#3 Investing 101: Business Valuation And Apple Case Study

Valuation is the hardest or the simplest part of investing. It all depends on your qualitative judgment.

This may sound counterintuitive but valuation is simple.

Or let me put it this way: Valuation should be simple.

I have observed that many investors think valuation as the hardest part of investing because it requires operating with complex financial models. That sounds smart so we tend to believe it. If it was easy, everybody could do it, right?

Wrong.

You don’t need fancy quantitative formulas, including discounted cash flow analysis, to value businesses.

In fact, Warren Buffett doesn’t use them. If you don’t believe me, hear it from Charlie Munger and himself:

It has to be obvious.

If you think it’s a too close call so you need complex DCF models and even calculus to understand the value, there is probably nothing there that you can exploit. Market has already priced it pretty efficiently.

Buffett tells this here again, he never actually sat down and ran the numbers on a spreadsheet.

Valuation should be a simple operation, the hard thing is making it simple.

Valuation basically has two parts: Qualitative and quantitative.

Better you do the qualitative part, the simpler the quantitative part becomes. Conversely, if you can’t get the qualitative part right, no deep calculus can help you figure out what the business is worth.

Valuation, mostly because of the qualitative aspects involved, is not a science. It is also not an art because there are some well established principles you cannot ignore.

Valuation, as Aswath Damodaran says, is a craft and you can definitely get better at it by practice.

Let’s cut the BS and get you equipped with the fundamentals of this craft:

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You Cannot Value Everything

As counterintuitive as it is, this is the first principle of valuation.

This doesn’t mean that not everything has value. No, everything has a value. The best business in the world has value, the worst business in the world has value, the shabbiest home in the world has value, a car that doesn’t work has value. However, you can’t dependably predict the value of everything.

Let’s go to the basics: Value of everything is determined by supply and demand dynamics.

For some goods and services, supply and demand dynamics are more predictable than others.

For instance, we can predict how much water in the world will be consumed with fair proximity. This is because we know how much water, on average, a person consumes and the population growth rate.

On the other hand, we can’t dependably predict how much a junk car is worth because it largely depends on whether there is anybody close to it who can make productive use of the junk. It doesn’t matter if there is such a person somewhere in the world because nobody would pay to transfer junk. That person should be close to it. It is either worth something, or nothing. Straightforward. All depends on the existence of such a person and we can’t predict whether such a person exists or not. We can only speculate.

In the same vein, there are businesses thereof performance can be dependably predicted and there are businesses thereof performance can’t be dependably predicted.

Valuation only concerns the first group.

If the earnings are not predictable, there is no valuation. It’s just speculation.

This is hidden in Buffett’s definition of fair value.

It is the discounted value of the cash that can be taken out of a business during its remaining life.

-Warren Buffett

If you can’t reasonably predict whether it will be alive 5 years from now and how much it may reasonably earn, you can’t do valuation. There is of course value in that business too, but it’s not for you to determine it.

Buffett clearly set this out in one of his lectures:

Therefore, the first step of valuation is determining whether the business has predictable earnings or not.

The question is, therefore, “what makes earnings predictable?”

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Unfair Competitive Advantage (MOAT)

Competitive analysis is long known within the theory of industrial organization.

Even if you don’t know anything about it, you intuitively know that not every business was created equal.

Ask this question to total strangers: Who do you think is a better company, Apple or Whirlpool?

Most of them will say Apple without actually knowing why.

In Buffett’s terms, Apple is an exceptional business.

This is illustrated by their revenues in the last 15 years.

This is how Whirlpool revenues look like in the last 15 years:

Can you tell what it’s going to earn 5 years from now? No. It's a total gamble.

On the other hand, this is how Apple’s revenues look in the last 15 years:

Can you tell what it’s going to earn 5 years from now? Well you may make a good prediction. It allows you to do that. Whirlpool doesn’t allow you to do that.

