The news of Berkshire Hathway's billion dollar stake in Apple reminded me of a post I wrote in January, 2014 explaining the math behind valuing Apple at over three trillion dollars.
From Matt Phillips at Quartz "Apple is the New IBM" and Timothy Green at Motley Fool "Apple is Not a Warren Buffett Stock" to Daniel Sparks at the same publication "Warren Buffett is Right: Apple, Inc. Stock is Undervalued" and John Gruber "Apple has long struck me as the sort of company Berkshire likes to invest in" opinions and interpretations of Buffett's investment have been all over the map.
To add to the conversation, I've reposted my January 2014 thoughts here. This is likely how Warren Buffett valued Apple before he invested.
Apple just released impressive quarterly results: $57.8 billion in revenue, 51 million iPhones, 26 million iPads, 4.8 million Macs, and 6 million iPods sold. So how should we value Apple? How much is a share of Apple really worth?
To read the headlines, you might think Apple is, again, doomed: "Apple's Shares Slump on Weak Forecast" and "Apple iPhone Shares, Outlook Come Up Short" are just two examples. These headlines always encourage people to tell Apple what they must do, and John Gruber wrote about the problem with this approach.
If you look at any valuation number for Apple (for example, a P/E of 12.6, an EBITDA multiple of 8.4) it is remarkably low relative to its competitors (for example, Google has a P/E of 32.2 and an EBITDA multiple of 18.6).
To put this into perspective, if Apple had Google's P/E, it would be worth $1.2 trillion (yes, trillion with a "t") instead of the $452 billion it is worth today. So why is Apple valued with a multiple so much lower than Google?
The Buffett model is important because it will tell us what assumptions we should analyze to determine Apple's value and ultimately its multiple. The model is straightforward: a company's value is based on its ability to generate future cash for its owners (what Buffett calls "owner earnings"). We can analyze Apple's owner earnings by taking its net income plus depreciation and amortization less capital expenditures. This number was $34.7 billion for the 2013 fiscal year.
The key to the Buffett model (and any valuation model, really) is projecting the growth rate of this owner's earnings number. If we assume a future growth rate we can determine the company's value. All of the future owner earnings are discounted back to today's dollars to determine the value of the company. The trick, of course, is being accurate about these growth assumptions, which is where disruption theory and jobs-to-be-done theory can help us.
If we assume that Apple will grow its owner earnings at 5% for the next 10 years, and then 2% for all years after that (with adjustments for cash and debt), Apple's market cap wouldn't be $453 billion. It wouldn't even be $1.2 trillion. It would be $3 trillion. This is a share price of $3,275 in contrast to today's share price of $506. At just 5% annual growth for Apple.
Here is the math behind this valuation:
Let's put this in perspective: from 2004 to 2013, Apple grew at a compound annual growth rate of 74% (meaning it grew owner's earnings basically 74% every year, see the chart above). That is impressive, but not likely to continue forever. So how do we determine if this historical growth rate will slow to 5% then 2%? As Horace Dediu and Jesse Felder have noted, the market is undervaluing Apple's ability to produce future cash flow, so understanding this growth rate assumption is critical to our assumptions.
Disruption helps us analyze Apple's future growth rate because (i) Apple's recent growth has been based on the premium iPhone and (ii) disruption ends up displacing the premium players in a market.
A quick review: Clayton Christensen first described disruption as the "process by which a product or service takes root initially in simple applications at the bottom of a market and then relentlessly moves up market, eventually displacing established competitors." (Christensen somewhat famously analyzed the iPhone's disruptive power incorrectly, but the theory of disruption is still correct).
So will Apple be disrupted? If they were, their growth rate would clearly slow, and thus their valuation would fall as well. The market seems to be saying that Apple will almost certainly be disrupted.
But let's look at an interesting chart tweeted by Jason Snell. It shows Apple's percentage revenue by product.
If we simplify this a bit, it looks like almost exactly like the classic disruption theory chart explaining how incumbents over-serve the market at the high end, while a low-end entrant starts at the bottom of the market, but takes over to become the dominant player.
