Value or Growth Stock? Pick Your Bite of the Apple

I love to find businesses that supply products or services we can’t live without when they are trading at dirt cheap valuations. This inherently means I spend a lot of time analyzing dull, slow-growth businesses that are really not very exciting. Unless you get all worked up over little things like investment profits.

Today, I stumbled into an analysis of a business that is outside of the dull and boring realm in which I usually find myself. However, once I thought about it for a bit, I can’t believe my devotion to Peter Lynch never caused me to take a really serious look at this business in the past.

Peter Lynch used to talk about going to the mall or talking to his family to find out what was popular. In the case of the business I am analyzing today, it is hard for me to speak to very many of the people I know without running across someone who owns the products this company produces.

Best of all, it is dirt cheap from just about any angle through which you want to view it.

An iconic brand with fierce customer loyalty

When I think of brand loyalty, Coca-Cola (KO, Financial) is the first name that comes to my mind. I grew up in the Atlanta area. When I was a kid down there, the only drinks anyone ever ordered were sweet tea and Coke. And it was almost unheard of to be told: “I’m sorry, we have Pepsi products.” It was Atlanta; the home of Coke. If it was Coke, sweet tea or coffee, it most likely wasn’t served as a nonalcoholic beverage. Pepsi was just short of a fighting word.

Apple (AAPL, Financial) has built a very similar type of brand loyal with its customers. I don’t own any Apple products, but I can’t look far without finding those who do. And they all love them! Personally, I can’t keep up with all the new stuff they come out with.

While I can say I don’t own Apple’s products, I must confess that I do buy them. They tend to be one of the most common brand names I see on the wish lists of those whose names appear on my birthday and Christmas shopping lists. This year is no exception and now my granddaughter has joined the cult. What’s a Poppy to do?

Analyze the stock. What else?

What brought Apple into my target window?

One of the ways I look for investment ideas is by running stock screens that I have developed and refined over the years. I have 16 different sets of screening criteria I use. However, one of them is simply to tell me how many stocks are trading at ridiculously high valuations. This screen just gives me an indication as to how much bullish emotion exists in the market at any given time.

I was quite surprised when I saw Apple show up as the top name on my “Shareholder Friendly” screen. Out of the entire universe of the U.S. markets, only 16 businesses meet my selection criteria for this list.

This particular screen is not specifically geared to identifying value investments. But it got my attention when Apple appeared as the number one name. I think you are going to agree with me that this Apple tastes much better from a value perspective than most of us might realize without a closer look.

How is Apple currently valued by the market?

Based on the consensus estimates of the 49 analysts providing guidance for the current fiscal year (ending September 2016), Apple is expected to earn $9.78/share this year. At last Friday’s closing price of $106.03 per share the current price to earnings multiple (P/E) is 10.84 times earnings. With the Standard & Poor's 500 index currently valued at around 20 times trailing 12 months earnings, this sounds like a cheap price for an iconic brand.

In addition to stellar earnings and a reasonable P/E ratio, Apple also generates rivers of free cash flow. On a trailing 12 months basis, Apple is currently trading at only 9.38 times cash flow. This is absurdly cheap for a brand of this stature and a business of this quality.

How many of the businesses in the S&P 500 are truly household names even among those who don’t use the products? Many are far better known by the brands they sell than the business that owns them. Not the case with Apple. There are probably not more than a handful of literate people in the developed world who don’t know this brand and its strong reputation as a leader in its space.

It is difficult to understand why this quality brand would trade at nearly a 50% discount to the S&P 500 in terms of P/E valuation. It seems to be mostly due to the continued speculation that Apple’s product sales will soon begin to decline. I think those negative rumors first surfaced about 20 years ago. One day, they will probably be right. I don’t know why we should believe today is that day.

An added margin of safety

Unless you have been sleeping under an investment rock for the past few years, it is hard not to know about the massive cash balance that Apple is holding offshore to avoid paying U.S. taxes.

