Saturday, February 20, 2010

Is Apple Really the Fourth Most Valuable Company in the United States?

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Upon glancing at the top holdings in the SPDR S&P 500 ETF (SPY), I must admit I was very surprised to see that Apple Inc. (AAPL) was the fourth most heavily held company in the index. Smack between Proctor and Gamble (PG) and Johnson and Johnson (JNJ), as I looked at the list I started to wonder whether the assumptions behind AAPL's valuation might be a little rosy.

To do this analysis, I used the financial information from Apple's most recent 10-K to build a discounted cash flow valuation model. My goal was to see whether the assumptions built in to AAPL's stock price were realistic. After really digging in to the numbers I feel confident that Apple, especially with a one year target price from analyst estimates of $248.33, is in a bubble.

Looking At the Numbers

From a price to earnings perspective, Apple (at 19.64) is somewhat overvalued. Exxon Mobil (XOM) trades at a P/E of 16.56, Microsoft (MSFT) at 15.85 and Proctor and Gamble (PG) at 15.11 (these are the only other companies in the S&P 500 more highly valued than AAPL). If one were to take an average of these three, and infer from this Apple's stock price, one would get a price of $162.68, $38.99 less than what it closed at on Friday.

But price to earnings ratio comparison would be a ridiculous way to value Apple, since obviously its shareholders believe there is still some growth to be had for the company. To see what these growth assumptions are, I projected out through 2015 a balance sheet and income statement for Apple and then did sensitivity analysis with a discounted cash flow to see how operating profit margins and sales growth rates impacted the company's valuation.

>To schedule out the balance sheet, I looked at Apple's ratio of either the various line items to sales or the line items to cost of sales from 2008 and 2009. I then used the average of these two ratios to infer the future values for the line items. While this is a relatively simplistic way of doing this and will no doubt not occur as projected in reality, I wanted to see how Apple would perform if they ran the company much like they have been doing in the recent past.

Looking at Apple's income statement, I tied R&D as a ratio to sales based on recent historical levels and cost of sales based on an operating profit margin. Looking at Apple's recent history, it becomes quite apparent that this company has been immensely profitable and successful based on its extremely high operating margins (40% in 2009) and robust sales growth, with 34% in 2008 and 13% in 2009.

For my DCF valuation, I just did a simple 10% discount rate. Looking at the sensitivity analysis, it becomes quite evident that Apple's future valuation is pricing in consistently strong sales growth and operating margins:

Based on Apple's current market valuation, it appears as though the market is presuming that Apple is going to maintain operating profit margins of 40% in perpetuity and that sales growth would be 14-15% next year tapering off to a terminal growth rate of 4% in 2015.

Since I thought that 40% operating margins in perpetuity was a little much, I looked at what would happen if it tapered off to a terminal level. In my opinion, I feel like it'd be very difficult to constantly stay ahead of the curve and provide products that were just so downright amazing so as to justify a 40% operating profit margin for the life of the company. To find this terminal rate, I took Dell's operating margin from their most recent 10-K and added 5% for good measure:

The valuations under these assumptions are no where near that of the market, which leads me to believe that this stock might be in a bubble.


Of course some of the assumptions I used in this model were a bit simplistic and if I had a little more time I could go in to more detail, but from my simple analysis I feel comfortable saying that the market has absurd expectations for Apple. Does this mean that I don't think Apple is a great company? Of course not. But I do feel like it's overvalued right now, and the analyst estimates seem downright ridiculous, putting it at a market capitalization of $225 billion one year from now.

When the very best case scenario is what seems to be driving the stock price I think it's time to look for greener pastures.

You can download my model below and play with the numbers if you like.

AAPL DCF Valuation

Tuesday, February 16, 2010

Winn-Dixie Earnings Surprise

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I mentioned last Friday that I was hoping to do some analysis on Winn-Dixie Stores (WINN) once they released their second quarter 10-Q. Looks like they beat analyst earnings expectations, which while not a buy signal in and of itself in my book is still a positive because it means they weren't losing money.

I'm hoping to write up some formal analysis and a recommendation on the stock either tonight or tomorrow night. I haven't looked at their 10-Q yet aside from reading the headlines, but I am slightly optimistic that their balance sheet has improved. The roughly 2.5% move up today also likely means that they're still at the P/B ratio I discussed in a recent post.

I'm also hoping to at some point dive in to the 10-Q The Pantry (PTRY) released February 2nd. My apologies for not being more on top of that. It seems that they went below analyst expectations with their loss, and I'll take a look to make sure that this stock still makes sense. Part of the way I pitched it was conditional upon them being able to turn a profit soon, and there's a certain point where your patience has to run out. It's not out of the realm of possibilities that upon further analysis I'll close my position on my motley fool profile.

In case you haven't seen it, a more formalized version of the VIX pitch I put up on my blog here got published on Seeking Alpha today. I think it turned out pretty well, so if you haven't read it yet you should take a look.

Sunday, February 14, 2010

Getting Exposure to the VIX as a Hedge: Is it Conditionally Correlated to S&P 500 Returns?