You have to find companies that allow you to do that.

Some businesses have unfair competitive advantages so the competitors can’t just enter the market and steal their sales.

Michael Porter, who pioneered competitive analysis, explained that competitive advantage originates from two sources: Cost leadership or product differentiation.

Mary Buffett reports in Buffettology that Warren Buffett often goes back to this basic principle:

Warren says “Exceptional businesses are either low-cost suppliers of consumer goods or suppliers of unique products or services.”

-Mary Buffet in Buffettology

Basic examples to the first group are Costco and Walmart. They are low-cost suppliers of everyday goods.

Perhaps the most clear example of the second group is Apple as the iPhone is truly a unique product and Apple has 100% monopoly on iPhones.

This is why Apple’s earnings are predictable.

We can predict how many iPhones in the world will be sold next year based on historical trends and we know Apple will be selling all those iPhones. Nobody will compete with Apple in selling iPhones.

Competitive advantage always originates from one of these sources but it can manifest itself in many different forms. Most known of those forms are:

• Economies of scale

• Brand recognition

• Network effects

• Pricing power

An exceptional business may have one of them or several of them.

Apple, for instance, has several of them:

• The Apple brand is one of the most recognizable in the world.

• Apple benefits from network effects because iPhone is a closed system and more people use iPhone, more people are attracted to iPhone to be compatible.

• Apple has pricing power because it’s monopoly on iPhones. If you want an iPhone, you have to pay what Apple says.

Nobody will switch to Samsung because the new iPhone costs $50 more.

Let’s take Coca-Cola: They have a unique taste and formula which gives them pricing power. If you want Coca-Cola, you have to pay Coca-Cola price.

No person will give up drinking Coca-Cola because it costs 10 cents more this year.

Meta? It has network effects and pricing power. More people use Instagram, more advertisers are attracted to Instagram and if you want to advertise on Instagram you have to pay what Meta asks.

Warren Buffett thinks such businesses as castles protected by wide moats around them:

Those companies are resistant to competition, meaning competitive forces have less effect on them.

You can’t just look at the company and determine whether it has a competitive advantage or not, you have to do reverse engineering.

What are the competitive forces?

Michael Porter set out that there are 5 competitive forces in the market:

All companies are, to some extent, sensitive to these forces. The work is finding out whether the company is more or less sensitive to these forces.

Let’s take Coca-Cola again and ask the questions:

• Is Coca-Cola sensitive to the bargaining power of suppliers?

No. If you are a Coca-Cola supplier, you are lucky. If you don’t meet expectations, Coca-Cola will replace you and there will be thousands of suppliers ready to provide at even cheaper prices.

• Is Coca-Cola sensitive to bargaining power of buyers?

Absolutely not. If a market doesn’t sell Coca-Cola, people will find new markets selling Coca-Cola, it will end up losing customers, Coca-Cola won’t lose customers.

• Is Coca-Cola sensitive to new entries?

Buffett famously asked himself “If I got $100 billion dollars, can I take on Coca-Cola?” The answer was a resounding no. It’s proven. Every year hundreds of drink brands get into the market. None of them has made a dent in Coca-Cola’s dominance.

• Is Coca-Cola sensitive to substitutes?

Everything is sensitive to some substitutes to some degree. However, in more than a hundred years, nothing has replaced Coca-Cola and there is no chance that something is going to totally replace it in the short to medium term.

• Is Coca-Cola sensitive to the industry rivalry?

Two big soda producers are Coca-Cola and Pepsi. There is no third. Their flagship products are their cokes. What determines consumer choice between them is generally palate. People decide very early on whose taste they like better and they stick with it. No Coca-Cola fan switches to Pepsi because Pepsi is cheaper and vice versa. Coca-Cola is indeed not that receptive to industry rivalry.

Coca-Cola can lose market share if Pepsi can do better in being the first one to reach potential new customers, but all things equal, both companies rarely lose customers to each other.

