A deep dive into Apple's (NASDAQ: AAPL) business, particularly its valuation and long term shareholder returns.
We often come across great businesses which are firing on all cylinders operationally. However operational excellence does not necessarily translate into shareholder returns. A business might be creating fantastic products (or services), enjoying high margins, and generating healthy ‘Owner Earnings’ (OE: The amount of cash the owners of the business can take out without affecting the current revenue levels) … but if that OE is not allocated judiciously, the long term returns of shareholders would disappoint. On the other hand, if the CEO is great at her primary job, which is capital allocation, it would make the shareholders wealthy.
The Intrinsic Value of a business is simply – The sum of all future cash flows generated by the business, discounted to the present day using a suitable ‘discount rate’.
This discount rate should compensate the investors for their opportunity cost, and can vary from investor to investor.
While this sounds simple, it is not an ‘exact science’ and is easier said than done. So how do we get around the challenges of ‘valuing a business’? … How do we estimate what kind of returns an investor can reasonably expect, having invested in a business at the current prices? … How do we know if the CEO is allocating the OE judiciously?
We have discussed all these topics in great detail and tied them together, in this (very detailed) case study of Apple. As you will soon see, we paid a hefty price (a lost multi-bagger opportunity) for not acting, even after understanding the upside potential in early 2019.
Below is a screenshot from a conversation I had with a London-based Fund Manager friend in January 2019. This chat will put a lot of what we discuss in this article in perspective, in case any of our readers accuse us of ‘hindsight bias’ :-). It’s a different story that in spite of intuitively understanding the upside potential, I failed to act just because I did not have the same framework that we discuss in this article, handy. Using this framework, you can estimate your long term returns from any compounder, and ensure you never make the same mistake like we did.
The Apple Case Study
Before we dive into our analysis, let’s tabulate and keep handy the financial summary of Apple for the last six years. You can come back and refer to this table.
With a cult-like following, Apple has become an extremely profitable business, as seen from its growing financial metrics over the last six years.
Note: The table below might not show up well on mobile browsers. For the best view of the table, please access it on a laptop.
(Note: Per share and outstanding share count figures have been adjusted for Apple’s stock split on a 4-for-1 basis on 28 August 2020. N/A = not applicable)
Apple’s Capital Allocation
Before we head to the valuation of Apple, here’s a quick look at its capital allocation track record over the years:
From FY2016 to FY2021, Apple has deployed 91% of the cumulative US$394 billion free cash flow (FCF) (before SBC) generated to share buybacks, and 21% to dividends, with the shortfall (of US$48 billion, or 12% of the total FCF generated) being covered by net debt issuance during that period (of US$61 billion, or 16% of the total FCF generated). Apple is extremely cash-generative that it plans to become net cash neutral over time.
For the capital retained, the company has achieved a high return on capital employed (ROCE) of 45% in FY2021, and the metric has increased from 24% in FY2016. Breaking down the ROCE into operating profit margin and capital turnover, the overall growth in ROCE over the years (from 24% in FY2016 to 45% in FY2021) was driven mainly by improvement in capital turnover (from 0.9 times in FY2016 to 1.6 times in FY2021), and slightly helped by improving operating profit margin (rising from 27.8% in FY2016 to 29.8% in FY2021).
For the 91% of cumulative FCF allocated to buybacks, Apple’s return on investment on the share buybacks has been outstanding. From FY2016 till 3 October 2022, its share repurchases have produced an XIRR of around 29%.
For the 21% allocated to dividends, they translate to a trailing dividend yield range of between 0.5% and 1.9% from 2016 to 2021 (averaging 1.2%), for the shareholders, based on data from Morningstar.
Apple’s ROCE has room to increase in the future with continuous improvements (or even just maintenance) of its operating profit margin, with increasing capital turnover mainly due to reduction in net cash.
Apple enjoys a very healthy ROCE and generates a huge amount of Owner Earnings (OE, i.e. the amount of cash the owners of the business can take out without affecting the current revenue levels. This is the cashflow available to the owners after maintenance capex and before the growth capex).
Its core business however does not offer much opportunity to reinvest that OE, so Apple has adopted the capital allocation strategy of returning capital to shareholders mostly via aggressive share buybacks and some dividends.
Estimation of Long Term Shareholder Return
One way to think about the long term shareholder return from investing in Apple at a reasonable price is to consider the components below:
Growth in intrinsic value of Apple over time, which would depend on the growth rate of FCF over time (which in turn will depend on the amount of OE that is reinvested in the business and the ROCE);
Buyback yield; and
Dividend yield.
