Why Apple Can Create More Value Than Expected?

Simply Wall St.2022-02-23

Apple (AAPL) is the US$2.7 trillion market company that has been continuously performing, and has delivered a 390% return over the last five years. What is it, that makes the company so valuable to ...

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What is it, that makes the company so valuable to investors? In this article, we will analyze the fundamental contributing factors to the company's performance.There are a few main factors that make a company valuable, which ultimately result in high positive future cash flows. These factors can be summed up as:GrowthReturns on capitalRiskProfitabilityAnalysts focus on profits but buy the cash flows.Free Cash FlowsFor Apple, the cash flows are consistent, high, and growing.In the chart below, we can see both past and future projected cash flows for the company. Considering that there are more than 30 analysts covering the stock, we can assume that the average estimates are of high quality.NasdaqGS:AAPL Financial Performance and Future Estimates, February 21st 2022We can see that Apple's cash flows are in-line with profits, reliable and expected to hold or even increase in the future. Apple made US$101.8b of free cash flows in the last 12 months, and they are expected to increase to US$126.6b by Q3 2024.Reinvesting into the BusinessOne of the reasons for this is that the company is continuously reinvesting in the business. Looking at the cash from investing activities, Apple spent some US$22b on investments in the last 12 months. However, Apple is a mix between a software and consumer electronics company, so there is a good argument to be made that part of the main assets the company has, are intangible and stem from their R&D expenses.When we capitalize the last 5 years of R&D research, we get a value of the research asset of US$57b, of which, a record US$23b were invested in the last 12 months. Clearly, the company has some big plans in the future, and the expected growth rates are backed by hard investments into the business.We need to net out depreciation, add back change in working capital (cleanup) and the result of both investments, is a total reinvestment of US$37b in the business!Note, that instead of cash from investing activities, we can just use CapEx - Analysts may choose different approaches.Fundamental Growth and ReturnsThere are multiple ways we can come up with expected growth rates.Management has internal estimates that usually go forward a year. Analysts on average seem aligned with these estimates, partly because it is the easier route to take, but also because they have someone to blame if things don't go as planned. The problem with management guidance, is that it can be wrong in a critical moment, as management has an incentive to give the most plausible optimistic projection on the future.Alternatively, we can see what management invests and use the return of investment to calculate a growth in operating income. To get that, we first need the returns.Return On Capital Employed (ROCE)For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. The formula for this calculation on Apple is:Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)0.50 = US$117b ÷ (US$381b - US$148b) (Based on the trailing twelve months to December 2021).So, Apple has an ROCE of 50%.  That's a fantastic return and not only that, it outpaces the average of 11% earned by companies in a similar industry.The company has also surpassed past returns of 26%, which is a great sign for more value creation.NasdaqGS:AAPL Return on Capital Employed February 21st 2022Now that we have the return, what does it mean for future growth rates?There are a few steps, but here is how it goes:First, we take what the company has reinvested in the business in the last 12 months.For Apple, that is the sum of capital investments + last year's R&D investments, which, as we mentioned before, comes up to US$37b.We use this number to get a reinvestment rate, by dividing it to net operating profit after tax (NOPAT), this yields a reinvestment rate of 34%.Finally, to get an expected growth in operating income (EBIT) we need to multiply the return on capital of 50% with the reinvestment rate of 34%.For Apple, the expected fundamental growth in operating income is 34.14% * 50% = 17%In terms of numbers, this means that we can expect next year's EBIT for Apple to be 117*(1+0.17) = US$137b on a fundamental basis!Risk and Creating ValueWhile there are many ways we can measure risk (CAPM, Standard Deviation of stocks, Multifactor models, etc), the old and reliable approach is to measure risk through the eyes of the marginal investor. This means that we align our view with how big price movers evaluate risk.For Apple, that can be either the cost of equity or the cost of capital.The cost of equity is 6.7% and the cost of capital is closer to 7.3%.The main difference between the 2 measures is that the cost of capital accounts for the US$123b of total debt in Apple.Why is the cost of capital important?In essence, this is what allows us to evaluate how much value a company is creating. By subtracting the cost from the return on capital (ROCE), we see that Apple is creating net positive value.Excess Value = 50% - 7.3% = 