As you see, Coca-Cola’s competitive position is rock solid and only for this reason it has pricing power.

It can adjust its prices in a way that, combined with organic growth, can drive 6-7% earnings growth consistently.

Try this with a packaged rice brand and you won’t get the same result. For many people, the best rice in the grocery store is the cheapest one. It’s a commodity.

You can’t predict future cash flows.

It can be the cheapest for this year and break revenue records, but next year, somebody will somehow sell for lower prices and it will lose customers. It’s a race to the bottom.

That company has definitely a value, maybe a big one, but you are not the one to value it.

You, as a retail investor, should find a company that has some sort of competitive advantage thus predictable earnings. This is the most important part of valuation, not running the numbers.

Expose the companies you are interested in to Porter’s five competitive forces and objectively decide how good they fare. If they don’t fare well, just drop them.

This is the first and most important step.

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Margin Of Safety

Margin of safety is the central concept of investing.

As you have already understood, valuation is based on making educated predictions as to the business’ future.

The future is uncertain and we pick businesses with considerable moats to decrease the level of uncertainty that goes into our calculations.

However, no matter what we do, we can’t eliminate uncertainty. Reality may, and it will most likely, deviate from our calculations.

To mitigate the risk deriving from that potential deviation, we accept it outright and use margin of safety.

Margin of safety is basically demanding a discount on the fair value of the business so you will be protected against the unforeseeable negative events in the future.

It is given that there is no promise of return if you are buying above fair value. You should only buy undervalued businesses. It can be undervalued by 1% or 50%.

The difference between the current price of an undervalued security and its fair price is your margin of safety.

Higher the margin of safety, higher your potential future returns. You want this to be as high as possible so even if something bad happens in the future, you will still have a chance to expect positive returns.

Margin of safety is applied through:

1) By being conservative in your predictions.

2) By demanding an additional discount on fair value.

If the business has been growing earnings 20% annually in the last 5 years, you should assume that growth rate will decline to, let’s say, 15%.

Normally, companies expand their profit margin as they grow because they enhance efficiency. You assume no or little margin expansion, or if it’s a growth company that has just become profitable, you don’t assume a profit margin higher than industry peers.

On top of all these, you should apply an additional discount on the fair value you come up with to determine your actual purchase price.

There is a simple principle you never forget: Demand margin of safety!

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Determining An Appropriate Earnings Multiple

Now that you have spotted a company with a moat around it and conservatively assumed a revenue growth rate and future profit margin and came up with an assumption of future earnings. This is the time to attach an appropriate multiple to it to value the company.

If you ask me, this is probably the hardest part of business valuation.

What I have observed is, in my own career and in other investors, process of attaching an earnings multiplier follows the similar arch:

• You start simple because you know little about it.

• You go deep into it and understand many factors that affect earnings multiples and you also understand the list is not exhaustive.

• You go back to basics because you understand how little you can really know about it.

I have read dozens of articles on P/E multiples and at some point I tried to use all those principles when I attach an earnings multiple to a business.

Result? Going back to basics.

You are probably asking now “Well, if I am going to return to the basics, isn’t it okay not to go through the second step?, Can I just not learn all the complex ideas about multiples?”

My answer is a resounding “No”.

When you stick with basics without deepening your learning, you are basically acting on dogmas.

When you go through the learning phase in the second step and then go back to basics, you return as a completely different man.

When I attach an earnings multiplier to a business now, I don’t go through all the ideas I learnt about it and determine how each one of them affect the P/E multiple.

However, all those ideas combined creates a paradigm in my mind. When I see something that is grossly inconsistent with that paradigm, an alarm goes off in my mind.

The paradigm is reduced to a simple process in my head and I can understand the reasoning behind the so-called “basics.” If you don’t understand that reasoning, you don’t have that alarm in your mind and that could be fatal in investing.