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I've uploaded the PowerPoint I just made for my presentation tomorrow for the Claremont McKenna College Student Investment Fund.

I was looking at the VIX, and whether or not having exposure to it might serve as a better-than-normal hedge for S&P 500 returns. My thought process was built on the assumptions that:
(1) Assets can be conditionally correlated (i.e. different events can result in different correlations between assets)
(2) In hedging against black swan events (statistically insignificant and unpredictable events that can cause financial ruin), the goal would be to ideally find assets that were uncorrelated to the market during sideways or bullish markets but highly-negatively correlated to market returns during market panics and sell offs.

You should read the presentation for my findings (note: the graphs used are from the Barclays prospectus for their VXX and VXZ ETNs and from Standard & Poor's website. I want to make sure I give credit where credit is due). In terms of my looking at the VIX, I tried to break up my time periods either based on significant market events (for example, the Bear Stearns bailout of their Sub Prime funds) or based on market bottoms or tops. It's somewhat of a mixed bag, but I feel like there's evidence, at least based on recent market history, to suggest that this conditional correlation is partially correct.

In terms of looking at what products to gain exposure to the VIX, I looked at Barclays' iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). While the Short-Term VXX has more liquidity and is more highly correlated to the VIX (and this correlation is more statistically significant), based on the way the indices that both funds are based on move (as seen in the graphs from the Barclays' prospectus I mentioned earlier), I feel that mid-term index has offered a better risk-reward payoff since 2005.

I justify this largely by the fact that humans seem to extrapolate market panic in to the future and to be skeptical during the boom times of future performance. While this skepticism might not be evident in the asset markets themselves, I do believe you'd see it in the derivative markets to insure against these positions.

The expense ratio of 0.89% for both funds is a level I believe to be reasonable, especially faced with the impossibility of effectively creating a product like VXX or VXZ on the small scale for retail investors.

From the articles I've read on the two products, the major complaint that I've heard is that the ETNs don't accurately capture the daily changes in the VIX. While I'm sympathetic to these concerns, I think it's important to remember that you're invested in futures based on the VIX and not the VIX itself (which isn't actually possible). To me it's plausible that you'd actually have meta-volatility (i.e. the volatility of the VIX) impacting the pricing of the products. Also, because the products are looking at what the VIX is going to be at in the future, the day to day movements are less significant.

My final conclusion with the PowerPoint is that I would go long the VXZ. I was not able to get actual data for the index that it is priced off of however, so my statement is more based on the chart and my behavioral explanation for the reason it has outperformed the VXX in both the upside and downside.

Friday, February 12, 2010

Analysis On Winn-Dixie Stores

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Although I'm waiting until they release their earnings next week, one stock I've been looking in to and have gone long on for my motley fool account is Winn-Dixie Stores Inc. (WINN), the southern grocer. I'm waiting for the earnings announcement so I can go in to more detail for my analysis rather than simply guesstimating what is going to happen. That doesn't seem prudent based on how close their earnings announcement is.

But here's a little preview of some numbers I ran off their Q1 10-Q:

As you can see, even after discounting intangibles and basically anything that you can't put your hands on, they still have a P/B of less than one. I'm not quite sure how I feel about their Property Plant and Equipment (PPE), since it appears they only own 8 stores and 1 distribution center, but I guess trading below hard assets is all I can really ask for.

If you ask me this seems very very cheap, especially since they have no long term debt, but I'll be interested to see how their Q2 earnings come out. Mean analyst estimate is a loss of $0.16, with a high estimate of -$0.09 and a low estimate of -$0.27. If they surprise on the upside it might push them past this price to tangible book ratio of one, but I think that's a risk you have to be willing to take.

Tuesday, February 9, 2010

A Justification for Government Interference in Pollution

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Although not a recent phenomenon, the particular flavor of the times (temporarily pushed under the rug over concern for the economy) is what should be done about global warming. Topics have included carbon cap and trade agreements, green energy grants and requirements, etc. One thing I think that is important to discuss is whether government regulation could effectively create a positive solution for the climate change problem.

To begin, I'll have to posit some assumptions, for which if one were to disagree with would inherently prevent the same conclusions I am about to draw from being reached:

(1) Pollution has a negative impact on everyone's health, yet remains unpriced because of a tragedy of the commons scenario and an incapability of observing its true cost
(2) Ceteris paribus, a firm earning a profit has positive externalities for society in so much that either through direct distribution or wealth trickle down effects, people are better off (i.e. profit seeking is positive for society, all other things staying equal)
(3) Earning a profit is not a zero sum game, in that if someone is making money someone else does not have to be losing money.

To start off, I think it's important to think of a basic scenario of two polluting companies, G and E. These two companies produce the exact same product for the same market, and the only two choices available to them are whether they're going to implement capital intensive pollution control devices, or not. This breaks out in to a game theory problem.
The picture above represents the payoff matrix for firms G and E in the market described earlier

We'll say that the market is fixed in terms of demand and whichever company can produce the product the cheapest is going to capture the entire market. In the case where the cost of producing the good is the same for the two firms, they will split the market. In splitting the market in the 'Not Pollute' scenario, both firms' payoffs are less than in the 'Pollute' scenario because of the cost of the pollution limiting capital expenditures, let's presume.

