so years (typical time for share price tointersect intrinsic value). The intrinsic value is relatively stable,it moves with the expected future earnings which in turn moveless the annual earnings which are more volatile. The shareprice however is relatively chaotic, deviating at times belowintrinsic value and at times above but intersecting at least onceevery seven years (more frequently for companies like Apple whichis always in the news). What appears to have happened with Appleis that the intrinsic value has moved up so rapidly that the shareprice has not had enough time to catch up. Trading still dominatesthe volume and traders will have been entering and exiting euphorically (nearly always successfully) but the price rate of change might havelagged intrinsic value rate of change.The next thing to consider of utmost importance beside Apple'smoat is their opportunities to expand sales over a series ofmany years. When you think about people with an iPhone, iPadand MacBook Pro upgrading each product once every two years - ahardcore customer - there comes a point where they just can't spendmore money each year - so the product cross-filtering only worksup to a point (not continuously scalable). The more importantavenue for growth is gaining new customers and some opportunities include: 1. Entering China - presently there but only 5% market share of SmartPhone market (and this high end phone market itself expanding rapidly and Apple's 5% will rise within that also). Nokia still dominant there - Chinese do not like having fake copies of things and prestige in owning original Apple products already similar size to US but China market will end up being quite larger than the US. 2. Established products, other than iPhone, still have a long way to grow: i. iPads continuing to take market share from Windows computers - have a long way to grow. ii. MacBooks continuing to take market share. Presently only 5% in largest market - US) from Windows computers. 3. While the above continues growing, introduction of new products starting with TVs that do not replace existing products but use their branding, iTunes and Apps moat as competitive advantage. Like the iPhone did, the TV will cross-fertilise buyers to other products.Some businesses have moats but a limit upon the sales growth. Forexample you could be a coffee shop with loyal customers but onlyone shop - you might make a lot of money with everyone coming toyour shop but in trying to expand you might find that the moat doesnot extend to the next shop - so you just retain the one shop andkeep making a huge return on equity (more customers continued yearafter year). Of the three growth points above, only the third pointhas a relatively low upper bound - while 1 and 2 can provide theopportunity (this does not mean it will happen but we mustfirst consider where the bounds are) for revenues increasing vastly(the upper bound might be five times current sales, so sufficientlyhigh that the boundary is not a significant concern versus thekind of multiple I'll be assigning to the current earnings).Next relating the moat and growth opportunities to current earnings.When assigning a P/E multiple it is important to look at a conservative estimate of how earnings will be sustained or growover a really long period of time such as 15 years. The use ofthe word 'conservative' is important, not merely because it providesa margin of safety, but much more importantly because it causesone to think about the relationship between the moat and the futureearnings. In estimating earnings conservatively we attempt to throwall sorts of obstacles at the company and ask whether we expect itwill still be making the same amount of money 15 years ago, and ifmore, then how much more after throwing all the obstacles at it.Given the existence of the moat combined with somewhat temperedconservative long-term (15+ years) growth opportunities we might assign a P/E multiple today of 20, versus the broadmarket's historical average P/E of 13. This multiple appears fairlyrich however it must be placed against the above discussion of Apple'smoat and combined with their significant, even if bounded, growthprospects.In their last conference Apple expected the next quarter willbring earnings of $8.50 per share. Last year they sustained theirearnings through Q2, Q3 and Q4 which rose in Q1 owing to peopledelaying iPhone 4S orders until its release. In any case as Iam factoring growth from the current earnings and *not* future earnings in selecting the P/E multiple of 20 above, it necessaryto use the trailing earnings per share of 14+7+7.9+6.5 = 35.4 whichgives an intrinsic value of approximately 35.4 * 20 = 708 per share.This is not to say that the stock might not rise significantly higherowing to (1) the company having a temporary condition at some timein the future, let's say 2015, of extremely high earnings which cannot be sustained; (2) Wall Street becoming excited about technologyvaluations at some stage in the future and accepting a high earningsmultiple (say 25) temporarily. Often the excitement and highP/E ratios correlate with temporarily high earnings so you have pricespikes which aren't rational but happen anyway. For example earningsof $70 per share in 2015 combined with a P/E of 23 would give a shreprice of $1,610. This seems ridiculous now but the environment changes.This seems to move away from the subject of investing and into speculating,however the last paragraph is not entirely of no value. A investor willfavour price volatility as something to be taken advantage of ratherthan something used against them and so an expectation of a valuationabove intrinsic value at some point in the future (even with thetime not known that is not important) will provide an excellentexit strategy. For this reason there has to be a notion of what"above intrinsic value" is, rather than resorting to an arbitrary priceor based upon the percentage gain that you have recently received.In any case (1) buying at $500 is 29% below my view of the current 'correct'value of $700, (2) there is presently strong share price gain momentumwhich increases prospects looking one year out when this point istaken in isolation, (3) the higher volatility of Apple's stock priceshould make the time in which price intersects intrinsic value shorterthan the average time you need to wait (generally less than 7 years,likely more frequent with a more volatile company more prone to periodsof euphoria and disillusionment). - Manlobbi
I give your post an A+ for content, but a D for formatting.Why the frustratingly short lines?
