Apple Inc.'s 10th anniversary smartphone will be the ultimate in cool when it launches this fall. But is cool really worth $70-billion (U.S.)?
That is how much Apple's market value has surged in less than two weeks. The immediate catalyst was an earnings report on Jan. 31 that revealed the company had ended a three-quarter streak of declining revenue, but the broader rationale has been growing optimism about the gadget maker's ability to return to sustainable growth.
Apple shares closed Monday at a record high after Goldman Sachs boosted its stock price target and gushed about the potential of the upcoming phone, which is expected to go by the funky name of iPhone X and arrive slightly more than a decade after the original device was introduced.
In all fairness, the rumours about the new iPhone sound enticing. Goldman's note, for instance, drops tantalizing hints about the gadget's "augmented reality" abilities. But viewed from a slightly more skeptical perspective, you could say that augmented reality is precisely the problem. Investors get into trouble with tech companies because they buy into the hype about what's coming next. Pouring money into a stock on the basis of vague rumours about a yet-to-be-released product is nearly always a bad idea, even if that augmented version of reality is connected to a company as renowned as Apple.
So people may want to try a less exciting but more down-to-earth way of viewing the company's stock. Let's assume that Apple follows the path typical of many successful technology companies – one where revenue continues to grow and profits continue to be strong, but the pace of growth slows and margins shrink as competition takes its toll.
Aswath Damodaran, a professor of finance at New York University, performed this painstaking exercise in number crunching just a few days ago. His calculations value Apple at $129 a share, a few dollars below where it is trading right now, and considerably below the $150 a share that Goldman believes is reasonable over the next 12 months. Prof. Damodaran wants to make it clear that he's not being critical of the tech giant when he attempts to anchor expectations around it. "Apple is the greatest corporate cash machine in history and it is fully deserving of its market value," he writes in his blog, Musings on Markets.
The problem is simply size, he notes. It's difficult for a company worth $700-billion to create enough disruption to significantly change the trend line of its earnings, cash flow and value.
The recent 10-per-cent gain in its share price demonstrates the problem. The $70-billion surge in the company's value over two weeks was larger than Bank of Montreal's entire market capitalization. To get near Goldman's $150-a-share target, Apple would have to add value roughly equal to a Royal Bank of Canada over the next year.
Making gains of that size is a daunting task, especially since Apple phones already account for one in every five smartphones sold worldwide. The company rakes in about 92 per cent of the profits in the sector, according to Canaccord Genuity analyst Michael Walkley. There's simply not a lot of obvious room to grow.
In his analysis, Prof. Damodaran assumes Apple's revenue will expand at 1.5 per cent a year for the next five years and 1 per cent thereafter, while its operating margin will decline from lush levels of more than 29 per cent to 25 per cent. Those figures seem reasonable for a mature company of Apple's size, but those who disagree can download the professor's spreadsheet from his blog and insert their own assumptions. If they do so, they're likely to find that it takes aggressive assumptions to derive a value for Apple's stock that is considerably higher than its current price. That doesn't mean it can't happen, of course, but it does underline just how difficult it has become for a company of Apple's size to outperform the rest of the market.
This should not come as a surprise to anyone who has followed the stock closely. During the five years between September, 2011, and September, 2016, Apple produced near identical returns to the S&P 500. It lagged behind the S&P Information Technology Index.
The smartest way to play Apple at this point may be as a contrarian bet, owning it when pessimism is running high and selling it when optimism picks up. That is more or less what Prof. Damodaran has done. He bought it in the late summer of 2015, when his calculations showed it was undervalued. Today, he stands ready to sell if the shares hit $140, the upper level of what he considers a reasonable valuation.
Until investors learn to live with Apple as it is now – a slow-growing giant rather than a nimble upstart – he believes its share price will continue to swing wildly, in line with market moods. "I hope to take advantage" of those fluctuations, he writes. You may want to make a similar resolution and note it on your new iPhone.