Tackling AAPL's $1 Trillion Question

Apple currently has a $750 billion market capitalization ($612 billion enterprise value). There are two factors that will determine whether Apple will reach a $1 trillion market cap: future financial performance and investor's willingness to pay for that performance.

Future Financial Performance

Apple's cash flow and earnings provide the best view on Apple's ability to sell products. Fortunately for investors, both data points are relatively straightforward with little in the way of required adjustments. Apple has $12 billion of deferred revenue on its balance sheet related to the way software is accounted for, but the overall impact to the bottom line won't change any conclusions found in this post. Carl Icahn raised issues concerning non-cash tax accruals, which have roughly a 10% impact on Apple EPS, but it remains to be seen if such an adjustment is completely warranted. Similar to the deferred revenue, I don't see the adjustment being a factor in the $1 trillion debate.  

Apple reported $44.5 billion of net income ($7.42 EPS ) in CY2014. The degree to which Wall Street forecasts future earnings depends on the industry being analyzed. For financial companies, certain financial metrics are typically forecasted three to four years out, while for a company like Apple, estimating beyond two years is a stretch.  Investors understand the volatility inherent in consumer technology companies and estimates, especially looking out beyond two years. For CY2015, I am expecting Apple to report $55.8 billion of net income ($9.95 EPS), implying 25% net income growth and 34% EPS growth due to the impact from share buyback. Potential earnings from unannounced Apple products are typically not included in forward estimates. Even though Apple will ship new product categories in the future, most investors are not willing to give credit for that potential EPS boost until more specific information is known.

Investor's Willingness to Pay For Performance

The much harder part in forecasting Apple's future value is related to gauging investor sentiment about Apple's future. Apple's price-to-earnings (P/E) ratio is the primary metric used to value Apple, with price-to-cash flow (P/CF) ratio serving as a secondary measure. Both ratios serve as a representation of how much an investor is willing to pay for a dollar of earnings. As an example, a P/E of 10x would indicate that investors are willing to pay ten times the amount of earnings in order to own a piece of the company and that future earnings stream. The P/E multiple mostly reflects growth expectations. If a company is expected to report strong earnings growth, a higher P/E multiple may be warranted. A P/E of 75x would indicate investors are willing to pay much more for a dollar of earnings because those earnings are expected to experience above average growth. Accordingly, companies with more mature growth have historically had difficulty achieving a P/E above the market average of around 20x. 

With AAPL trading around $130/share, Apple has a 17.5x trailing twelve month P/E ratio, which is a bit lower than the overall market. I'm not a fan of trailing P/E ratios because the future is more important than the past. In addition, the current stock price already reflects future growth, so trailing P/E ratios are a lagging indicator (i.e. they don't provide much value). With the stock trading at $130/share, Apple has a 13.1x forward P/E ratio, which is a discount to the average 16x P/E for large cap tech stocks. 

Requirements for $1 Trillion

Apple could reach $1 trillion ($171.50/share given current shares outstanding) in two ways:

A) Higher P/E multiple. Apple shares would increase in price if investors are willing to value the company using a higher P/E multiple. Currently Apple has a 12.9x forward multiple. How much higher would the multiple need to increase for Apple to be valued at $1 trillion assuming earnings remain unchanged? Investors would need to pay a 17.2x forward P/E multiple, which is 33% higher than the current 12.9x multiple. Why would an investor be willing to use a 33% higher P/E multiple to value Apple's expected future earnings stream? Two of the more likely reasons include an overall stronger equity market where the overall tide rises as investors rush into equities, and increased confidence in Apple's products and outlook. 

B) Stronger earnings growth. If we assume the forward P/E multiple remains unchanged at 12.9x, then Apple would need to grow earnings by another 32% to reach $1 trillion. Assuming Apple grows earnings by approximately 15% annually over the next 2-3 years, Apple would be valued at $1 trillion sometime in 2017. I have doubts it will ultimately play out this way though as I have difficulty seeing the P/E multiple remaining unchanged for the next three years. Investors will likely change their opinion on Apple at some point over the next three years, either becoming more positive or negative. 

Easiest Path to $1 Trillion

Apple can reach $1 trillion if investors become 33% more optimistic (using P/E multiple as a proxy) about Apple's future or if Apple is able to grow earnings by 32%. I think Apple's best chance of reaching $1 trillion will be a mixture of the two: higher-than-expected earnings growth and a higher P/E multiple as investors show renewed confidence in Apple as an ecosystem with annuity-like features (a stream of device and services revenue). 

With shares trading at $128, investors are relying on certain expectations for Apple, including iPhone and Apple Watch sales, to value the company. Since the iPhone accounts for over 70% of Apple's operating income, any significant change in sales expectations going forward will play a large role in the way investors value Apple. Last week, I detailed an achievable strategy for Apple to grow annual iPhone unit sales by 50% within three years. Is this type of growth reflected in the stock price at current valuations? The question will depend on how many investors believe the strategy is achievable. I suspect there is a bit of skepticism surrounding the thesis. 

As for Apple Watch, I published Apple Watch sales estimates of 20-30 million units for the first 12 months on the market, rising to 40-60 million units in the second year on the market. Consensus currently stands around those numbers, with 15-20 million Apple Watch units expected to sell from April to December. In theory, Apple's current $128/share price and analyst estimates already reflect these Apple Watch projections. Therefore, actual watch sales would need to come in stronger than these estimates for positive EPS revisions. In a scenario where EPS estimates are rising due to stronger iPhone or Apple Watch sales, investors may also be willing to pay more for those higher earnings, resulting in a rising P/E multiple.    

Given the current share price, Apple is 33% away from a $1 trillion market cap. While that may seem close, it represents nearly $250 billion of additional market capitalization, hardly an easy feat. Apple's best shot of reaching the arbitrary value milestone is reporting stronger than expected iPhone sales over the next 2-3 years and having a successful Apple Watch launch. Since it is impossible to know why every investor buys or sells AAPL shares, no one knows if Apple will reach a $1 trillion market cap. As long as the economy and equity market don't experience any huge shocks or surprises, Apple's existing product categories have enough potential to propel the stock to $1 trillion train. 

How about $2 trillion? That is a much more complicated story that deserves its own post. 

Wildcard: Apple's stock buyback program represents a very significant unknown in this discussion. Apple has the potential of buying back close to 20% of itself within three years. How will that impact the odds of AAPL reaching $1 trillion? In order to gain a bit of perspective in terms of size, Apple's buyback over the next two years has the potential of boosting EPS by 10-15%. Most analysts should have this type of buyback already included in their estimates and therefore already priced in the stock. The impact that the actual act of buying back shares has on AAPL is another story. There could be a beneficial impact on AAPL shares if management decided to accelerate share buyback and current shareholders show little motive to sell shares. In such a scenario, there would be upside pressure on the stock as the market price rises to find the point where supply and demand is in equilibrium. Conversely, if management slows buyback, any support that resulted from Apple being an active buyer in the market has been removed which may result in stock price weakness. I suspect the stock buyback and Apple's $178 billion of cash are something to keep a very close eye on going forward. 

This report was produced by Neil Cybart on March 3, 2015 and is not meant to be used as investment advice. 

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