Friday, January 11, 2013

Valuing Apple - Again



              In a previous post on valuing Apple, I explained that the value of a company equals its book value ($126 per share in the case of Apple) plus the present value of all future expected excess earnings.  Excess earnings equal the difference between the rate of return the company is earning on its book value in excess of the cost of capital times its book value.

              The valuation model implies that if the market for the company’s products is competitive, so that the company earns only its cost of capital, the company’s stock should sell at about its book value.  The key to value creation, therefore, are barriers to entry – factors that prevent competitors from entering the market with comparable products.

              One barrier to entry, often associated with Apple, is superior technology.  Although superior technology may appear to be a great barrier to entry at first blush, research I have done over the years indicates that it is not.  The problem is that good ideas in software and computing are evolving so fast that technology quickly becomes obsolete.  The real barrier to entry is not having the best technology today, but having an organization that can continue to be a technological leader for years to come.  And that is where the concern about Apple creeps in.  The genius of Steve Jobs was not in inventing new products, but in motivating people who did and then making sure that those products made it to market in a form with which he was satisfied.

              There are now those, such as HenryBlodget, who are saying that Apple has lost its edge, that the organization is no longer innovating at the rate required to keep competition at bay.  If that is so, then the stock price is at risk.  The year 2013 will be a critical one for Apple.  Continued marginal improvement in existing products is unlikely to be a sufficient barrier to entry to maintain the current levels of return on equity.  To justify a stock price of $600 or more, the company will have introduce truly new innovations in 2013.

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