Here is an example: Peter Lynch thinks a fairly valued business would have a P/E ratio equal to earnings growth rate.

If the earnings are growing at 25%, a fair P/E ratio should be 25.

Well, that’s a helpful starting point, but it’s not definitive.

Let’s assume that a business grew earnings 100% last year and it’s now trading at 100 P/E.

Now assume that this is a medical mask company and last year was the peak of Covid-19 pandemic.

Would you be willing to pay 100 times earnings to acquire the company?

You would be out of your mind if you were.

It’s a cyclical company in a highly competitive and price sensitive market. Even if you assume it’ll double the earnings next year too, it will still trade at 50 times earnings. Chances are great that its growth will stop and you won’t get a return on investment for the next 50 years.

So, for Lynch’s principle to apply, growth should be somehow sustainable.

If you don’t have this paradigm in your mind you will look at the growth and P/E ratio and say it looks reasonable. That would push you off the cliff.

We will have a post dedicated to nuances of P/E ratio later in this course, but for now let me give you some basic principles for the purposes of this issue.

• Graham’s Base P/E Ratio

Benjamin Graham thinks that a profitable company with no growth should be valued at least 8.5 times earnings. His valuation formula reveals this:

That 8.5 you see in the equation is the base P/E for no growth companies.

The idea of base P/E makes sense because, within the market dynamics, it’s definitely possible that a company can trade at any valuation. This creates a spread and where there is a spread, there is mean. Where there is mean, there is also “mean reversion.”

Therefore, the idea goes on to suggest that when a profitable company with no growth is valued below that, it should revert to 8.5 times earnings over time.

So the principle that can be derived from here is that if you are looking at a consistently profitable company, it would be wise to attach an earnings multiplier no less than 8.5, following Graham’s principle.

• Company Specific Median P/E

If the company you are looking at has a long enough history behind it as a public company, looking at the median P/E for the last 10 years may give you a good idea.

As an alternative, you may take the lowest and highest multiples it traded at in the last 10 years and calculate fair value separately for each of them to see the spread and have a better idea of the range you can expect.

• Industry Specific Median P/E

The company may be performing exceptionally good or below standard in the last years.

In both cases, it will likely revert to mean in the future.

Given that your valuation also concerns the future, past P/E for the company may not be indicative.

In this case, you may be better off looking at the P/E multiples of more stable and mature companies in the industry.

All these are helpful basic principles to start with but they are not definitive. You still have to go through all the complex ideas behind it so you can have the paradigms in your mind to make required adjustments more correctly.

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Discount Rate

After attaching a multiple to your future profit estimate, you come up with a future business value. Now you have to discount it back to now to see the valuation it should be getting today for you to expect positive returns.

What discount rate should you use?

Well, what return do you want? In principle, I want at least market return, which is 10%.

It’s the historical average return of S&P 500 and gives you what price you need to expect market performance so you can correctly adjust your expectation and margin of safety relative to the market.

This is because all investment opportunities compete with each other and you won’t assume an additional risk of picking a stock if it doesn’t promise more than 10%. You can easily get it by buying the index.

Don’t be too smart and use something different because you think the market will do better or worse than 10% in the future.

Just stick with 10%.

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Apple Case Study

I picked Apple as the subject of our case study because all the basics we mentioned here are easily trackable in Apple.

We will do two valuations here:

1) First we will value Apple today and decide whether it’s an attractive investment opportunity now.

2) Second, we will go back to 2016, when Buffett first bought Apple, and value it today to see whether it was an attractive opportunity back then. With the power of hindsight, we will also see how well our valuation would play out.

Let’s get started:

-Are Apple’s earnings predictable?

Let’s expose Apple to 5 competitive forces of Porter:

• Supplier Bargaining Power

Being an Apple supplier is a privilege. Its suppliers don’t have power to create any kind of pressure on Apple.

If they don’t deliver, Apple will replace them with minimal loss but the supplier will likely go bankrupt.