This pile of cash is listed on the balance sheet in the Non-Current Assets section as “Investment and Advances-Other” and totaled $164.065 billion at the end of September. However, when looking at the Current Assets section of that same balance sheet, you will notice that they list an additional $41.601 billion in cash and short-term investments that are held here in the U.S. This means the company has over 40% of its entire market capitalization in cash and short-term investments.

Just how strong is Apple’s balance sheet?

One of my regular methods for assessing the safety a business provides for my capital is to calculate the net balance of cash, receivables and inventory less the total liabilities of the company.

The tables below, from the Fidelity Investments website, provide that information from the company’s most recent SEC filings.

Assets

All numbers are in millions of U.S. dollars.

Liabilities and shareholders' equity

All numbers are in millions of U.S. dollars.

The balance sheet shows cash, receivables and inventory valued at $74.293 billion and we have the offshore cash and short-term investments in the “Non-Current Assets” of $164.065 billion. This produces a total balance of very liquid assets of $238,378 billion or 40.32% of the total market capitalization of the business.

Against this ocean of liquidity, the total liabilities of Apple are only $171.124 billion.

Apple could pay off all of its liabilities and still be sitting on a $67.254 billion pile of liquid value plus the entire business operations as well. Zero liabilities and $67.254 billion left over? How’s that for safety of your capital?

Investors must remain focused on the future

Finding businesses that are financially solid and safe is wonderful. It is even better when they are cheaply valued. But that is not what investing is about. Investing is about allocating capital to businesses that will do well in the future.

One way to evaluate the future prospects of a business is to review its past performance over several years and compare those actual results to the future results being projected. Most successful businesses don’t fall apart over night and most poorly performing businesses don’t fix their problems quickly either.

In the case of Apple, we have a business with a long history of successful growth and a long history of prognosticators predicting its demise. The table below tells an interesting tale when we look at the actual results the company has produced over the past five years in terms of growth and then compare it to the forward projections.

For just about every year for the past five years, the past five years of performance results would have looked similar to the table below and the projections for the next five years to come would have looked quite similar as well.

Apple has always had strong skeptics who believed its great run was over and the company has consistently proven those skeptics wrong. This fact probably has a lot to do with the current low market value being assigned to this stellar business.

Growth

Even though growth is expected to slow significantly from 29.08% annualized over the past five years to 15.34% over the coming five years, 15% annual growth rates would be phenomenal for a business this size and are also well above its current P/E ratio.

One of the items I noticed in performing my due diligence on Apple was a recent announcement that the company was going to work with GoPro (GPRO, Financial) to develop technology that will allow the Apple Watch to remotely control a GoPro camera.

Interestingly, there is some speculation that GoPro is heading for difficulties in the not-too-distant future due to completion in its action camera market. With a product that would be a nice compliment to Apple’s increasing integrated offerings and a market cap of only $2.63 billion, it almost seems like GoPro could easily become a bite for the Apple rather than a bite of the Apple. Its line of personal action cameras would seem to fit nicely into Apple's growing product lines.

What is the current fair value of Apple?

This question is a bit tougher for me than normal because I have never understood how to appropriately value a cool image in intrinsic terms. Because I don’t understand how to do it, I don’t. I can’t describe it on a napkin with a crayon so it doesn’t get done.

In terms I do understand, I believe Apple should be worth a price to earnings growth multiple of at least one times its projected five year forward growth rate of 15.34%. Based on the current year’s projected earnings of $9.78 per share, this calculation produces a current fair value of $150.02 per share or 41.5% above the current price.

Using a slightly less conservative measure, we could apply the average P/E multiple of 20 times earnings and produce a current fair value of $195.60 per share or 84.47% above the current price.

Final thoughts and actionable conclusions

Apple is one of the top global brands of our time. It is currently valued at about half the price of the broad market. The business trades at less than 10 times free cash flow. Its balance sheet contains liquid assets equal to about 40% of the total market capitalization of the business, and the company trades with a PEG of less than one.

There just isn’t much not to like about Apple unless you already own the shares at a higher price. Is the price today the low we will see in the stock? Probably not. Is the value at which we can buy the shares today truly compelling? You bet it is.

Buy Apple now and plan to hold it for five to 10 years, and you are going to be glad you did.