Here is the simplified Apple chart:
But there is a fundamental difference between the two. In disruption theory, it is a new entrant who disrupts the incumbent. But in Apple's case, the iPhone and the iPad are an example of self-disruption. Apple disrupted the Mac (and the PC) with the iPhone and iPad. While the Mac continues to be a healthy high-end product, Apple absolutely destroyed its own iPod. Six years ago, the iPod was almost half of Apple's revenue. In the latest quarter, iPod sales fell by 50%.
MG Siegler noted that Apple "wants to be the ones to disrupt themselves... But never with stakes this high..." But I would argue the stakes were incredibly high when Apple decided to disrupt the Mac and the iPod (both about 100% of their revenue) at the same time. And history is a good indication that Apple is probably thinking about disrupting the iPhone, even now. A truly disruptive product to the iPhone might not emerge for years, but I can't think of another company that would prepare for and execute a self-disruption strategy like Apple. It is in their culture to do it, as long as the new product is insanely great. As a result, Apple deserves a higher future growth rate than the market is currently giving it.
Disruption theory is a good tool to analyze what happens to companies, but it is not a good tool to help companies figure out what to do. How do you respond to disruption? When is the right time to disrupt? How do you disrupt yourself before a competitor does? These are the really hard questions.
The answer is jobs-to-be-done (JTBD) theory, popularized in Christensen's Innovator's Solution. In short, JTBD theory shows that markets should be defined not by products, which change (and are disrupted) over time. Markets should be defined independently of any product. They should be defined based on the job the customer needs to get done. Products change, jobs are stable.
The iPod is a great example. Microsoft made the mistake of targeting the "iPod market" with the Zune. But JTBD theory shows us that there is no such thing as an iPod market, just as there isn't a cassette market, an LP market, or a CD market. Companies get disrupted because they define the market based on their product, not on the customers job-to-be-done, e.g. the markets for listening to music and discovering new music.
And even simple jobs are extremely complex. Every job has 50 to 150 different customer needs that are independent of any product or solution.
This is the real reason Apple succeeds: they focus on jobs and the customer needs. In the recently discovered Lost Interview with Steve Jobs, we get a look at how Jobs thought and how I think Apple as a company innovates. Jobs says designing a product is a process of "keeping 5,000 things together in your brain" and getting them to fit together. In addition, while people frequently think Jobs said "customers don't know what they want," he actually never said that. What he did say was: "you can't just ask customers what they want and then try to give that to them. By the time you get it built, they'll want something new." And second he said, "you've got to start with the customer experience and work back toward the technology--not the other way around."
So this is how Apple innovates: they don't ask customers what product they want, they focus on the job they are trying to get done (the customer experience), the hundred of needs required to get the job done (the details of the customer experience) and the different technologies and solutions to get the job done best (the "5,000 things" are the 50 to 150 needs combined with an almost infinite number of possible product solutions).
I have worked with a lot of companies over 25 years, and almost none think like Apple and are organized to focus on the customer experience like Apple. And I have been an Apple customer continuously since 1979. If Apple is acquiring new customers today that have even a tiny percentage of my loyalty to Apple products (and I buy them because they help me get important jobs done better in my personal and professional lives), then they will almost certainly be able to sustain at least a 5% growth rate.
Finally, let's look at Apple's product success rate vs. Google. This is another important number, like a batting average for a baseball player. Who would you rather bet on? A player with a .175 average or one with .400?
I am sure my list isn't complete, but if you look at the Google Graveyard of products and the history of Apple launches (from the new Jobs era), Google has about a 7% success rate and Apple has about a 90% success rate. My quick analysis is here (Download Apple vs. Google), and while I am sure it isn't entirely accurate, it is generally correct.
So in summary, this is Apple:
1. A company with a track record of growing at 74% per year.
2. A company that knows how to disrupt its own products better than any other company.
3. A company that knows how to focus on the customer's job-to-be-done.
4. A company with a 90% product launch success rate.
It is a good bet that Apple will beat a 5% growth forecast over the next ten years...