or they drink the Apple Kool-Aide!!!Plonk. Buh-bye.-awlabrador
People who upgrade every two years are delusional.Geez, so judgmental.Kool-AideIsn't that what they called a person who helped produce the songs "Cherish" or "Celebration"?dsbrady
Very thoughtful analysis! Does this mean you think apple is worth $700 right now? If that's the case, how long would it normally take for the market to catch up to this valuation? Do you think that the currernt audit/examination of the working conditions in apple's subcontracted factories will result in a material increase in manufacturing costs and if so, isn't it somewhat likely that competitors will see their costs go up also since, I believe I heard somewhere, that they use the same manufacturers? If so, will apple (and others)raise prices or absorb lower margins? How price sensitive do you believe their customers are and what impact might a price increase have on sales volume?Isn't it likely that apple will split soon to say 5 for 1 and that will increase ownership?Finally, do you think a dividend is likely soon?Thanks.
Thanks for sharing your analysis. I especially liked your part II in another thread.Coming to the question of moats, purely based on my own circle of friends, I am not seeing much of a moat.1. Network effect - The number of apps for a platform would likely not be a big factor for users. It is not like Ebay where the number of sellers increases the value to buyers and vice versa. The most common apps and those which the users care about are quite limited in number. Once a core set of say 5000 apps are developed, it really does not make much difference to how many additional apps are available. These core set of apps would be avialable on other platforms as well. Users are going to iPhone mostly because it is such a well made device and it is so easy to use. Once the others catch up in learning curve this difference would become minor enough to not be a significant factor in purchase decision. I see the iPhone more as a fashion choice and fashions do (or rather must) change over time. 2. Switching costs - Most of the tasks that are performed on apps are very easy, non critical and does not require much training to become proficient. There is very limited data in any of these apps. Even the data that exits would become portable between platforms in future. The cost of apps also is minor compared to device or yearly phone costs. So I do not see much of a switching moat here.Much of the above would be true for iPad as well. Thanks
>Thanks for sharing your analysis. I especially liked your part II in >another thread.Thanks maharg34 and I agree with you completely about switchingcosts being relatively low for Apple's business as a whole. WithiPads and iPhones constituting for now the bulk of their profitthe switching costs there are really quite low in practice evenif they can be rationalized as high. In Part 1 note I wrote that theswitching costs were only 'half ticked' as a moat characteristic.Regarding the Network Effect you are also right in that it doesn't scale continuously as the number of users increase. However the NetworkEffect is there and an important characteristic of their moat whichrequires only a certain critical mass to function as you point out.This critical mass however is vital and makes it difficult forcompetitors to do much. There is an Android market and an iPhonemarket - competitors have a huge hurdle to have a market hereand that's all we care about. Easy to forget what we already havewith Apple once it's already there for a while but the investor must measure what's old even more judiciously than what's on thehorizon. I'm going through Android in Part III.Part III is coming shortly, and they'll be more after.- Manlobbi
>Very thoughtful analysis! Does this mean you think apple is worth $700 >right now? If that's the case, how long would it normally take for the >market to catch up to this valuation? I'll get to that in Part IV. In an nutshell it's worth somewherein the vicinity of $700 if measured on a rather conservative basisbut I will discuss the nuances behind this in great detail - theintrinsic value is actually the easier part and less importantthan knowing how to act upon this information.>Do you think that the currernt audit/examination of the working >conditions in apple's subcontracted factories will result in a >material increase in manufacturing costs and if so ..This is absolutely no effect on the intrinsic value as it isnot very consequential in the short-term but most importantlyit is a temporary factor. The BP spill by contrast was very consequential but owing to being a temporary factor it didn't change the intrinsic value much (nor price the company would trade at 3 years later).>Isn't it likely that apple will split soon to say 5 for 1 and that >will increase ownership?Completely unimportant for short-term price and intrinsic value alike.>Finally, do you think a dividend is likely soon?I don't think it will be soon but there is no hurry here - relativeto current earnings the cash equivalents are not that high (about20% of the market capitalization, same a Google and a lot of others).Spending power to resume a leadership position is going to be extremely important at times if some of the products fall a little out of favour,hard to imagine now but things can change suddenly, and if all goesvery smoothly then they can start to issue dividends but as anowner I'd view the company as hotly ambitious right now andneeding everything at it's disposal to realize these ambitions.- Manlobbi
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