To better help us understand Intrinsic Value, let's look at two completely different companies. Both are making money and doing fairly well. One is well known and one is not. The first one is Apple Inc. The second one is a small ($70 million in annual sales) company that focuses on regional delivery of air freight and aircraft servicing equipment (such as deicing and catering lifts). For simplicity, we are not going to look at their balance sheets. Instead, we are only going to focus on earnings. To summarize their earnings picture:
- Apple's 2007 earnings increased by 71% ($4.04/share vs. $2.36/share in 2006); trailing 12 month earnings are $4.56/share
- Air T's 2007 earnings increased by 22% ($.94/share vs. $.77/share in 2006); trailing 12 month earnings are $1.29/share
How much growth?
If instead we assumed earnings growth of 20% per year for the next 10 years for each company, you would get the following (I'm discounting using 5%, which is roughly the current yield on high quality corporate bonds):
AAPL:Keep in mind that we are not looking at any assets as part of intrinsic value, just earnings. While it would cost money to do so, the Apple brand clearly has a lot of value (goodwill) that could be monetized through licensing, royalties, etc.AIRT:
- Year 10 earnings of $28.11/share, present value is $17.26/share
- The discounted earnings for the next 10 years add up to $101.74/share
- Year 10 earnings of $9.42/share, present value is $5.78/share
- The discounted earnings for the next 10 years add up to $32.26/share
Is this good or bad?
What does all this mean? As of yesterday (2/5/08), AAPL closed at $129.36/share and AIRT was at $10.83. Assuming these companies can grow earnings at 20% per year (10 years is a long time--life in prison sometimes lasts only 7 years), we can say the following:
- AAPL's current price, about $130, indicates it's going to grow earnings at about 25% for the next 10 years
- AIRT's current price, about $10, implies it's going to grow earnings at about 1% for the next 10 years
This leads me to believe that even 20% earnings growth may be optimistic. Still, let's leave the 20% earnings growth estimate for both companies. Here are some additional thoughts, starting with Air T Inc:
- If 20% earnings growth is sustainable, AIRT is currently priced at about 40% of its intrinsic value
- Even if earnings grow at only 3% per year, AIRT is still about 10% below its intrinsic value
- AIRT has a great financial position (see my previous post) which, combined with the upside potential, provides a nice margin of safety
- About half of AIRT's business depends on Fed Ex (risk); with that being said, they have been working with Fed Ex since 1980 (stability)
- Assuming a 20% earnings growth for 10 years, at $130, AAPL is still priced about 30% above its intrinsic value
- At $130, AAPL's earnings will have to grow at about 25% for the next 10 years to justify this price (i.e., for the Intrinsic Value to be about $130/share)
- AAPL also has a great financial position, although it needs lots of cash to constantly reinvent itself and its products (I have 4 Apple computers; each one was only sold for about a 6-7 month period before being replaced by a newer model)
- Ten years is a long time; about 10 years ago, rumors of AAPL's demise and even bankruptcy were widely circulating
While I am inherently bullish on both companies, AAPL has lots of execution risk and most (if not all) of the upside is already built into its current price. As it's currently priced, AAPL's earnings will need to continue to growing at about 25% despite economic downturns, competitive pressures, and shrinking margins--not to mention the vagaries of consumer likes and dislikes. In contrast, AIRT is priced very attractively. Even at modest single-digit earnings growth, AIRT is below its intrinsic value. The company's strong financial position also provides a nice margin of safety.
7 comments:
AAPL
Year 10 earnings
4.04 * (1.2 to the power of 10)= 25.01
How did you get your number?
Sorry about any confusion. To clarify, I used the trailing 12 months earnings to calculate the year 10 earnings. Specifically, for AAPL I used $4.56/share. This gives the value specified. Also keep in mind that I discounted it back at 5% to current dollars. Thanks for the question.
I think you're making the assumption that GE and Chevron will not grow in the next 10 years. How much were they valued ten years ago?
Another thing is your other assumptions of apple will not exist anymore after 10 years. Do you know something that I don't? How do you know that they will go out of business in 10 years (after making 20% growth rate year after year)
WHen you add the constant growth value, you'll see that the valuation will be significantly higher than what you have.
Regardless, this valuation model is far from valid. I honestly and sincerely think that you need to open your finance book again. That's if you actually ever openned one.
I wish you luck in your future endeavors.
To the anonymous comment poster:
"WHen you add the constant growth value, you'll see that the valuation will be significantly higher than what you have. "
Please give your calculation. Very much appreciated.
Could you please expand your comparison and add google to it?
to anonymous asking for my calculation, please check the Seeking Alpha blog about this http://seekingalpha.com/article/63549-air-t-vs-apple-not-even-close
Turley Muller, not me, gave a good explanation on the constant growth model.
The price of the company is basically the present value of the expected future cash flow. Daniel model here tried to explains only the first 10 year of the future cash flow (I said tried to because it's not close to explaining it). First problem is Daniel uses earnings, which is not valid since part of this earnings is needed to fund the growth. See if apple gives all of its earnings to the shareholders, they don't have anything left for R&D, etc, that's needed to keep their growth rate.
Second as I repeatedly mentioned, Daniel's model only explains the next ten years. In valuing company, we usually expect the company to exist indefinitely. Apple will not go out of business in ten years, so it doesn't make any sense to only value the company based on the cash flow for only the next ten years. The good people in the finance world were smart enough to solve this problem by introducing the value for a perpetual cash flow. The formula goes Price = CFnext year/(discount rate - perpetual growth)
Using Daniel model, if we assume apple perpetual growth to be 1%, the constant growth value will come up to be $705, after discounting back 10 years to today's number the value would be $535.
Now if we add that to the present value of the next 10 years earning of $102 by the way, and not $119 as Daniel calculated, since you actually shouldn't include the today's earning to your present value, the value of apple should be $637, which is absurd.
Why do we get this outrageous number? well, a couple of things are wrong in Daniel's assumptions. First of all, the discount rate shouldn't be 5% it should be higher. Second, we shouldn't use earnings, we should use FCFE.
Hope this helps.
How is Apple going to do now with these rumors about Steve Jobs?
Post a Comment