How to value a company: Apple (NASDAQ: AAPL) Pt. 3

Bryce: [00:00:13] Welcome to another episode of Equity Mates, a podcast that follows our journey of investing, whether you're an absolute beginner or approaching Warren Buffett status. Our aim is to help break down your barriers from beginning to dividend. My name is Bryce and as always, I'm joined by my equity buddy, Ren. How are you? 

Alec: [00:00:29] I'm very good. Bryce is very excited. We are still in Owen studio. He hasn't kicked us out yet and we're here for the third part of our Value Investor series. 

Bryce: [00:00:39] That's it. If you are just joining us over the last two episodes, we have discussed what is value investing and the different ways that you can value stocks. Second episode was the valuation of zero taking the the framework that you can learn in the Value Investor program. And then today we are actually going to unpack Apple and talk about the valuation. And to do it, we are joined by Owen again. Owen, welcome. 

Owen: [00:01:04] Thanks, guys. Pleasure to be here.

Bryce: [00:01:06] All right. Well, we all know what Apple is, I was. 

Alec: [00:01:09] Going to say, but we spent about 10 minutes talking about Xero's business model. Let's say we know what Apple is. 

Owen: [00:01:14] Yeah, Yeah. 

Bryce: [00:01:15] But the business model has changed over time. So when you're building an investment thesis, what are the assumptions that are going into you creating an investment thesis for Apple? 

Owen: [00:01:26] Yeah. You make a great point quickly about it being a massive business. That means that the valuations are often tighter, meaning that so many analysts are covering it. So the chance of getting a seriously undervalued investment is very slim because there's so much information out there. So when it comes to assumptions, you basically have to have a variant perception, You have to have a reason why you think everyone's wrong, and it has to be pretty strong when it comes to a blue chip like Apple. I remember a few years ago, so we've talked about it a little bit on the show, but my inspiration for value investing comes from Joe Mega, who's now back in the United States. And I remember I said on Twitter that Apple's like one of my best Large Cap company ideas. And he then had another tweet maybe like a week or something later saying that I just don't see it. And I was like, Well, this is like, this scared me because here's the guy that I'm like, This is my God. I'm saying I don't get it. And I'm like, Well, okay. So the basic idea is the business model has shifted dramatically over time. So once you go back, you never go back as the saying, you know, will you get this Mac? Then you get the watch, then you get the Apple iPhone and you just continue down that path. Now, what we know and what we see in front of us is hardware and the actual hardware of Apple. The diehards are going to hate me for this. It's not that different to Microsoft products or like a Toshiba or like a Dell PC. It's really not that different. Like they run on a CPU of a JP, blah blah, blah. But the difference is the software. So the software is that iOS software we know and love, it's secure, it's safe, it's like private, encrypted, it's all that stuff and it's the same across every device. And that is what keeps people in the ecosystem. So Apple has taken that over the past, say, 5 to 8 years. It's taken that and it said, well, how can we fix this? How can we take that thing and put it everywhere in people's lives? So that then became a watch. It got the AirPods, it got everything in the ecosystem. And you know what? You can even get an Apple Music subscription to go with your AirPods for $3.99 a month. Well, that was when they promoted it. You don't even need to look at your iPhone anymore. You just when you put the AirPods in, it prompts you. Right. And that's an example of how they can have this integrated circuit of apps and tools and they can start pushing more software into your life. If you've got photos on your phone, you get that stupid notification. It's like your uncle had it for you to upgrade and you click the button and it's literally like one button, you're done. And then it's instead of two bucks a month, it's ten bucks a month. And that's what we call services revenue inside Apple. And so this is this software only revenue that they're harvesting just by you using their products. And that is the big shift. And that was my very perception early on when that business was nascent, like really, really small. In 2015, it was only 8% of revenue. That's up to 20% today. But take it in context. The business is also a lot bigger today than it was in 2015. So that's a lot of revenue coming through and the profit margins are delicious. 

Alec: [00:04:23] So before we get to what it is today and where it's going to be in the future or where you think it's going to be in the future. Did you ask Joe why he didn't say it? 