(Note: In addition, the change in the FCF multiple over time would also have some impact on the long term shareholder return. However, we will not worry about the ‘multiple change’ in this report, as over a long holding period, the effect of the above 3 will be materially higher than this factor.)
To get a rough sense of the long term shareholder return from investing in Apple at a reasonable price, let’s assume that going forward, Apple would on average allocate:
around 10% of its OE for reinvestment in the core business as growth capex and any additional working capital (for context, from FY2016 to FY2022, Apple’s capital employed base excluding cash & equivalents had grown by around 11% of its cumulative OE during those years);
around 10% of its OE for dividends; and
around 80% of its OE for share buybacks.
Now, let’s look at the 3 components above in turn, at a high level.
First, let’s look at dividend yield.
Based on Morningstar data, in the past 5 years (2017-2021), Apple has been trading at a P/E multiple of ~13 to 40 times (averaging 24 times), and with the current P/E multiple (as of early October 2022) standing at ~24 times. Apple’s OE conversion has been broadly at ~100% in the past few years, so let’s assume that Apple has been trading at P/OE multiples similar to the P/E multiples.
If we assume that going forward, investors would be buying Apple’s shares when it is trading at P/OE multiples of ~20 to 30 times, then coupled with our earlier assumption of 10% of OE allocated to dividends, that results in a (pre-tax) dividend yield of 0.33% to 0.50% (= 0.10 / 30, or 0.10 / 20, respectively).
Second, let’s look at share buybacks yield.
If we assume that going forward, Apple would be able to buy back its shares at P/OE multiples of ~20 to 30 times (consistent with the multiples assumed in our dividend yield calculations above), then coupled with our earlier assumption of 80% of OE allocated to share buybacks, that results in annual share count reduction of 2.67% to 4.00% (= 0.80 / 30, or 0.80 / 20, respectively). This implies a buyback yield of 2.74% to 4.17% respectively.
Third, let’s look at Apple’s intrinsic value growth, which would be similar to its FCF growth.
The FCF growth rate is in turn driven by:
the additional earnings/ cash flows generated through the improvement of the ROCE on existing capital; and
the return achieved on the incremental capital invested in the business (the growth capex & additional working capital).
On the improvement of the ROCE on existing capital, Apple could generate more revenue or profits/ cash flows using the same or similar amount of capital, for example by deriving more revenues from services instead of from products, etc.
Let’s just, at a high level, broadly estimate the impact of Apple’s revenue transitioning (towards the services segment) on its profit margins.
In FY2021, the Services segment contributed to 18.7% of total revenue (vs Products’ 81.3%), and that segment has a much higher gross profit margin (GPM) (of 69.7%) than the Products segment (of 35.3%).
Per the table below, if we assume that, over the next 10 years:
the Services segment continues to grow faster than the Products segment, and contributes to 25% of total revenue (in the low scenario); and
the Services segment maintains its GPM at 69.7%, and the Products segment also maintains its GPM of 35.3%;
then the overall GPM would be 43.9%, which is higher than the FY2021 GPM (of 41.8%) by about 2.2 percentage points, or by 5.2% (= 43.9% / 41.8% – 1) relatively. That 5.2% relative growth in gross profit margin, or by extension gross profit amount, over a 10 year period translates to an annual compounded growth of 0.5%.
In other words, even if Apple maintains the same level of revenue, but due to a change in its business model of having a higher proportion of Services revenue (which has a higher GPM) than Products revenue, then:
In the low scenario, its gross profit amount would be higher by 5.2%. If that happens over a 10 year period, then the annual growth of gross profit would be 0.5% a year; and
In the high scenario, in which the Services revenue grows to 30% of total revenue (instead of 25%), then the resultant annualised growth in gross profit is higher, at 0.9% a year.
Next, for simplicity, let’s assume that any future increase in revenue (and earnings) of Apple would require some incremental capital investments, in the form of growth capital expenditure and higher receivables and/ or inventory etc (e.g. when Apple sells more iPhone unit volume, or when it increases its product prices).
In this case, all the future revenue (and earnings) growth would come from the reinvesting of the (10% of OE) additional capital into the business.
Historically, Apple’s OE and net profit are not too different. Thus, assuming a reinvestment of 10% of OE into the business is equivalent to assuming a reinvestment of 10% of net profit.
