Apple: What You Can't Know, What You Can Know

I had an interesting debate recently with a Portfolio123 user who was big on combining stock screening with a subjective company-by-company analysis focusing on things like whether the company's business is understandable, whether it has a durable competitive advantage, whether it has a talented management team, and so forth. (If this strikes you as a Warren Buffett-esque approach, you're right; Buffett's name often came up in the discussion.)

In playing devil's advocate, I asked how confident he could plausibly be in his ability to accurately assess such issues. I'm concerned that well-meaning investors armed with books that present an overly idealized view of what you can learn by studying a business overestimate how much they know and, hence, wind up making bad decisions.

A Case Study: Apple

Let's focus on Apple (AAPL), which ought, one would think, be easy to decipher given how widely talked and written about it is.

Consider iPad, which is likely to pay a big role, for better or worse, in Apple's ongoing profit trends and stock price. Many of us have seen it; some of us own it; most of us believe it's either a game-changing milestone or an over-priced toy, and, it seems, everyone has an opinion on how well or poorly it will do.

The Art, Science And/Or Voodoo Of Forecasting

Unfortunately for forecasters, nobody can really predict what's going to happen. The forecasts you see depend, by necessity, on a chain of assumptions many of which are themselves highly uncertain.

Prognosticators can start with plausible assumptions about population and the percent of people who own laptops, iPods and/or iPhones. From there, however, we shift to guesswork. What percent may add iPad to their existing repertoire of gadgets? How many may take this as a first such gadget? How many more might buy it if or when prices get cut? How far will prices have to fall to boost demand? Might Apple introduce super higher-priced adaptations? What new apps might come out that persuade detractors to switch gears and jump on the iPad bandwagon? What will the pattern of growth look like, meaning how fast will market penetration ramp up from zero to a "normal" level beyond which general economic factors will play a bigger role (as may now be the case with iPod)?

If you haven't got a headache by now, consider that iPhone 4. We need to engage in similar exercise for that. We also have to make assumptions about how competitive efforts from Research In Motion (RIMM) and the Android consortium developing between Google (GOOG), Verizon (VZ) and Motorola (MOT) and potentially others. Speaking of competition, we have to assume a slew of iPad killers will be launched and wonder if any will rise above the crowd.

Bad News, Worse News, Good News

This looks bad. We don't really know as much about Apple as we might have thought we did.

Now, for some good news. Investors can live with the uncertainties described here because there are, actually, a lot of other highly relevant things you can know about Apple that will help you make a thoughtful yes-or-no decision about the stock.

The solution is to be found in the numbers, things we can know. If we can learn to move beyond the "past performance is no guarantee . . . " mantra foisted upon investors by lawyers and regulators, we'll find a wealth of information that can help us develop very reasonable assumptions about the future.

Growth Rates


Let's consider Sales and EPS growth rates for Apple, which are shown in Table 1. As you review the numbers, bear in mind that the original iPod debuted in late-2001 and the original iPhone came out in mid-2007.

Table 1 - Annual % Growth Rates

	2002	2003	2004	2005	2006	2007	2008	2009
Sales	7.1	8.1	33.4	68.3	38.6	27.2	52.5	14.4
EPS	267.8	4.1	267.0	351.4	46.3	73.4	72.6	33.9

When iPod was born, consumers didn't quite know what to make of it or iTunes and we see a slow build in sales. As to the mega-percent gains we see in early-decade EPS, brush them aside. I haven't dug deeply yet but pending further review, I'll assume those reflect unusual gains or charges, not recurring business trends. Starting in 2004, though, it looks like iPod began to pick up serious traction, helped probably by consumer familiarity, increasing comfort with and credibility for iTunes, and new iPod variations. This isn't an idle history recitation: notice how those developments translated into numbers.

By 2007, though, we saw some deceleration since by then, many owned iPods and felt no need to buy new versions. We also see the upward jolt resulting from iPhone's debut. Notice, too, the quick deceleration in 2009. Note the pattern: an initial ramp-up, as market penetration went from zero to something, followed by a leveling off.

Hold these thoughts. Let's now move on to something else.

Valuation

Table 2 shows some basic valuation metrics.

Table 2 - Annual % Growth Rates

	AAPL	Industry Median
PE (using estimated EPS)	20.17	17.57
Projected LT EPS Growth Rate	17.5%	15.0%
PEG Ratio	1.15	1.17

That should give pause to those who say Apple is overpriced. The valuation might actually be OK. It all depends on the reasonableness of the earnings projections.

Analysts are looking, on average, for a 49% EPS gain in 2010.

Does that make sense? Go back to Table 1 and look at how the catching on of iPod and the ramp-up of iPhone impacted results. We can't expect the current new products to match because they will not be as large a proportion of Apple's total business as the old pioneers were. But the gain analysts expect in 2010 is well below what we see associated with prior new launches. So analysts are leaving room, quite a bit of room, for the new products being smaller portions of the total business and for potentially slow initial consumer adoption. Bear in mind, also, that estimated 2010 results reflect two major product launches, iPad and iPhone 4, in contrast to the past, when major launches occurred one at a time. There's a lot that can go wrong that can cause Apple to miss the target, but that's always the case in Corporate America. Based on what we're seeing here and now, I'm inclined to accept the projected 49% 2010 EPS gain. That means the 20.17 forward PE presented in Table 2 is legitimate.

Now, look at the projected long-term (assume three to five years) 17.5% EPS growth rate and notice how modest it is compared to what Apple has achieved in recent years. While nobody knows if iPad or iPhone 4 will take over the world, it seems clear that such a level of success is not necessary for the company to hit the 17.5% growth projection. All that's needed is for the iPod to not fall off a cliff (or if it does, to at least have the fall cushioned by increased iTunes sales based on a larger customer base) and for the new products to have at least moderate success. Anyone comfortable with these unspectacular assumptions should be willing to accept the 17.5% growth-rate target, which would make the 1.15 PEG ratio legitimate.

What We Now Know

This is just a sample of the analytic process, so there's a lot more that can be done with Apple's financials. That said, even this gives investors a lot to go on than they get by watching or participating in the endless and often virulent debates between Apple fans and Apple haters.

We still don't know the future, but we have learned some important and relevant things: (1) while numbers that depict past performance guarantee nothing, they can teach us a lot about the dynamics of a business, and (2) it won't take nearly as much success as many assume in order to justify Apple's current stock price.

Subjective issues like durable competitive advantage, etc. are fun to contemplate, but if you really want to make thoughtful decisions about stocks, you really need to work with the numbers.