42.7%This is a staggering amount, especially when you consider that the company seems poised to keep growing its business.Capturing ValueA company may create a lot of value, but only capture a very small portion of it. For example, we can argue that in the first decade of the 21century, Microsoft (NASDAQ:MSFT), revolutionized the world with its operating system and office suite. But, the technology was so widely available, that the company managed to capture only a small fraction of what it created.While Apple is still a technology company, it has consolidated its business in a very efficient manner, creating almost a full closed ecosystem between the software, hardware and accessories. This allows the company to capture a higher portion of the value it creates, which we can measure on the margin.While not a perfect measure, profitability margins show how much of the created value, a company is managing to capture.The most relevant margins, are those that are closest to the cash flows attributed to investors, which is why we will look at EBIT, Net Income and Free Cash Flow margins.In the last 12 months, Apple posted:30.9% EBIT Margin26.6% Net Income Margin26.9% Free Cash Flow Margin (to the firm / unlevered)As we can see, Apple is capturing more than 1/4 of the created value, and by looking at the past, we notice that these margins have been increasing.This ultimately goes back either into the business as retained earnings or to shareholders via buybacks and dividends. It is quite amazing that a company of this size is as profitable and still very efficiently growing.SummaryApple, is one of the flagship companies that have justifiably earned the trust of investors. The fundamentals indicate that the company will continue to grow, create value and be stable even in more turbulent markets.Here is the rundown of the main fundamental factors for Apple:Implied Fundamental Growth in EBIT in the next 12 months: 17%, expected free cash flows US$126.6b by Q3 2024Reinvestment into the business, US$37b ttmReturns on capital 50% (ROCE) ttmRisk as estimated by the cost of capital, 7.3%Profitability: 30.9% EBIT ttm and 26.9% Free Cash Flow Margin ttm","kind":"news","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[{"id":636967016,"gmtCreate":1645630956289,"gmtModify":1645630956289,"author":{"id":"3586434896339890","authorId":"3586434896339890","name":"Nkx","avatar":"https://static.laohu8.com/default-avatar.jpg","vip":1,"crmLevel":2,"crmLevelSwitch":0,"authorIdStr":"3586434896339890","idStr":"3586434896339890"},"htmlText":"read","listText":"read","text":"read","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":1,"commentSize":23,"repostSize":0,"link":"https://laohu8.com/post/636967016","repostId":2213984922,"repostType":4,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"comments":[{"id":7309867,"gmtCreate":1647951773183,"gmtModify":1647951773300,"authorId":3586434896339890,"author":{"id":3586434896339890,"idStr":"3586434896339890","authorId":3586434896339890,"name":"Nkx","avatar":"https://static.laohu8.com/default-avatar.jpg","vip":1,"crmLevel":2,"crmLevelSwitch":0,"individualDisplayBadges":[]},"repliedAuthorId":0,"objectId":636967016,"type":1,"supId":0,"prevId":0,"content":"<u>2</u>","text":"<u>2</u>","html":"<u>2</u>"},{"id":7306690,"gmtCreate":1647829050619,"gmtModify":1647829050708,"authorId":3586434896339890,"author":{"id":3586434896339890,"idStr":"3586434896339890","authorId":3586434896339890,"name":"Nkx","avatar":"https://static.laohu8.com/default-avatar.jpg","vip":1,"crmLevel":2,"crmLevelSwitch":0,"individualDisplayBadges":[]},"repliedAuthorId":0,"objectId":636967016,"type":1,"supId":0,"prevId":0,"content":"s","text":"s","html":"s"},{"id":7305933,"gmtCreate":1647775734147,"gmtModify":1647775734236,"authorId":3586434896339890,"author":{"id":3586434896339890,"idStr":"3586434896339890","authorId":3586434896339890,"name":"Nkx","avatar":"https://static.laohu8.com/default-avatar.jpg","vip":1,"crmLevel":2,"crmLevelSwitch":0,"individualDisplayBadges":[]},"repliedAuthorId":0,"objectId":636967016,"type":1,"supId":0,"prevId":0,"content":"<u>D</u>","text":"<u>D</u>","html":"<u>D</u>"},{"id":7305102,"gmtCreate":1647705190032,"gmtModify":1647705190067,"authorId":3586434896339890,"author":{"id":3586434896339890,"idStr":"3586434896339890","authorId":3586434896339890,"name":"Nkx","avatar":"https://static.laohu8.com/default-avatar.jpg","vip":1,"crmLevel":2,"crmLevelSwitch":0,"individualDisplayBadges":[]},"repliedAuthorId":0,"objectId":636967016,"type":1,"supId":0,"prevId":0,"content":"1","text":"1","html":"1"},{"id":7301746,"gmtCreate":1647557972843,"gmtModify":1647557972949,"authorId":3586434896339890,"author":{"id":3586434896339890,"idStr":"3586434896339890","authorId":3586434896339890,"name":"Nkx","avatar":"https://static.laohu8.com/default-avatar.jpg","vip":1,"crmLevel":2,"crmLevelSwitch":0,"individualDisplayBadges":[]},"repliedAuthorId":0,"objectId":636967016,"type":1,"supId":0,"prevId":0,"content":"x","text":"x","html":"x"}],"langContent":"CN"}],"isCommentEnd":false,"newsSizeData":{"likeSize":5,"commentSize":1,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":false,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"laohu8","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2213984922"}