On the returns achieved on those reinvestments, let’s assume that the reinvestments would generate a return on capital (after tax) of around 100% (= 386% x 25.9%), considering Apple’s:
historical incremental capital turnover of around 386% from FY2016 to FY2021 (based on incremental revenue of US$150 billion and incremental capital employed (excluding cash) of US$39 billion); and
most recent net profit margin of 25.9% in FY2021, assuming that as Apple grows larger, it would not benefit from any improvements in its:
gross profit margin (other than the improvement due to changing revenue mix discussed earlier); and
operating profit margin (from any operating leverage), considering that its operating expenses as a percentage of revenue have remained roughly stable in the past 6 years (at around 11% to 14% in FY2016 to FY2021, as any reduction is selling, general & administrative expenses as a % of revenue during that period was roughly offset by increases in research & development expenses).
Based on the above, the 10% of net profit reinvested would lead to a growth in net profit of 10.0% (= 10% x 100%).
Given Apple’s capital light nature, plus its increasing focus on Services revenue which is likely to require less capital to grow (than Products), it is possible that Apple would be able to achieve a higher return on incremental capital employed, of say 150% (in the high scenario), and therefore a higher level of profit or FCF growth with that assumed reinvestment level.
Therefore, in our calculations, let’s assume that Apple could achieve future annual profit (or FCF) growth of 10.0% in the low scenario, or 15.0% in the high scenario, considering the growth driven by both the existing capital and new capital.
Thus, per the table below, the resultant FCF growth is 10.6% or 16.0% in the low or high scenarios respectively.
(Note: The implied growth in FCF is calculated as, e.g., 10.56% = [ (1 + 0.5%) x (1 + 10.0%) – 1].)
Now, coming back to the overall long term shareholder return, let’s put the 3 components of return together.
As shown in the table below, based on the assumptions and calculations above, if an investor buys into Apple’s shares at a reasonable price, then in the long run, the long-term shareholder return is expected to be around 14% to 21%.
(Note: The dividend yield, and by extension the long term return, above are before any applicable dividend tax).
Given Apple’s capital light business model and increasing focus on its services business, if Apple manages to maintain its moats and reinvest at higher returns on capital or achieve higher profit margins, and hence grow its FCF faster than the rates assumed above, then the long term shareholder return from investing in Apple’s shares could be (quite) higher than the rates calculated above (particularly considering the compounding effects of buyback yield with FCF growth, a concept that we have discussed in our Multibagger Research Series Meetup in September 2022).
Reverse DCF Valuation
We are now going to value Apple by doing a reverse discounted cash flow (DCF). A reverse DCF looks at the implied FCF growth rates (intrinsic value growth) in the context of the current stock price. This gives us an idea of how overvalued/ undervalued the business is currently.
For Apple’s reverse valuation, we are using the following:
Discount rate of 15% (this is our required rate of return/ opportunity cost, and can vary between individuals)
Adjusted FCF (after SBC expense) of US$85.0 billion for year 0
We tweak (using trial and error) the FCF going forward to see what would be the approximate growth rate of FCF (for next 10 years) that results in the fair value of Apple to be equal to the current market price. This is the growth rate that the current market price would be implying.
Free cash flow (FCF) growth rate beyond 10 years (or to perpetuity) of 7% (which, along with the 15% discount rate assumption, implies a terminal FCF multiple of 12.5x)
Market capitalisation of US$2.29 trillion, as of 3 October 2022
Using the above, we arrive at an implied FCF growth rate of 17.0%, where the intrinsic value of Apple equals to that of the current share price of US$142.45 (equivalent market capitalisation of US$2.29 trillion).
So, we need to ask ourselves if Apple can realistically achieve or even exceed the 17.0% FCF growth rate from year 1 to year 10, and 7% beyond that.
If you think the company can surpass the above rates based on your understanding of Apple, the tech giant can be said to be undervalued. In other words, if you believe that Apple’s FCF can grow faster than what we have stated, you would expect a return higher than 15% when you buy Apple at the current price.
On the other hand, if you believe the implied 17.0% annual FCF growth for the next 10 years and 7% beyond that (as implied in the current market price) are too aggressive and the actual growth is going to be lower, your expected long term return from Apple would be less than 15% (the discount rate we used).
To put things into context, Apple’s adjusted FCF has grown by around 12% annually over the past six years. However the 7% terminal growth rate that we used earlier is a very conservative scenario which assumes Apple’s ROCE would fall below the cost of capital.
