Apple stock analysis and valuation - Why Warren Buffett loves it

This week’s casual valuation is Apple. I hope you enjoy these posts and feel free to add your take.

Disclaimer: I do not own shares in Apple.

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The post is divided into the following sections:

• Introduction

• Historical financial performance

• The balance sheet

• Assumptions and valuation

• Valuation based on different assumptions (and discount rate)

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Introduction

Apple is the largest public company with a market cap of almost $3 trillion. We can go look back at its history and admire its outstanding performance, but even if we take a look at the last 5 years, its share price is up over 300%! For comparison, S&P500 is up 60% over the same period.

My one-sentence summary of Apple would be – A technology company with strong brand and pricing power.

At the end of March 2023, Apple was 46% of Berkshire Hathaway’s portfolio.

Since Q1/2016 until today, Berkshire has bought over a billion shares in Apple at an average price of $39.65, leading to a total cost of almost $42 billion. Out of all the shares bought, 123 million have been sold for $12.5 billion, and the remaining 916 million shares have a market value of $171 billion. This leads to a return of 346%, excluding dividends.

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Historical financial performance

Since 2017, Apple provides a split of its revenue into:

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• Products (iPhone, iPad, AirPods, Mac, Apple TV, Apple Watch, etc.)
• Services (Advertising, Cloud, Digital content, App store fees, Payment services, etc.)

Why is this relevant? Well, services naturally have higher margins.

If we take a look at the data related to this split, we'll see that the % of revenue generated from services increased from 14% back in 2017, to 21% today.

This is an important piece of the valuation puzzle. The assumptions regarding future profitability depend on the assumptions about how this will develop in the future. If the trend continues and services increase as % of revenue, then higher profitability should be expected. If the trend reverses, then lower profitability should be expected.

Many analysts point to iPhone as the biggest risk. Back in 2017, iPhone sales were responsible for 62% of all of Apple's revenue. Over the last twelve months, that % is down to 52%. It is still significant and it should not be ignored. If Apple disappoints with the next iPhone model, it will have a significant impact on its profitability, and valuation. It can also be argued that the new models aren't significantly better than the previous ones and come with slight design changes and limited additional features. However, as long as the customers are willing to pay for them, well, that's what matters.

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Let's take a look at the financials and how they've changed over the last 5 years.

The gross profit increased from 38% in 2019 to 43% for the last twelve months (ending April 1st, 2023). Based on the development of the mix between products/services, this doesn't come as a surprise.

The operating expenses (Research & Development, and Selling, General & Administrative) have been incredibly stable, between 13-14% (combined) of revenue. Many investors love predictability, and Apple definitely delivers that.

All of the above translates to an increase in the operating margin from 25% back in 2019 to 29% over the last twelve months.

With revenue of $385 billion, Apple is generating over $100 billion in operating profit per year.

More importantly, during this period, there were two events that impacted most of the companies:

The pandemic (Covid-19) and high inflation.

We cannot see any negative impact coming from these events on Apple's financials. It continued to perform exceptionally even through uncertain and difficult times. The increased costs (due to raw materials, but also higher employee salaries) were successfully passed on to the final customers.

It doesn't come as a surprise that Warren Buffett loves it. What is there not to love?

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The balance sheet

So, what happens with all of the excess cash that is consistently being generated? It is being returned back to the shareholders, via share buybacks and dividends.

Over the last decade, Apple reduced the # of outstanding shares by a third. In addition, its annual dividend payment is over $14 billion per year.

The decision to return cash back to the shareholders is basically the management admitting that they don't have projects to invest in, that will yield acceptable returns. Whether buybacks are the way to go at today's share price, is another question.

If we take a look at the balance sheet, the company has $180 billion of cash, short and long-term investments. Although this might sound impressive, this is roughly 5% of their market cap.

On the other side of the balance sheet, there's $110 billion in debt (including leases).

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Assumptions and valuation

Here are my assumptions for the future:

Revenue growth: 7% per year over the next 3 years, then declining over time to 4%. With this assumption, revenue in 10 years' time increases by 71%

Operating margin: 29%, increasing to 32% over the next decade (I expect services to increase as % of revenue, leading to higher margins)

Discount rate: 11% discounting to 8.7% over time

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After adjusting for what is on their balance sheet, as well as the equity options outstanding, the value of Apple is roughly $2 trillion ($127.24/share).

For comparison, today’s market cap is 2.94 trillion ($186.68/share).

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Valuation based on assumptions different than mine

The future is uncertain and my assumptions could be significantly wrong. Let's take a look at how the valuation (per share) changes if we use different assumptions related to the revenue 10 years from now as well as the operating margin.

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For Apple to be fairly valued, it needs to grow its revenue at 10% annually over the next decade and increase its operating margin from its current 29% to 34%.

At the moment, the market is paying a significant premium for Apple and there is positive sentiment around the company.

Overall, I do like the company, and I can see myself buying shares at a reasonable price. It is quite clear that Buffett got a great deal by buying shares at an average price of $39.65.

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As always, thank you for reading the post and for all the support.