Owen: [00:04:33] Well, according to Twitter and what I remember of it is basically that he didn't see that transition being very smooth. So like from hardware dependent people at the time, I remember Steve Johnson, another great Australian investor from Forager funds, he had this view that like, how can people pay $2400 for an iPhone? Surely this is tapped out. And he's probably right. So to be honest, it kind of is tapped out like and so they have like I've got my my 12 pro here and so they went to 5G with the phone. I was not interested in upgrading. I was going to let my old thing die. But then it was like a faster internet, like I can hot hotspot when I'm on the road. I was like, Yes, got it. And so that's what we call a supercycle. And it happens probably every four years with Apple, where there's some sort of ground breaking thing that you need on the phone and you get through it. And so here's to back to Joe's concern from what I could tell was it's just not going to transition that well. But if you take that super long term horizon, you believe in that ecosystem. It worked. 

Alec: [00:05:32] And I think, again, that's just a reminder that we keep hitting in this three part series that the challenge in valuation isn't in the maths, it's in accurately forecasting the future prospects of the business. So Joe and Owen would probably have a similar discount rate and would similarly calculate their spreadsheets would look very similar. But it's the assumptions that lead to the numbers being put in there that separates them. So let's get to the assumptions. 

Owen: [00:05:58] Yes, So basically my assumptions at and this was out to past 2030 was that the services revenue would be over 40% of the business. Now that's a huge thing. If you think, like I just said, 2015 was 8%. So you might think, okay, that's a big number, but let's just kind of think about that. Well, the profit margins on that revenue are north of 65% versus on the iPhones and stuff. You get like 30 to 40%. So you're doubling the profit that you get from this new service line, which is also growing five fold in, say, 10 to 15 years. And so that's where you start to get more and more and more profits, even if the business doesn't grow that fast. You know, most recent growth was around 5 to 7% revenue growth. The services revenue did actually fall a bit, which is a bit concerning. But the key there was like it's not growing as fast, but under the surface, like if you go and you pop the hood, you see that the business that is valuable, it is services business, is actually still growing and it's more profitable. And that's the key thing. And that's where the key thing that I watch going forward. And so Apple made this just in terms of assumptions. Apple made this choice maybe two years ago now where they said we're not going to publish the number of iPhones that we sell like the units anymore. And this was at a time when they'd just come out through a supercycle of these new iPhones. And it was obvious that the market was saturated with Apple iPhones and they knew that they couldn't at last year's results. So they were like, we're going to drop this metric. And all the analysts were like, I remember this, this distinct quarterly call. It was actually like an arrow. So how do we going to do this? And the stock dropped because and also, like I don't know though, this is my assumption in my model, like what we're going to do. And to be honest it is scary because basically what it meant was that the key business that was inside Apple at the time, no one could be like, exactly. That's how many units were sold. And so what they've done is sporadically, they've given this other number, which is a bit blurry, which is installed, base installed base is basically everything is you could just have the Apple Watch or just the iPhone or just the Mac, which is not nearly as valuable as the how many Macs, how many iPhones, how many watches. And so that's where it gets a bit blurry. And that figure is currently 1.8 billion. 

Alec: [00:08:15] Yeah. But it's like installed base. I probably have two old iPhones sitting in a drawer that don't work, but like, I don't want to sell the I can't sell them. I don't want to throw them out. I haven't taken to an electronics recycler. Do they count? 

Owen: [00:08:27] You know, they probably do this if they get switched on once that year, maybe they count. I don't know. And so that's that's from a modelling perspective, what this means is that you have to basically drop that and then you have to just take whatever was like last quarter or last year's results and just imply a growth rate, which is very blunt when it comes to modelling, you basically have to go, well, $100 billion revenue last year I think is going to grow 10% because of increased prices, 5% and they'll sell 5% more this year or something like that. And that's where it gets a bit hard tomorrow and that becomes a bit blunt.

Alec: [00:08:57] All right. I'll and let's pause there and take a quick break to hear from our sponsors. 