With Apple’s increasing focus on the Services segment and with lots of room for growth in this area, the company’s ROCE is likely to increase due to the capital-light nature of this part of the business, lifting the overall ROCE for Apple.
If we apply a 10% terminal value (base-case scenario) (which, along with a 15% discount rate, implies a multiple of 20x), the 10-Year FCF growth rate implied by the current share price drops to 12.7% (from the 17.0% earlier).
And if we apply a 12% terminal value (high-case scenario; implying a multiple of 33x), the 10-Year FCF growth rate implied by the current share price would be only 7.9%.
In addition, the reverse DCFs above implicitly assume that the FCF generated by Apple every year would be reinvested (either by Apple, or by the shareholders if distributed out as dividends) at an annual return that is equal to the assumed discount rate of 15%.
In the past, Apple has had an excellent track record of using its FCF to buy back its shares. The XIRR achieved on those buybacks stands at around 29% (for its buybacks done in FY2016 to FY2021). Tim Cook has stated his intention for Apple to be cash-neutral going forward.
Therefore, if Apple deploys its FCF in the future to buybacks at rates above the assumed discount rate of 15%, then the overall shareholder return would be a lot higher than 15%.
(Note: Even if Apple achieves a FCF growth that is lower than the implied FCF growth rates, if the returns from the buybacks are > 15%, then the overall shareholder return could still be 15%).
For reference, when we consider a long horizon, like 10 to 15 years or more, the XIRR on company buybacks would tend towards its sustainable ROCE. To understand this point, just imagine you are buying the stock in a good quality company. If you have bought the stock at a discounted price, your short term investment return would be higher than the growth in intrinsic value of the business, as you would also benefit from the increase in trading multiple (and vice-versa). However, the effect from the multiple reversion (either expansion or contraction) becomes less significant, the longer the holding period is. Over a long period, the main driver of return is the growth in intrinsic value of the company, which is linked to the company’s long term sustainable ROCE.
For example, when we look at another high-quality and highly FCF-generative company that has been deploying lots of FCF for share buybacks, Adobe, we noticed that, in general, the higher the ROCE range, higher the overall XIRR for the buybacks.
Let’s look at a summary table below for the share buybacks and ROCE of Adobe and Apple over the past several years (with the buyback XIRR calculated as of 3 October 2022).
(Note: The annualised share price gain is based on the share prices on 3 January 2011 and 3 October 2022 for Adobe, and the share prices on 2 January 2013 and 3 October 2022 for Apple.)
If we look at another two high-quality and highly FCF-generative companies (covered under the Multibagger Research Series) – Alphabet and Meta, they have a shorter buyback history of about seven and five years respectively (starting from 2015 and 2017 respectively). Although the period examined is shorter, the results show a similar trend for Alphabet. However, for Meta, since its shares have plunged a lot since FY2017 and with a relatively shorter time frame, its share buyback XIRR is in the negative range.
(Note: Share price calculation for Alphabet was done using ticker GOOGL. The annualised share price gain for the period examined above is based on the share prices on 2 January 2015 and 3 October 2022 for Alphabet, and the share prices on 3 January 2017 and 3 October 2022 for Apple.)
(Note: (1) The long term annualised share price gain is based on a period of around 10 years, per the tables above. (2) Please note that, for the overall XIRR for the buybacks, the XIRR for Alphabet and Meta are for a shorter period, and as mentioned earlier, the longer the time period (like 10 to 15 years or more), the closer the buyback XIRR and ROCE figures would be.)
As seen in the earlier table, Apple’s overall ROCE has been 21% to 45% in the past six years. If it can maintain this range, or even increase it in the future, then it’s likely that the capital that is continuously deployed to its share buybacks would achieve a long-term return that is close to its high ROCE, which is above our assumed discount rate of 15%.
As of 25 June 2022, the company had around US$60 billion net cash, and around US$86 billion remaining that has been authorised to use for share buybacks (which is around 4% of its market capitalisation). At Apple’s current share price of US$142.45 (or market cap of US$2.29 trillion of as 3 October 2022), if Apple uses all of its US$60 billion net cash to buy back its shares, its share count would be reduced by 2.617%, which translates to a (one-off) buyback yield of 2.620%.
Note: The objective of this report is not to predict the future or recommend Apple as an investment. We are merely evaluating the current facts and using a framework that can help us think about how the future shareholder returns could look like for different growth trajectories for the business.
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