On January 24, Apple Computer released its 1st quarter earnings report. To say it was stunning would be an understatement. Investors’ enthusiasm was wildly optimistic that these big earnings would translate into a big increase in the stock price. While Apple did hit new highs on January 25, 2012, the rise in the stock, some would say, was muted. Can model price explain why Apple isn’t trading at a higher multiple considering the financial results just reported and ever increasing expectations to come, with iPhone 5 and a new iPad scheduled for release sometime in the near future.
Convexity is a concept that may be difficult to grasp, but one we believe to be important as it represents a unique characteristic in model price. Under “Key Concepts”, and “Model Price” we have the description of model price. Point 2, in our 3- factor model, we state “The sensitivity of [the] company’s balance sheet structure to changes in its market value. (Structure)” We call this Convexity.
We calculate convexity for all companies in our database. This measure determines the sensitivity of the value of the economic structure to changes in market value. We have found that the more sensitive a company is per our measure (the higher the convexity), the higher the valuation in terms of the stock price.
How did we find Convexity?
The development of this factor began with the inquiry of why certain companies have “price momentum”. These stocks typically have high valuations, as the underlying earnings and/or earnings growth are not sufficient to support or explain their valuations. The result is changes in the securities’ own price seemingly reinforcing itself. Rather than just apply the “momentum” label to these companies and leave it at that, our approach was to determine whether certain types of companies are pre-disposed to higher valuations because of their economic structure. The price momentum observed in the market would therefore be, at least in part, a function of this structure as valuations gravitate to levels dictated by the structure. We also can think of the convexity as analogous to friction. The less friction (the higher the convexity) there is, the higher the potential valuation.
Getting back to Apple
Let’s look at the calculated convexity score for Apple and other large capitalized technology companies.
|Intl. Business Machines Corp.
|Cisco Systems Inc.
As one can see Apple is way to low compared with not only large cap technology but also with other companies in the S&P 500, which has a cap weighted convexity of 1.43.
What are we saying? Quite simply, the balance sheet of Apple is too big. Yes, management is performing brilliantly, results were spectacular and they have a bright future. Yes, Yes, Yes. However, they have a steamer trunk on their backs that the market will discount. A hundred billion dollars of cash, great if you are paranoid but the market doesn’t pay you for it in terms of valuation.
How can management get convexity up?
- Split the stock. Yes, there are those people who say, splitting the stock will not make any difference. “Simple division” they say. Unfortunately wrong in our view. Splitting the stock will increase convexity, increasing convexity will increase model price. We believe the share price will increase in recognition of this fact. Anyone in the business knows intuitively stock splits make a difference however current financial textbooks cannot prove, as yet, what we know intuitively.
- Pay out an extraordinary dividend. Certainly management can get by on say, $50 billion cash on hand. This won’t change the business one iota, however this distribution will shrink the balance sheet quickly and increase convexity. Shareholders will get a taste of Apple’s success and we bet the market price will quickly increase to make up any ex-dividend differential. (Microsoft saw the light, maybe it’s time you did to.)
- Buy back your shares. Over the last ten years has there been any better investment than Apple? Management could have been purchasing shares with excess cash, making a great investment and increasing their convexity in line with other large cap tech. That is perfect hindsight you say, what about the next ten years? Simple, you are purchasing shares at the current model price, i.e., fair value with current convexity. If management has a 5-year objective to getting convexity to 2, moving the model price substantially higher irrespective of what your business does.
- Do all three points above. (Or some combination would be helpful.)
Apple now trades around its model price (434.31) as of January 25, 2012. We calculate the model price for next year at $484, implying an 11.5% gain. Not bad, when treasury bills are zero. However, Apple could be a whole lot more if management considered the above. On the back of an envelope Apple could easily double their share price by doing a little “financial engineering” [We know the worst two words one can write post 2008 crash!] and certainly on its way to become the first trillion dollar company post the 2000 technology bubble.