Bryce: [00:09:03] So with a company like Apple, where you said at the start, it is so well covered that there are, you know, you could just jump online and get models from some of the best investment banks around the world, best fund managers, and get a valuation probably across the board. Yes. So what are you doing in your model that you think they all have wrong? Or are you just tinkering with yours from five years ago? 

Owen: [00:09:26] Yeah. So I just tinker with mine every you know, I probably jump into it maybe every 6 to 12 months. But when there's something that would materially change the thesis. So some people model quarter to quarter because the US companies report quarterly. I don't do that because I feel like the more time you spend in your model, the more likely you are to make a change with your investment. So I try and limit my exposure basically, like when you have your phone before bed, you do limit your exposure. For me, it's about when there's something that headlines like in a quarterly call or, you know, in a media release or even there's something in the industry, that's when it triggers me to be like, Go back in. What was your assumption for that thing? Has a changed? And so, you know, one of those things recently is slowing services growth. Now, you would expect that we don't need a new iPhone every year. Some people do that. But most of us, I think the average lives between two and four years before people upgrade again. And there's a lot of switches. Most of the new acquisitions for Apple are switches. People have come across from the other ecosystems like Android. But you know, for the services revenue, if that slows, that's concerning because that means that the current usage of the current fleet of iPhones and Apple products maybe not as intended, like maybe not as expected. So I would expect that services revenue continues to grow double digits, probably between ten and 20% over the next five years in order to justify a valuation that might be above what analysts are expecting. 

Alec: [00:10:53] Now, the challenge with services revenue is that it actually is so many different business units within Apple that's just rolled up into this one number. It's Apple Music, it's iCloud, It's help me out here, guys. What are the subscriptions that are Apple TV? Who is Arcade? Yeah, Apple News. Yeah. 

Owen: [00:11:11] Podcasts, potentially. 

Alec: [00:11:13] They have paid podcast subscriptions now. Yeah. So it's all those different business units working on different things. And for Apple, when they report, they just give you a services number. It's not like we have X number of Apple Music subscribers and X number of Apple Arcade subscribers. So then when it comes to modelling it, how do you actually do that work? Because modelling a subscription business isn't that hard. We spoke about it with Zero. It's Apple, Arcade costs $4 a month and as a million users, $4 million revenue a month. And then you do that for all of them. But if Apple aren't giving you a starting point, how do you even start saying here the service business lines, here's how much revenue they'll be making, here's how that rolls up. 

Owen: [00:11:53] Yeah. So there was a few like you remember how so they dropped the iPhone units. Well, we know the revenue and we can see the prices on the shelf in that store. So we could estimate roughly how many units are being sold so we can back the number out over time with the services. Revenue is much harder because these are basically launching behind closed doors like Apple News, for example, launched when services revenue was already bundled together. There was never a like you couldn't never see it separately like you could with different units. So basically what you rely on is you rely on a lot of like industry reports and surveys and these types of things that come through either investment banks or they come through like Bloomberg. Our Bloomberg had this story probably about a year ago now where one of the things was like how much Google is paying to Apple to be installed in the. 

Alec: [00:12:41] Yet to be the default search engine on the iPhone. 

Owen: [00:12:43] Yeah, like like the Internet Explorer back in the heyday from Microsoft and that estimate estimates are that could be as high as 50%. Now I don't think it's that high at the moment, but that's a huge number. If it's true. 

Alec: [00:12:56] What do you mean, 50%.

Owen: [00:12:57] Of services revenue? Oh, well, yeah. So I don't think it's that high, but that could be something that we're looking at Now if there's a legal stoush or there's is some sort of like regulation that comes in and says you need to give users more choice, well then maybe what happens And that's probably more of a scary thing for, you know, everyone else. I think for most people like you want, you want to have some understanding of that. They do disclose the number of subscribers, so they do describe disclose it. I think it's about 800 million subscribers at the moment. Such a huge number. 

Alec: [00:13:29] And to be clear, if Bryce subscribes to arcade music, Apple TV, he's count it three times.

