Apple: Valuation Is Getting Steep

Summary:

• Apple’s stock is currently close to an all-time high, with the upcoming WWDC conference potentially serving as a catalyst for further growth.
• The company enjoys a strong competitive position due to its marketing strategy and high customer loyalty.
• However, the stock’s valuation is becoming hard to justify, making it a better option for those who already own shares rather than new investors.

Apple Inc.’s (NASDAQ:AAPL) stock is currently trading near an all-time high. It’s a remarkable thing to witness. Just last year, tech stocks (including Apple) were down for the count as rising interest rates and a string of disappointing earnings releases took the wind out of their sails. Today, they are thriving, primarily due to excitement about artificial intelligence [AI].

It’s interesting that Apple is being lifted with obvious AI-beneficiary names like NVIDIA (NVDA) and Microsoft (MSFT), because it isn’t particularly well known for AI. The company does not have a chatbot and Siri, its voice assistant that has some AI features, is not well regarded. Apple does have some AI in features like Face ID and voice generation, but it isn’t making big moves in LLMs, the type of AI that’s making waves today.

It could be that investors like Apple’s buyback program. The company authorized $90 billion worth of buybacks at its last quarterly earnings release; according to YCharts, the company did $20 billion worth of buybacks in March alone. Apple is a very profitable company, and it can certainly afford the buybacks it’s doing. With that being said, the company experienced negative growth in net income last quarter, buybacks only pushing EPS growth up to 0%. So, we have a richly valued stock with not a whole lot of growth.

My opinion on Apple at these levels is mixed. I’m not selling the shares I already own, but I’m not buying at these levels either. My average cost on AAPL is much lower than the share price, so I can afford a minor drawdown. Somebody buying afresh at today’s prices might not have a great experience.

Apple is a great company, but its valuation is getting hard to justify. According to writer Daniel Pronk, 12.5% of Apple’s returns over the last decade have come from multiple expansion. If that’s the case then multiple contractions, brought on by slow growth, more interest rate hikes, or some other combination of factors, could suppress the stock price quite a bit. For this reason, I consider Apple stock a classic ‘hold,’ a stock that is fine to continue holding if your average cost is much lower than the current price, but probably not the best stock to invest money into today.

The Obvious Catalyst

Before going any further, I should be clear that Apple has an obvious catalyst on its hands: the upcoming WWDC conference. At the conference, Apple is expected to launch a new VR headset, marking Apple’s first new product category in years. Apple product launches tend to be successful. The Apple Watch quickly became the world’s #1 smartwatch by a wide margin, and wireless AirPods do more revenue than several major tech companies combined. If Apple’s headset is a success, then it could be a totally new line of business that leads Apple to resuming its previously high growth. In a best-case scenario with the headset, Apple could be worth more than today’s stock price, without a doubt. However, it isn’t prudent to speculate on the success or failure of product launches, which aren’t predictable.

Competitive Position

Next, we can look at Apple’s competitive position. Apple enjoys many advantages over its competitors and has an economic moat that can’t be breached.

Far and away Apple’s biggest advantage is its marketing strategy. It has one of the most valuable brands in the world, according to several market research firms, and it has a unique ecosystem strategy that incentivizes customers to buy multiple products. Apple products all sync their data in the cloud; when you buy a new Apple product with an Apple ID, your photos, saved password and music are immediately ready to go. No other tech company has this level of integration. Alphabet (GOOG) comes the closest: you can sync data across your phone, tablet and smart home with Android, but Google laptops are not widely used, so one piece of the puzzle is missing.

For the reasons listed above, Apple enjoys high customer loyalty and a strong competitive position. It’s not #1 in every category-Android for example has more installs than IOS-but it’s in the top two in almost all of its markets, and it’s #1 by revenue in several.

Valuation

Now for the reason why I’m not buying more AAPL, despite the praise I just gave it:

The stock is getting very pricey.

At today’s prices, AAPL trades at:

• 30.6 times earnings.
• 7.5 times sales.
• 45 times book value.
• 25.8 times operating cash flow.
• 29.52 times free cash flow.

It’s a pricey stock. It’s pricier than the weighted average of the NASDAQ-100, which is currently at 23.72 times earnings. Furthermore, if you assume 0% growth and discount Apple’s trailing 12-month free cash flow at the 10 year treasury yield, you get only a $165 fair value estimate, which is below the current stock price. If you include a 6.3% risk premium, you get a mere $61.1 FV estimate. So it would appear that Apple stock lacks a margin of safety here. You need to assume future growth for the investment to make sense. If Apple’s anticipated VR product and the next iPhone succeed, then maybe it will in fact get that growth back. But under the strictest value investing methodology, Apple is not a buy here.

Why I Continue Holding

Having established that Apple’s valuation is stretched, I should explain why I’m not selling Apple stock here.

First, my average cost ($135) is well below the current price. I could take a 20% drawdown and still have the money I invested in 2022 be well spent. There’s little reason for me to be hyperactive, especially since Apple pays a little bit of dividend income.

Second, my stock selection methodology isn’t pure value investing. I’m closer to value investing than any other approach, but I do think that future growth can sometimes be anticipated and intelligently purchased. In Apple’s case, there are two major product launches coming up in the second and third quarters: the likely VR headset on Monday, and the iPhone 15 in September. It doesn’t strike me as unreasonable to expect these launches to drive some growth. In the first quarter, Apple was many months out from its most recent major product launch, and had Christmas shopping in the rearview mirror. It’s not surprising that there was no growth in that period. In the third quarter, Apple will be launching a new flagship phone–I’d expect some growth there.

Risks and Challenges

My position on Apple is very close to neutral right now. Great company, high stock price-it’s a mixed picture. I’ll certainly keep holding my shares. As for those taking positions now, there are risks-to longs as well as shorts.

• Risk to longs: underwhelming response to the VR headset. If Apple’s expected VR headset announcement underwhelms Wall Street, or if there is no new product announced at WWDC, then Apple’s stock could experience turbulence. Apple’s growth rate was approximately 0% last quarter. The idea that this company can return to growth soon-and it needs growth in order to be worth its current valuation-largely hinges on successful product launches. If the VR headset launches and is a hit, and if the iPhone 15 is a hit as well, then AAPL stock could easily do well for the remainder of the year. If not, earnings may disappoint leading to poor stock performance.
• Risk to shorts: continued buybacks. Apple’s most recent buyback authorization was for $90 billion, or 3.4% of the float. According to fund manager Mohnish Pabrai, buying back 50% of a stock (with no earnings change or multiple expansion/contraction) yields a 100% price gain. Based on the table Pabrai used to show this, it would appear that Apple could move its stock price up a few percentage points by deploying all $90 billion in buyback cash over the course of a year. The table shows that the gain from buybacks under ‘no change in earnings or multiple’ assumptions is 1/(1 – percentage of float bought back). A 3.4% buyback should therefore yield a 3.5% price gain, all other things the same. That’s not even counting Wall Street’s possible joy at seeing the buybacks being executed.

As you can see, there are significant risks to shorts as well as longs here today. Which is why I think Apple is a stock best suited to those who already bought it in the past. If you’re sitting on a nice sized gain, just ride it out. As for deploying cash today, there are better places to look.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of AAPL, GOOG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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