“Apple’s valuation is a riddle wrapped in a mystery inside an enigma.” I have revised Winston Churchill’s famous quote on Russia to make a point on investors, both professional and do-it-yourself types, that seem perplexed on Apple’s current valuation. We have all watched while Apple’s stock price has inexplicably eroded from just over $700 per share to its current value of $452.08. Why? This to my mind is what is wrong with the current state of finance. There is no definitive source or service available to have any discussion about valuation. There is currently no math that exists today, in published textbooks or accredited courses that answer the question of valuation properly to the common man or investor.
New math has to be created. New tools should be invented. The current orthodoxly is broken. Isn’t there a Harvard MBA anywhere that can tell anybody the valuation puzzle that investors crave? What is the key to unlock this valuation question?
Model Price Math to the Rescue!
First we calculate the model price or fair market value of Apple Inc. everyday – along with 2000 other companies. As of last night the model price of Apple is $591.64. Simple.
Here is our model price chart not only showing last night’s output but also a history of our model price calculation for our users benefit. (Purple dashed line)
Apple Inc. with weekly price bars and model price calculation (dashed line)
For those interested, a daily updated chart of AAPL subsequent to this post will be maintained on Facebook, here.
How do we do this?
We created an algorithm that is so robust it works across all companies and industries. Think of the differences in all these companies. Think of the peculiarities of each company’s business model and balance sheet. How is this possible? By finding and inventing new mathematical equations that are relevant to the process of business. By thinking about the process of solvency within the process of doing business, which every businessperson constantly thinks about not in an academic way but in a real world way. By looking and examining balance sheets of all enterprises both private and public containing information that most if not all the investment community discards.
So in this blog I want to highlight just two concepts that reside in our calculation of model price that can go a long way to help in this valuation question on Apple Inc.
Theoretical Earnings (TE)
When I was introduced to the beginning mathematical concepts of model price work, some 15 years ago, one of the first concepts that peaked my interest was theoretical earnings or TE. One of the big problems with analyzing any business, especially public companies, is that they are constantly in flux. There is no constant or benchmark for analysis therefore all analysis is based on regression or relative measures with other businesses in the same industry. If company X has a price/earnings ratio of 10 then company Y in the same industry with a P/E ratio of 8 must have some relative value.
The genius of theoretical earnings is the constant we are looking for is contained in the balance sheet of the company itself. Using a company’s balance sheet, we can calculate a specific earnings number this same company needs in order to maintain state or constant in the future. This constant or specific earnings number we call theoretical earnings. It didn’t take us long to realize that the higher or greater the differential between theoretical earnings and estimated earnings per share the higher valuation the equity in question will achieve. This is what the market, it seems to us, wants to value through a company’s share price among other concepts we have developed.
Apple Theoretical Earning’s
Here a chart of Apple’s TE relative to its’ 12-month forecast of earnings per share (EPS)
What is obvious from this chart is the parabolic growth of Apple’s earnings since 2007. Remember the iPhone was launched in 2007 and the first iPad was released in April 2010. One could argue Apple, with its brilliant founder – Steve Jobs – hit the perfect “three-peat”. iPod with iTunes, iPhone and iPad launched Apple’s earnings into the stratosphere as you can clearly see. What’s next? Can these current levels of earnings be sustainable? Will there be a “reversion to the mean” with earnings in the company’s future?
Let’s go a step further.
Taking the data from the above chart, we can form a ratio of EPS/Theoretical Earnings – see chart below.
By looking at the chart you can see Apple went through three distinct periods. The first period was between 1995 and 2005. The period shows earnings relative to its TE fell to zero or Apple’s earnings were equal to its’ Theoretical Earnings and then rebounded. The second period goes from 2005 to the beginning of 2010. This second period highlights Apple’s EPS/Theoretical Earnings ratio of about 4 times. The third period, when the iPad was launched saw earnings grow almost 8 times Apple’s TE. Understandably the higher the EPS/Theoretical Earnings ratio the higher Apple’s valuation.
This brings us to the end of our chart. Where is this ratio going in the future? Will the EPS/Theoretical Earnings go back to a ratio of 4 times? Will it go back to zero? Or will the innovation keep happening, without Steve Jobs, and have this ratio turn around to achieve new highs? What is your guess?
To date the market sees atrophy in this ratio and has acted on Apple’s share price accordingly.
Convexity is one of our must difficult mathematical concepts to explain in relation to finance and the public markets however in some ways it’s an important part of our calculation of model price. This mathematical construct is the feedback mechanism where the balance sheet of the company feeds into the stock price’s ultimate valuation in the public equity markets. The higher convexity number computed the higher the company’s valuation. However too high a convexity number will give a given company a higher valuation but will substantially increase variability (or volatility) in the company’s stock price as this feedback mechanism can become unstable.
Here is our chart on the calculation of convexity for Apple going back to 1995.
What is this chart saying? Convexity will NOT be a driver for increased valuation until this chart or convexity starts turn up. There is a consequence of Apple’s management decision to capture its’ excessive profits on its balance sheet in the form of cash reserves or other assets – a lower share price valuation because of very low convexity. Assuming Apple’s EPS/Theoretical Earnings returns to a ratio of 4 times, Apple’s overall valuation will probably be lower if this convexity number is unchanged in future periods.
How would you increase this convexity input into our model price calculation? Reduce the size of the balance sheet is one answer. This can be easily achieved by reducing the cash on the balance sheet by either paying out dividends and/or buying back company shares. Interestingly another way to increase convexity is by way of a stock split. The math works! Yes, this is counter-intuitive but anecdotally all market participants know that when a company announces a stock split this is viewed as a positive usually pushing the market value of the company up! Increased convexity is the mathematical reason.
Apple’s convexity number is 0.12. To give you some context, the S&P 500 has convexity of 1.40 which is market capitalized weighted like the S&P 500 itself. As you can see Apple has a long way to go to catch up with other companies in the popular index. (Apple obviously influences this convexity number with being a large weight in the index.) Microsoft has convexity of 1.86 and Amazon 1.17 for comparison purposes.
Hopefully this blog gives you a whole different perspective on Apple and its fundamentals. The good news is Apple is currently trading under its calculated model price calculation, which we calculate nightly. Another piece of good news is the shareholder base is changing as we speak. Growth, and the momentum crowd are clearly exiting being replaced by the value crowd, probably more patient and more happy clipping coupons than price appreciation and or volatility.
The bad news for Apple is where our EPS/Theoretical Earnings ratio will travel? Innovation and new products was the key to Apple’s enormous success, which translated into record profits and valuation highs. Is this Apple’s future? Was this a product of Steve Jobs unique vision that obviously will not be around in the future?
The numbers suggest to me, especially convexity, that Apple’s current management is happy to consolidate their position – giving out fresh iterations of their current product line (iPhone 15 anyone) – sitting on this enormous cash pile, waiting. Wait for what you ask? Waiting for the next big product to launch. Yes, this could be years down the road but no matter. What is probably more important to Apple right now is to preserve the Job’s legacy and not screwing up then going back to its roots as an iconoclast think differently company that everyone finally came to admire.