Intrinsic Value
The calculation of intrinsic value needs to pay great
attention to business' economic moat. I have spent the
last three days almost exclusively researching and thinking
about Apple's moat - and not just how it appears right now as
the definition of a true moat requires thinking about
a changing environment many years out. You can't predict what
the changes will be but you have to bet on the environment appearing
quite different and think about the elements in place now that
allow the business to endure through the changes. Ten years ago
Shareholders of Nokia talked about their company's moat owing
to the incredible loyalty towards the brand, the low cost of
product owing to scale dominance and exceptional management. The
moat looked wide. But the environment changes. Companies like Coke
tend to have true moats because their business is immune
to changing environments.
Apple's moat right now looks extraordinary. On paper it is
incredible, looking at it less superficially it has some
problems but is still difficult to refute. Remember that a moat
needs to be indestructible in order to be a moat. Key moat
categories include:
1. Low cost of product or cost advantage.
- Ticked
2. 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 categories
provided 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 about
them. 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 to
Apple's moat which over the past seven years has allowed for such
superb margins as well as revenue growth.
To emphasize, when thinking about moats we are trying to estimate threats to
Apple over a series of ten or fifteen years, not just threats
over the next few years. This is then combined with the likely
magnitude of sales we may expect ten years away in order to come
up with a sensible multiple of today's earnings and arrive at our
goal of calculating the intrinsic value - the reasonable value
which the share price will be expected to deviate around over
a series of five or so years (typical time for share price to
intersect intrinsic value). The intrinsic value is relatively stable,
it moves with the expected future earnings which in turn move
less the annual earnings which are more volatile. The share
price however is relatively chaotic, deviating at times below
intrinsic value and at times above but intersecting at least once
every seven years (more frequently for companies like Apple which
is always in the news). What appears to have happened with Apple
is that the intrinsic value has moved up so rapidly that the share
price has not had enough time to catch up. Trading still dominates
the volume and traders will have been entering and exiting euphorically
(nearly always successfully) but the price rate of change might have
lagged intrinsic value rate of change.
The next thing to consider of utmost importance beside Apple's
moat is their opportunities to expand sales over a series of
many years. When you think about people with an iPhone, iPad
and MacBook Pro upgrading each product once every two years - a
hardcore customer - there comes a point where they just can't spend
more money each year - so the product cross-filtering only works
up to a point (not continuously scalable). The more important
avenue 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. For
example you could be a coffee shop with loyal customers but only
one shop - you might make a lot of money with everyone coming to
your shop but in trying to expand you might find that the moat does
not extend to the next shop - so you just retain the one shop and
keep making a huge return on equity (more customers continued year
after year). Of the three growth points above, only the third point
has a relatively low upper bound - while 1 and 2 can provide the
opportunity (this does not mean it will happen but we must
first consider where the bounds are) for revenues increasing vastly
(the upper bound might be five times current sales, so sufficiently
high that the boundary is not a significant concern versus the
kind 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 grow
over a really long period of time such as 15 years. The use of
the word 'conservative' is important, not merely because it provides
a margin of safety, but much more importantly because it causes
one to think about the relationship between the moat and the future
earnings. In estimating earnings conservatively we attempt to throw
all sorts of obstacles at the company and ask whether we expect it
will still be making the same amount of money 15 years ago, and if
more, then how much more after throwing all the obstacles at it.
Given the existence of the moat combined with somewhat tempered
conservative long-term (15+ years) growth opportunities
we might assign a P/E multiple today of 20, versus the broad
market's historical average P/E of 13. This multiple appears fairly
rich however it must be placed against the above discussion of Apple's
moat and combined with their significant, even if bounded, growth
prospects.
In their last conference Apple expected the next quarter will
bring earnings of $8.50 per share. Last year they sustained their
earnings through Q2, Q3 and Q4 which rose in Q1 owing to people
delaying iPhone 4S orders until its release. In any case as I
am factoring growth from the current earnings and *not* future
earnings in selecting the P/E multiple of 20 above, it necessary
to use the trailing earnings per share of 14+7+7.9+6.5 = 35.4 which
gives an intrinsic value of approximately 35.4 * 20 = 708 per share.
This is not to say that the stock might not rise significantly higher
owing to (1) the company having a temporary condition at some time
in the future, let's say 2015, of extremely high earnings which
cannot be sustained; (2) Wall Street becoming excited about technology
valuations at some stage in the future and accepting a high earnings
multiple (say 25) temporarily. Often the excitement and high
P/E ratios correlate with temporarily high earnings so you have price
spikes which aren't rational but happen anyway. For example earnings
of $70 per share in 2015 combined with a P/E of 23 would give a shre
price 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 will
favour price volatility as something to be taken advantage of rather
than something used against them and so an expectation of a valuation
above intrinsic value at some point in the future (even with the
time not known that is not important) will provide an excellent
exit strategy. For this reason there has to be a notion of what
"above intrinsic value" is, rather than resorting to an arbitrary price
or 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 momentum
which increases prospects looking one year out when this point is
taken in isolation, (3) the higher volatility of Apple's stock price
should make the time in which price intersects intrinsic value shorter
than the average time you need to wait (generally less than 7 years,
likely more frequent with a more volatile company more prone to periods
of euphoria and disillusionment).
- Manlobbi
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