Owen: [00:13:35] Yeah, yeah, exactly. They have the bundle app one where you can bundle everything together. But again, in that instance, like are they making more or less money? The family members could have something else. I think I paid $99 for iCloud, but I also have Apple Music. So, you know, I'd probably consolidate. So the actual number of subscribers probably doesn't make a lot of.

Alec: [00:13:55] Sense because otherwise that's 10% of the world. Yeah, yeah, yeah.

Owen: [00:13:59] It'd be crazy. Yeah. And like. Be honest. Yeah, it's it's, it's probably like those things where you get through like a a trial. You get like the Apple music, you get this, you get that. So who knows what's going on in there. But you can use that, you know, if you get that sporadically throughout the year, you get a number here or there. You can take that and you can be like, well, services revenue is X divided by subscribers equals Y, and you can use that. I don't use that particularly well. I keep my model with Apple very simple because my thesis is very simple that services revenue continues to grow just like a subscription business from Adobe or something like that, where you just see price increases and you see the number of users growing.

Bryce: [00:14:37] All right? And so at the time of recording like 2022, Apple have just reported and numbers were a little bit soft. So we're not going to talk specifics in terms of the number here. But generally, where do you see the valuation of Apple going?

Owen: [00:14:49] Yeah. So I guess at a current price, which is around about 140 bucks, you could say it's probably fairly valued. Now, I would say that if you look at it, remember we talked about multiples in the last show where we talked about and in that first episode where you could use multiples to try and estimate the value of something or get a sense. Apple's like price earnings ratio is actually lower than both Microsoft and Netflix right now. If you think about in context of that, if you just had that as your opportunity set, would you say Apple is higher quality than Microsoft or likely to grow faster than Netflix per grow faster than Netflix, but maybe not Microsoft because it's sweet So we can get a general sense of that and how much would be be willing to pay. I would say about 20 to 25 times for a business like Apple is good because you can actually remove the cash, but it's in the business because that's not part of the business. And you get to a reasonable figure, you know, in the high teens, I think that's a reasonable price to pay for a business of this quality. Consider that the ASX, the average ASX company trades at around about 15 times price earnings ratio. So you're not paying that much more for the world's biggest and maybe one of the best brands in the world that can compound slowly over time. 

Alec: [00:15:56] I will. I think if people want to see more of your valuation work, the place to go is the Value investor program. They can see it on the Rask website, they can see it on the Equity Mates website, they can say it in the show notes. Honestly, you can't escape it. It's everywhere. There is also a free course to get started investing course. If people want to do that as well. Wherever you are in your investing journey, it's worth refreshing your knowledge. But on something you said, get my ears up. Earlier in this episode you said, I modelled it and then I returned to it every 6 to 12 months. It just made me think, How many of these models have you got? How many companies are you? Do you have models for that? You refresh once a year, twice a year. And can I access your harddrive? 

Owen: [00:16:42] Yeah. So we use Google drive and notion to do all these so a lot of them are there and you can just update them very quickly in the course itself . there's five solid reports as a model so you can access them and they'll be updated regularly like every six months. But in terms of my own I probably have floating around in the aether probably 50 to 100 models or somewhere. But how many do I actually keep tabs on very closely and very intimately? It'd be no more than 20, probably 10 to 20, because most companies don't make it to modelling. Most companies are just simply not in my wheelhouse. I'm not comfortable owning them for whatever qualitative reason. It's not worth me putting in, you know, three or 4 hours or 5 hours building a new model from scratch for one of those companies. So, yeah, to your point, rent like time is valuable. Don't waste your time with companies getting to modelling if you're not ever going to invest in them. 

Bryce: [00:17:31] Love it. Well, if you want access to those four or five models in the course equitymates.com/online-courses, it'll be in the show notes. Right. Oh, and thank you so much for that for the last three episodes, learn a lot. And as I'm sure members of both of our communities have as well. Always a pleasure chatting. Thank you very much. 

Owen: [00:17:47] Thanks guys. Really appreciate it. 

Alec: [00:17:48] Thanks, Owen.