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Last updated: February 12, 2013 7:33 pm
The Apple saga is a reminder of how quickly momentum can shift in financial markets. Just six months ago, having released the iPhone 5 and with its stock price peaking at $705, the tech company that changed the way we live and created fabulous wealth for investors was on top of the world.
The months since have not been kind – either to a company with more cash than it knows what to do with, or to investors confused and divided about what to do next. With expectations high, market reaction to the iPhone 5 was a disappointment. Apple’s stumbling response to minor problems (such as its Maps app) accelerated a sell-off that led the stock price to drop to $500 at the turn of the year. January’s earnings report, showing slowing revenue growth and pressure on operating margins, resulted in a fall to $440.
This has led to soul-searching among current and potential investors. Is the price drop an opportunity to buy into one of the world’s great companies at a bargain price or is there more pain to come?
To make that judgment, it is worth recognising that, as with all publicly traded stocks, two processes are at play. The first is the stock’s value, driven by fundamentals: growth, risk and cash flows. The other is the price, set by demand and supply. Here, the fundamentals are one input among many, along with momentum, fads and hype.
Apple’s mix of momentum, growth and value investors, and a rumour ecosystem that feeds trading means the two processes can yield very different numbers. Investors have to make judgments: first on the stock’s value relative to price; and second on whether the gap will close.
The first question is answered more easily than the second. Apple has $137bn in cash and net income exceeding $40bn in the most recent year. I estimate that with conservative forecasts – modest revenue growth (6 per cent) and declining margins – its value tops $600 per share. You can arrive at a value of $460 – close to the current stock price – with no revenue growth and significantly lower margins.
The second question is more difficult because the momentum is not in Apple’s favour. Institutional investors who piled into the stock as it rose are abandoning ship – and equity research analysts, who were the stock’s biggest cheerleaders, are lowering their target prices.
When pondering whether to invest, you must pass two tests before you act. First, are you willing to buy Apple as a business rather than as a stock, and accept healthy cash flows as your pay-off, even if the market does not come round to your point of view? That would require a long time horizon and a strong stomach. Second, do you believe there is in prospect a catalyst that would move the stock price, disrupting market momentum? It could be a product announcement, a stock buyback or an activist investor with deep pockets and persistence. That is why, no matter what you think of hedge fund star David Einhorn’smove last week to sue the company and force it to grant preferred stock to its stockholders, it is potentially good news because it is making waves. One of the most critical lessons of value investing, however, is that if you wait until the momentum shifts in your favour and a catalyst appears, it will be too late.
Apple is no helpless bystander. Its actions have fed the noise machine and contributed to its stock’s volatility. It can do three things to help its cause. First, it should behave more like a business and less like a national security agency. Secrecy on everything from products to plans for its cash may once have worked as a marketing ploy, but the information vacuum created in markets has been filled with misinformation and distractions.
Second, it must recognise its status as a mature company with growth prospects and behave accordingly, returning more cash to stockholders and being open to alternative financing vehicles. Third, it must change the narrative, which for the past year has been almost entirely about smartphones – a lucrative market but one in which competition will inevitably force down margins.
Apple is more than an electronics company. Its success has come from combining elegant design with innovative thinking to disrupt settled markets from portable media players and music retail to smartphones and tablets. To reclaim its lost sheen, it must find new sectors to disrupt.
The writer teaches corporate finance and valuation at the Stern School of Business, New York University
This article has been amended since original publication to reflect the fact that Apple’s net income in the most recent year exceeds $40bn, not $40m
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