• Buyer Bargaining Power

Apple buyers seem to have very little bargaining power. Apple already charges above industry prices and buyers are happy to pay.

Apple hasn’t lost any market share due to its price increases in recent years.

• Threat Of Substitutes

Apple products proved to be resistant against competitor products with incremental developments.

Samsung has come up with phones with superior technical specs to the iPhone but it couldn’t shake the iPhone’s dominance so far.

Slightly better products are not enough to replace the iPhone, you need disruptive innovation, a completely new product that is 10x better than iPhone.

• Threat Of New Entries

Apple is now a $3.5 trillion company with more than 2.4 billion installed bases across the globe.

It will take at least two decades for a viable new entrant to match Apple in terms of research and development, supply chain and distribution.

• Industry Rivalry

Apple has consistently proved to be resistant to industry rivalry.

It’s the most recognized brand in the world and its customer base is significantly more loyal than that of other companies.

From a competition perspective Apple looks incredibly entrenched.

This position is manifested by its brand recognition and pricing power.

Ask Apple users whether they will give up their iPhone if the next iPhone is $100 more expensive. Most of them will say “no” in a heartbeat.

I think it’s fair to say that Apple is an exceptional business protected by a wide moat.

When you look at its revenues, this assumption is justified.

Its revenues don’t fluctuate much year-over-year and its moat allows us to make future predictions depending on the past data.

-Forward Looking Assumptions

Apple generated $171 billion revenue in 2013 and $383 billion in 2023.

This gives us 5.8% annual revenue growth rate for the last 10 years.

Now, let’s remember the concept of margin safety and assume that it will grow revenue 4.5% annually in the next 5 years.

This gives us $595 billion revenue for 2033.

Now let’s turn to profit margin.

In the last three years, Apple’s net profit margin was fixed at nearly 27%.

Given that Apple benefits from economies of scale, it benefits from operating leverage and we can argue that its profit margin will enhance from 27%. However, let’s stay conservative and assume that it will stay constant at 27%.

This gives us $161 billion net income for the year 2033.

-Earnings Multiple

In the last 15 years, Apple traded at a P/E between 8.5 and 35 with a median of 20.

Looking at the industry peers as an original equipment manufacturer, Samsung is the most comparable one to Apple and it’s currently trading at 14 times earnings with a 5 year median of 15.

However, when you also take into account that Apple has an amazing ecosystem and platform and consider it as a diversified company, your industry peers suddenly become companies like Microsoft and Google. Over the last 10 years, Microsoft had a median P/E of 30 and Google had 28.

Combining these three viewpoints, it looks reasonable to stick with 20 as the appropriate earnings multiple for Apple.

This gives us a $3.2 trillion company.

Apple today is already a $3.5 trillion company. This means that the next 10 years have already been priced in with a fair 10% premium. This only makes sense as the market also knows Apple is highly predictable so it’s natural that next 10 years are already priced in.

-Discount Rate

Now let’s see how it should have been priced today for us to demand at least the market return.

When we apply 10% as the discount rate and discount it back to 2024 (9 years) we get a $1.25 trillion company.

Meaning, if Apple was valued at $1.25 trillion today, we could expect it to market perform and reach full valuation in 2034 based on our predictions. However, we shouldn’t expect any positive returns for the next 10 years as the future is already priced in the stock.

Does this mean Apple is grossly overvalued? No, Apple is fairly valued. Market correctly prices the next 10 years in the stock today.

The market doesn’t wait for actual events to price them in. It prices everything to the extent that they are readily available.

When we attach an earnings multiple to the future earnings, we find the future fair value of the business. If you want to know how much it is worth today, just use inflation rate as the discount rate.

We are using 10% to determine the price we can pay today to expect at least 10% return.

In the case of Apple, the next 10 years are priced into the stock. There is nothing to exploit.

Does this mean Apple won’t appreciate in the next 10 years?

