My wife and I gave our first son an Apple II computer for his ninth birthday. When he opened the box, I took the instructions and he took the computer. He had it up and running before I finished reading the instructions.
Legendary mutual fund manager Peter Lynch said that some of his biggest winners came from going to a mall with his daughters, giving them some money, and seeing where they spent it. He argued that, “ If you like the store, chances are you’ll love the stock.” His shopping strategy might be justified by the argument that new stores fly under Wall Street’s radar.
The Apple II was one of my (few) Peter Lynch moments. I saw first-hand how easy the Apple II was to use. Apple AAPL, +1.12% stock back then didn’t pay dividends and its earnings were dodgy, but I bought some stock anyway. I also bought my son Apple stock for his high school graduation present. In retrospect, I was lucky. Dozens of other PC makers did not survive; indeed, Apple itself at times was near-death.
Apple now has evolved into a mature company that derives most of its revenue from its iPhones, which, like the Apple II and, then, the Macintosh, were revolutionary. Apple still makes computers, of course, and has a solid Apple-ecosystem that is used by millions of Apple fans. Apple is now a money machine that can be assessed by value investors.
But is Apple stock still worth buying even at almost $200 a share?
Let’s find out, using three different valuation benchmarks: the John Burr Williams equation; Shiller’s cyclically adjusted price-earnings ration (CAPE), and the Bogle model. (Disclaimer: I hold an imprudently large portion of my stock portfolio in Apple stock.)
The John Burr Williams (JBW) equation is R = D/P + g: R is the total annual return; D is the annual dividend; P is the current stock price, and g is the annual rate of growth of dividends.
Apple’s current annual dividend is $2.92 per share. A $200 stock price gives a dividend yield of 1.46%. That’s a bit less than the 1.80% dividend yield for the S&P 500 SPX, +0.31% as a whole. If Apple’s dividends grow by 5% annually — roughly the long-run growth rate of S&P 500 dividends and the U. S. economy — this implies a 6.46% total return, which is 3.58 percentage points above the current 2.88% 10-year Treasury TMUBMUSD10Y, +0.16% rate.
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A 5% dividend growth rate for Apple seems conservative. Apple’s dividends have increased by 12% a year since Apple instituted a dividend in 2012; Apple’s earnings per share have increased at a 30% annual rate over the past 10 years, and at a 13% annual rate over the previous five years.
Many fear that Apple is no longer a premiere growth stock. It certainly gets harder to maintain a crazy growth rate as a company gets larger but, still, it is hard to imagine that Apple will grow more slowly than the average company in the S&P 500 over the next 10- to 20 years. Plus, there is nothing inherently bad about being a mature money machine. In fact, it may be a safer investment than a young startup with nothing more than hoped-for profits in the future.
Apple has tens (or perhaps hundreds) of millions of devoted customers thriving in the Apple ecosystem, where elegant Apple products are seamlessly interconnected and work right out of the box: iPhones; iPads; iMacs; Apple Watches; AirPods; iTunes; iPods; the iCloud, and more. Apple had been No. 1 in Fortune magazine’s annual ratings of the most admired companies for 11 years running.
To be sure, Apple’s earnings certainly won’t grow by 30% forever, nor will its dividends grow by 10% forever, but a 5% growth rate for dividends is surely conservative. Let’s suppose that Apple’s dividends grow at 10% a year for 10- or 20 years, then drop to a 5% growth rate. The table below shows the implied returns for shareholders who are long-term investors.
A 1.46% dividend yield gives a 6.46% return if dividends grow by 5% a year forever and an 11.46% return if dividends grow by 10% a year forever. If the dividend-growth rate is 10% for a while and then drops to 5%, the return will be between 6.46% and 11.46%, and the return will be higher, the longer the 10% growth rate is maintained.
Are these calculations dependent on the heroic assumption that Apple will be around forever? Not really. The heavy discounting of distant dividends makes them essentially meaningless. The chart below shows the cumulative intrinsic value of Apple’s dividends, if dividends grow by 20% a year for 20 years and 5% thereafter, using an 8.09% required return. Almost all of Apple’s intrinsic value comes in the first 80- to 100 years. If Apple were to disappear 100 years from now, it would have essentially no effect on the current intrinsic value of Apple.
The point of assuming an infinite horizon is to keep us from guessing what the price of Apple stock will be tomorrow or a year from now. The infinite-horizon model makes no assumptions about the future price of Apple stock.
Cumulative intrinsic value of AppleNow let’s value Apple using Shiller’s cyclically adjusted P/E (CAPE), which is the ratio of the current stock price to the 10-year average of inflation-adjusted earnings. Apple’s average inflation-adjusted earnings is $6.60 and, at a $200 stock price, Apple’s CAPE is 30.30. Apple’s cyclically adjusted earnings yield (CAEP), a rough estimate of a stock’s inflation-adjusted rate of return, is calculated by dividing Apple’s average inflation-adjusted earnings by a $200 price for Apple stock: CAEP = $6.60/$200 = 0.033 (3.30%)
Cyclically adjusted earnings are intended to adjust for the ups and downs in business cycles. Movements in Apple’s earnings during the years 2009 through 2018 were not due to a business cycle, but to Apple’s growth. The figure below shows that Apple’s earnings per share (in 2018 dollars) increased a 26% annual rate over the past 10 years. Because of Apple’s rapid growth, the $6.60 average over this 10-year period greatly understates Apple’s current and projected future earnings.
Apple’s inflation-adjusted earnings per shareOne way to adjust a growth company’s earnings for the business cycle is to fit a line to the earnings data, as you’ll see in the next chart, below. The fitted line smooths out the year-to-year fluctuations, as intended, but allows for growth. By this reckoning, Apple’s 2018 cyclically adjusted earnings were $11.05, giving a CAEP of 5.53%, approaching double the value using the 10-year average earnings of $6.60: CAEP = $11.05/$200 = 0.0553 (5.53%)
A regression line fit to Apple’s earningsSince the earnings yield is a rough estimate of the real rate of return on stocks, I compared CAEP to the real interest rate on 10-year Treasurys. The table below shows the calculations, using an assumed 2.5% rate of inflation, the average over the past several years. There is a 2.87 to 5.10 percentage-point difference between the Apple’s cyclically adjusted earnings yield and the real return on 10-year Treasury bonds.
Finally, let’s look at Vanguard Group founder John Bogle’s model for estimating stock returns over a 10-year horizon:
Stock return = dividend yield + annual growth of earnings + annual change in P/E
At $200 a share, Apple’s price-earning ratio would be around 19. The table below shows the returns predicted by the Bogle model for the assumption that Apple’s price-earnings ratio in 2028 is still 19, then falls to 16 (the historical average for the S&P 500), or rises to 22, and that both dividends and earnings grow by either 5% or 10% annually for 10 years.
As with the JBW and Shiller metrics, the Bogle model make sense. If Apple’s P/E ratio stays at 19 and its dividends and earnings grow at 5% a year for 10 years, it will give investors a 6.46% return over this 10-year horizon. If Apple’s earnings and dividends grow by more than 5% a year over the next 10 years or its P/E is higher than 19 in 2028, the rate of return on Apple stock will be higher than 6.46%, perhaps substantially higher. If Apple’s P/E is only 16 five years from now, the returns will be lower, but still better than 10-year Treasury bonds.
By all three valuation benchmarks — Williams, Shiller, and Bogle — even at $200 a share, Apple looks to be a stock you can buy and hold, and be happy you did.
Gary Smith is the Fletcher Jones Professor of Economics at Pomona College and author of “Money Machine: The Surprisingly Simple Power of Value Investing.”
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