Why Carl Icahn’s $216 Fair Value for Apple is Unrealistic

You may have read Carl Icahn’s letter published yesterday in which he outlines why he believes Apple stock is worth $216 per share today. With the stock currently fetching an all-time high of $127, making it the most valuable company ever, you might be wondering if a company already worth nearly $750 billion can really still be 70% undervalued. Quite simply, I do not believe so. Let me explain why.

First, I think it is helpful to look at a snapshot of the last five years, to give you an idea of where Apple stock has traded relative to its business fundamentals. Below is a chart I constructed that shows Apple’s revenue, earnings per share, ending stock price, and ending P/E ratio since fiscal 2010, along with consensus forecasts for the current 2015 fiscal year and Carl Icahn’s above-consensus estimates.

apple-feb-2015From this chart you should be able to see how Icahn is getting such a sky-high fair value estimate for Apple; he’s using an extremely optimistic P/E ratio assumption. There are many reasons why Apple shares are unlikely to fetch a P/E ratio of 20+ ever again. Some that come to mind are:

1) Apple’s current size – With annual sales of over $200 billion, investors are unlikely to assume dramatic growth rates from here, which limits the multiple of earnings they are willing to pay.

2) Apple’s industry – Though it may be hard to fathom right now, the tech sector has a decades-long history of musical chairs when it comes to market dominant companies, so investors often will discount their valuations if it seems as though things can’t get much better and a technological shift in consumer preferences is likely at some point in the future.

3) Apple’s poor capital allocation – When you are keeping $141.6 billion of net cash on your balance sheet investors will not always give you full credit for it since it is not generating an adequate return. When the cash pile reached $100 billion people were miffed and the hoard is more than 40% higher. For comparison’s sake, Apple’s total cash outlay for capital expenditures and acquisitions was $13.5 billion in fiscal 2014, making their cash “buffer” equal to more than 10 years’ worth of growth investment.

4) Apple’s historical valuation – Over the last five years Apple’s average P/E ratio at the end of its fiscal year has been 15. Carl Icahn’s insistence that Apple is worth 50% more than that does not make much sense. Over that five-year period Apple’s sales have tripled. A higher P/E ratio usually implies the expectation of higher growth. It will be very difficult for Apple to triple its business over the next five years, which would mean that the average P/E ratio during that time could very well be less than 15 (not over 20).

So what do I think Apple stock is worth? Well, first off let me point out that I am far from an Apple bear. I have been long the stock for many years and some of my clients have an average cost basis in the single digits per share. I just think investors’ expectations should be more muted than Carl Icahn’s. Consistent with the points outlined above, I think Apple shares will trade at a P/E ratio between 10 and 15 going forward. Using a $9 EPS figure for fiscal 2015 and giving the company full credit for its cash position, that gets you to a range of $114-$159 with the midpoint being $136 per share. Relative to today’s price of $127 Apple stock is neither dramatically overvalued nor undervalued.

 

4 thoughts on “Why Carl Icahn’s $216 Fair Value for Apple is Unrealistic”

  1. I don’t really disagree with you, but just to play devil’s advocate:

    1) Apple’s current size – With annual sales of over $200 billion, investors are unlikely to assume dramatic growth rates from here, which limits the multiple of earnings they are willing to pay.

    True, but that’s been a concern for quite a few years now and has proven to be wrong. So far. Yes, they can’t grow to the sky.

    2) Apple’s industry – Though it may be hard to fathom right now, the tech sector has a decades-long history of musical chairs when it comes to market dominant companies…

    This is a fundamental question. A lot of ppl have feared the commoditization of their products. Some ppl (e.g., Einhorn, Uncle Carl, etc.) believe the ecosystem strength will sustain them and even strengthen them (assuming they don’t do something stupid, of course).

    3) Apple’s poor capital allocation

    But they’ve been doing buy-back, dividends, and taking on debt. How much debt do they have now? 30-40B? We need to factor that in. They don’t want to repatriate their overseas cash. Need to look at net cash. They just announced a new bond sale a couple days ago.

    4) Apple’s historical valuation

    Yes, but it’s proven to have been wrong. Amazon is doing ~ 90B in sales. Why aren’t they penalized for the “law of large numbers” and given a P/E < 15, since they can't seem to actually make any money? I know, it's all about growth… but the point is, Apple has in fact grown *profitably* with a very conservative P/E whereas the Amazons and Teslas are growing unprofitably and sporting sky-high multiples.

    But yes, there's two ways for that to correct, and I suspect the other P/Es will be coming down.

    I am long AAPL although I've been selling into this strength. I bought back when AAPL was doomed at the end of '12, so I agree that much of the upside has already been realized.

    1. Good counterpoints. I’ll add some more figures to back up the original points…

      Re: Law of large numbers:
      Fiscal 2011 sales growth was 66%, followed by 45% growth in fiscal 2012, 9% growth in fiscal 2013, and 7% growth in fiscal 2014. It won’t be a perfectly linear relationship (2015 acceleration), but for the last 5 years it has been pretty strong.

      I like the ecosystem thesis, but I wonder if investors will give them credit for this in terms of valuation, or if in fact it will just prove true and allow the company to get bigger than many thought it would.

      I agree that “net cash” is the way to look at it since they started doing bond deals. However, their net cash position right now is $142B (an all-time high). The figures for fiscal 2010-2014 were: $51B, $82B, $121B, $130B, and $120B. It’s not really going down at all. If they took it down to, say, 10% of their equity cap ($75B), I’d leave them alone on this point (and Icahn likely would too).

  2. Also, not completely disagree, but these arguments feel a little weak overall, and do not rely on the assessment of the business.

    For example, “I like the ecosystem thesis, but I wonder if investors will give them credit for this in terms of valuation”. So you are wondering what other people are wondering. It sounds like speculation to me.

    Long Apple too.

    1. Yes, I am speculating as to whether the market will assign Apple a multiple equal to or above the S&P 500. Since I don’t believe it will, I do not think the most bullish analysts on the stock will be correct. If I don’t make an assumption about the valuation, I can’t make a decision on the stock.

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