No. Apple may come up with something we can’t see now and that may skyrocket the earnings. Another possibility is that Apple may keep getting the high premium it gets today and the stock will naturally appreciate as the earnings grow. However, these are scenarios an intelligent investor cannot bet on.

We have to say that everything looks priced in and Apple is trading at a fair premium given the 10 year outlook. There is no investment opportunity.

However, this hasn’t always been this way.

Now let’s go back to 2016 and determine whether there was any investment opportunity back then.

Apple Back In 2016

In the end of 2016, Apple financials looked like as follows:

2010 revenue: $76 billion

2015 revenue: $234 billion

5 Year Revenue CAGR: 25%

2015 Profit Margin: 22%

In August 2016, Apple was trading at 11 times forward earnings with a market cap of $535 billion.

You could highly conservatively argue that Apple would easily grow revenues 10% annually from 2015 to 2023.

This would have given you a revenue estimate of $501 billion for 2023.

Apple generated $383 billion revenue in 2023. Your prediction would have proven optimistic. But this is not the end.

If you stayed conservative and assumed that Apple’s profit margin would remain the same, you would expect $110 billion net profit in 2023.

Apple generated $97 billion net profit in 2023.

Thanks to your generally conservative attitude, upside mistake on revenue would have been corrected to some extent.

If you attached the same 20 PE to $110 billion profit, you would get a $2.2 trillion company. Discounting it back to 2016 at 10% would have given you nearly a $1.1 trillion valuation.

Apple was trading around $530 billion. You would have 50% margin of safety.

You would think there was a big opportunity in the stock and such an investment would have met your expectation as the lowest valuation of Apple in 2023 was $2.1 trillion.

Now I am going to tell you what you have been thinking about: This was a very bad valuation. It was.

I could have done much better estimates by going deep and looking at how many people had iPhones in 2016, how many more could get one in the next 7 years, what price increases could Apple actually make etc…

I could perhaps come up with an 8% average annual revenue growth rate. Nothing would change, I would still find that Apple was grossly undervalued. This is the beauty. It was obvious.

If you think such obvious things are rare, think again. TSMC was at $90 a year ago, American Express at $150, UnitedHealth at $460 etc…

You want more? Okay, Coca-Cola was $52 in October 2023, Meta was $390 in February, Nvidia declined to $76 in April…

There are going to be more… 

Find those companies that are so strong and so grossly undervalued that the mistakes in your valuation could be corrected over time.

This is why Buffett says “time is a friend of exceptional businesses.”

As you see, valuation is far from being a science.

Every valuation is open to mistakes and the best we can do is to remain generally conservative.

We should be willing to underestimate the power of the business rather than overestimating it.

Good surprises are welcome but bad surprises make you lose money.

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Conclusion

Valuation is where you show off your craft.

It’s where you put everything you learn in application. This is why it’s so interesting, complicated and also simple at the same time.

More you learn about the qualitative aspects of investing, the more you learn about general industrial organization, market characteristics and capital allocation, the easier valuation will become.

There is no way to advance your valuation skills just by concentrating on them.

More you know, the more you think about the fundamentals, better companies you will pick, better assumptions you will make and more appropriate multiples you will attach to different businesses.

In simple terms, valuation process looks like follows:

• Pick a business that is predictable.

• Make conservative assumptions based on the past performance.

• Attach the appropriate multiple.

• Discount what you find back to the current moment to determine what you can pay to expect your determined rate of return.

If you want to advance your valuation skills, my advice to you is not spending more time with spreadsheets and models. It is spending more time learning more about business, competition, entrepreneurship, marketing etc…

Learn more about businesses. Investing in common stocks is essentially buying a piece of a business.

Learn more about business, you will become a better investor and your valuation skills will also get better.

That’s all friends!

Thanks for reading Capitalist-Letters!

Please share your thoughts in the comments below.

👋🏽👋🏽See you in the next issue!