Over the past year, Apple (AAPL, Financial) has been on an absolute tear. Since early 2019, the stock has more than doubled from ~$150 per share to ~$310 per share. As shown below, much of this appreciation has been attributable to an increase in the stock’s price-to-earnings (P/E) ratio.
Today, AAPL trades at roughly 23.7x consensus forward earnings of $13.1 per share for fiscal 2020. A year ago, the stock traded at roughly 12.9x forward earnings on fiscal 2019 (which ultimately came in at $11.9 per share). Said differently, about 10% of the increase over the past year has been attributable to EPS growth, with the remainder driven by an increase in the forward P/E ratio.
While this has resulted in impressive returns for Apple shareholders in the short-term, this is a double-edged sword. I say that because the company is in the midst of an unparralled capital returns program – most notably through share repurchases. As management has noted on recent conference calls, their goal is to return the balance sheet to a “net cash neutral position over time.” Unless they change their current approach through methods such as special dividends, larger acquisitions, or a temporary pause to the "net cash neutral" objective, that means that we will continue to see outsized share repurchases over the coming years. By my math, if the company hopes to reach net cash neutral over the next five years through fiscal 2024, that implies somewhere around $300 billion of repurchases. This is not a trivial decision.
Some math shows why (I use a few other assumptions to draw these conclusions, most notably low-to-mid single digit revenue and net income growth). As shown below, if the company repurchases $300 billion of stock over the next five years at the current forward P/E of 23.7x, I estimate that they will repurchase roughly 4% of the outstanding shares a year. The net result will be an 18% reduction in the share count over the next five years.
On the other hand, if the stock had stayed at the valuation of a year ago, I estimate that Apple would've repurchased 8% of the outstanding shares every year. As a result, the diluted share count would have declined by roughly one-third through fiscal 2024.
This results in a material difference in the terminal period. In the first scenario, I think Apple will earn around $17.2 per share (assumes ~$65 billion in net income). But if the stock had instead maintained a forward P/E ratio in the low double digits, diluted earnings per share (EPS) in 2024 would be $21.1 per share, 23% higher than in the first scenario. In terms of EPS growth, the compounded annual growth rate (off of 2019) would be four to five percentage points higher in the second sceario. This is not an immaterial difference.
Warren Buffett (Trades, Portfolio) of Berkshire Hathaway (BRK.A, BRK.B) discussed this idea in his 2011 shareholder letter:
“Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period? I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.
If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the “high-price” repurchase scenario had taken place.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon.
Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus. And here a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.
In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million, I will abandon my famed frugality and give Berkshire employees a paid holiday.”
That same logic applies to Apple (of which Berkshire owns nearly $80 billion of the stock at the time of writing). Long-term Apple shareholders, of which I’m one indirectly through Berkshire Hathaway, are worse off as a result of the significant stock price appreciation over the past year.
I know many Apple shareholders are excited that their stock has appreciated so materially over the past year - but barring any changes in the company's capital allocation plans, this development will ultimately become a material headwind to the company's per share earnings power.
If you plan on holding this stock for the next five-plus years, and do not expect management’s capital allocation decisions to be materially affected by the stock price (as I do), you should hope that the stock sees it’s P/E multiple contract significantly in the near future. If you own Apple, whether you agree or disagree with that conclusion may shed some insight into whether or not you truly want to own this company for the long-term or if you’re just hoping to trade in and out of the stock.
Disclosure: Long BRK.B
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