The payoff matrix is quite simplistic, but the goal is to convey that in a situation where the winner is the company that can produce the product the cheapest, the Nash equilibrium is going to be that the firms will pollute (in this case, [4,4]).

Now this might not be the most beneficial situation for society, based on the cost we place on pollution (or value on clean air). Let's say cost of pollution to society is 10, such that even though the firms in aggregate would be making a profit of 8 in any combination involving pollute, society as a whole would be incurring a negative payoff even with the addition of this 8 of profit.
In this scenario, it might be in the best interest of the society (of course not for the companies individually) for the government to require a certain level of pollution control, thus forcing the [2,2] payoff to be the Nash equilibrium by preventing the choice of pollution. Presuming this 10 cost is eliminated in this scenario, there's a positive 4 aggregate payoff where before there would have previously been a negative 2.

This can generally be summarized such that the government should intervene when the aggregate payoff from not-polluting is greater than polluting, or:

Er(Diminished G and E earnings, bureaucracy costs, no pollution payoff) ≥ Er(Heightened G and E earnings, pollution cost)


While this is a fun way to look at the problem, it doesn't address the fact that we still don't have a price for pollution. Some have tried in this department, but you will still have difficulty valuing some of the side effects not directly related to human health (i.e. how do you value things like biodiversity?).

In addition, although the bureaucracy cost of implementing said regulation should be a considered cost, it is very likely that the group determining if and how we should regulate (the bureaucracy) might not consider this cost or might dramatically undervalue it.

In light of this, while it is theoretically easy to determine whether to regulate, the inputs of the equation are still unknown. To an investor involved with the G or E firms of the world, a big chunk of the valuation of your investment is determining what the likelihood is that those making decisions will determine that the left side of the equation is greater than the ride side i.e. the value they and their constituents place on clean air. Perhaps this is why in a Democratic regime coal burning utilities and other environmentally questionable investments have gotten crushed.

Thursday, February 4, 2010

The Fallacy of Greed: The Case Against the Corporate Tax

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The following is an article I wrote for the Libertarian publication on my college campus. Although it was for a publication that identifies itself as Libertarian, this does not necessarily reflect views I personally hold. This was a piece discussing the corporate tax, but does not advocate for a particular regulatory or fiscal policy.

A corporation is merely a shell containing assets: without its shareholders, bondholders, managers and employees, it would have no future earning potential. In principle, the legal entity “corporation” is simply the desire of investors to escape risk. In sole proprietorships and partnerships, the people that own the company are financially and legally responsible for the actions of their company. If the company goes bankrupt in one of these instances, the person or persons that own the company can watch their own personal assets (cars, houses, golden retrievers) be called in to repay obligations. This is not the case for corporations: barring serious foul play, the people that run and own the company can only lose their initial investment and have personal protection from people suing the company (except in cases of criminal mismanagement: thanks, Sarbanes-Oxley).

This is absolutely essential in a large multinational corporation with investors spread around the globe. If a Taiwanese investor can be financially held responsible beyond their initial investment for the mistakes made in a company halfway around the world, this risk is going to have to be compensated for. Corporations create an effective way of mitigating this problem and allowing firms to have a broader set of potential investors.

Their stand-alone nature is one of the major arguments for taxing the profits of corporations at very high marginal rates, which resemble those levied on personal income. Proponents of the tax argue that corporations are seen as individuals in the eyes of the law, so they should be seen as individuals in the eyes of the IRS.

The issue with this reasoning is the fundamental but ignored truth that corporations are owned by investors. Unless dispersed in the form of dividends, share buybacks or capital appreciation (stock price increases due to the increase in the value of the company), it is impossible for individuals to directly benefit from the corporation’s profits, aside from salaries and stock options in the company. The money that is not given out in dividends or share buybacks is plowed back into effective investments.

With the highest marginal federal tax rate currently at thirty-five percent of pre-tax profits, the United States has one of the highest corporate tax rates in the world. This represents a significant amount of money that is not available to be invested back into the company.

The benefits of eliminating the corporate tax are significant. First, American companies would have an immense strategic advantage over foreign companies which are also generally subject to a corporate tax. Such an advantage would stimulate permanent and productive job creation here in the United States. Second, this would encourage more people to invest because it would remove inequities in the tax code that disadvantage the poor. As it stands right now, regardless of how rich or poor you are, if you are invested in a company, your “income” from that firm will be first taxed at the corporate tax rate.

Is this fair? If you are making $30,000 but are still committed to building wealth and investing for retirement, should your return from investing in a corporation be initially taxed at the same rate as someone who makes $200,000 a year? As things stand right now, apparently.

The final, but most important positive side effect of eliminating the corporate tax is it abolishes the tax shield that companies receive by issuing debt. Interest paid to bondholders is tax deductible; this creates a large amount of money that can be kept from the government out of the same initial profit. Arguably, this aspect of the tax code encourages companies to take on more debt than they normally would.

After a financial meltdown that was largely caused by the overleveraging of individuals and companies, does it make sense that our current tax system encourages leveraging up?