Would Warren Buffett Buy Apple?

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It is well known that the world’s greatest value investor likes to buy beaten down stocks, and no stock is more beaten down right now than Apple (NASDAQ: AAPL). With Apple down nearly 26% from its highs in September, does it now constitute a decent value investment for Buffett?

Buffett does not like to invest in something he does not understand, and I follow the same methodology. However, the Sage of Omaha has expressed his frustration in the past for not being able to get into Apple when it was an undiscovered story.

Unlike the majority of tech stocks, Apple has significantly less of its income and balance sheet devoted to patents and unfathomable technology and intellectual properties. The majority of Apple's revenue stems from the sale of products, which is a simple business model and the reason I believe Apple could be a worthwhile investment for Buffett.

Buffett's reputation is based on his well-timed buying of stocks, like his purchase of Coca-Cola (NYSE: KO). At a time when a lot of Wall Street analysts had deemed Coca-Cola as a “very expensive stock,” Buffett believed the stock was significantly undervalued. When Berkshire had finished buying its initial holding in KO in 1989, Coca - Cola was valued at $15 billion - Buffett believed the company was worth closer to $30 billion. This well timed buying and calculation has helped make Berkshire what it is today.

Another example of Buffett's well timed buying style is American Express (NYSE: AXP). Rocked by scandal when Buffett first brought the stock in the 1960's, American Express looked cheap to Buffett based not only on current figures and projections, but also his historical analysis of the company. This rigorous research led Buffett to believe that the sell-off was overdone, and he bought the stock heavily.

So, what does Buffett look for in an investment? How does Apple stack up against Buffett’s criteria and do Coca-Cola and American Express compare?

This is not a definitive analysis by any means, it is just a rough idea.

 1.Value

The first area I will be taking a look at is value. Buffett is a well know value investor, so how does Apple stack up against its peers?

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>Apple</p> </td> <td> <p>Industry</p> </td> </tr> <tr> <td> <p>P/E ratio</p> </td> <td> <p>11.9</p> </td> <td> <p>21</p> </td> </tr> <tr> <td> <p><span>Price to Sales (<span>TTM</span>)</span></p> </td> <td> <p>3.2</p> </td> <td> <p>3.4</p> </td> </tr> <tr> <td> <p><span>Price to Book (<span>MRQ</span>)</span></p> </td> <td> <p>4.2</p> </td> <td> <p>6.8</p> </td> </tr> <tr> <td> <p><span>Price to Tangible Book (<span>MRQ</span>)</span></p> </td> <td> <p>4.4</p> </td> <td> <p>6.8</p> </td> </tr> <tr> <td> <p><span>Price to Cash Flow (<span>TTM</span>)</span></p> </td> <td> <p>11</p> </td> <td> <p>18.7</p> </td> </tr> <tr> <td> <p><span>Price to Free Cash Flow (<span>TTM</span>)</span></p> </td> <td> <p>12.8</p> </td> <td> <p>17.5</p> </td> </tr> </tbody> </table>


Apple currently presents a strong value play compared to the rest of the industry. Trading on an earnings multiple currently half the industry average, the stock also offers a strong discount to cash flow and free cash flow when compared to its peers. However, Apple is trading at 4x its book value; this could be a significant issue for a value investor like Buffett.

P/E High 5-Yr      38

Current P/E        11.9

P/E Low 5-Yr       8

Taking a closer look at earnings multiples, we can see that Apple is currently trading near the bottom of its 5-yr range. This once again supports a low valuation investment opportunity.

2. Has The Company Consistently Performed Well?

This is a key point for Buffett's historical analysis of the company. The company’s performance is usually measured by Return On Equity (ROE), or stockholders return on investment.

 

<img src="/media/images/user_14485/roeall_large.png" />


The comparison between Apple, Coke and American Express is revealing. Not only has Apple been a consistent performer over the past few years, but ROE has actually grown  from just under 30% in 2006 to an average of 45% this year. This is a good signal for a prospective Buffett investment, as ROE is a key metric that the legendary investor looks for when evaluating the prospective future returns of a company. Buffett likes to see a strong, steady, and increasing ROE produced by the company, as this increases its prospective future investment potential. Both KO and AXP on the other hand have seriously under performed in recent years!

3. Cash Flow & Profitability

Buffett likes his investments to have a strong free cash flow. This allows the company to reinvest in its growth or return excess cash to shareholders.

Free Cash Flow

<table> <tbody> <tr> <td> <p>$US Billions</p> </td> <td> <p>Company</p> </td> <td> <p>2011</p> </td> <td> <p>2012</p> </td> </tr> <tr> <td> </td> <td> <p>Apple</p> </td> <td> <p>33.3</p> </td> <td> <p>40</p> </td> </tr> <tr> <td> <p> </p> </td> <td> <p>Coca-Cola</p> </td> <td> <p>6.8</p> </td> <td> <p>6</p> </td> </tr> <tr> <td> <p> </p> </td> <td> <p>American Express</p> </td> <td> <p>9</p> </td> <td> <p>9.8</p> </td> </tr> </tbody> </table>

 

This a test that Apple passes quite handily.  In fact, Apple's free cash flow accounted for 70% of gross income in 2011 and 60% of gross income in 2012.

<img src="/media/images/user_14485/net-profit_large.png" />
 


Apple has also been able to consistently grow and maintain a strong profit margin. This is a test that Apple easily passes. Once again both KO and AXP are showing weaknesses in this test. Although American express has a relatively stable profit margin it is still significantly less than Apple’s. Coke has the has the most erratic unpredictable profit margin although in some periods it is higher than that of Apple.

4. Debt & Balance Sheet Strength

 Another key test, not only for Buffett but all investors, is the health of a company's balance sheet.

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>Apple</p> </td> <td> <p>Coca-Cola</p> </td> <td> <p>American Express</p> </td> </tr> <tr> <td> <p>Total Assets</p> </td> <td> <p>176.06B</p> </td> <td> <p>78B</p> </td> <td> <p>155.2B</p> </td> </tr> <tr> <td> <p>Cash & Short Term Investments</p> </td> <td> <p>29.13B</p> </td> <td> <p>14B</p> </td> <td> <p>25.5B</p> </td> </tr> <tr> <td> <p>Other Long-Term Investments</p> </td> <td> <p>92.12B</p> </td> <td> <p>9.4B</p> </td> <td> <p>0</p> </td> </tr> <tr> <td> <p>Total Liabilities</p> </td> <td> <p>57.85B</p> </td> <td> <p>48B</p> </td> <td> <p>136.4B</p> </td> </tr> <tr> <td> <p>Long-Term Debt</p> </td> <td> <p>0</p> </td> <td> <p>13.7B</p> </td> <td> <p>48.5B</p> </td> </tr> <tr> <td> <p>ST Debt & Current Portion LT Debt</p> </td> <td> <p>0</p> </td> <td> <p>15B</p> </td> <td> <p>14.5B</p> </td> </tr> <tr> <td> <p>Current Ratio</p> </td> <td> <p>1.5</p> </td> <td> <p>1</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>Quick Ratio</p> </td> <td> <p>1.5</p> </td> <td> <p>0.9</p> </td> <td> <p>N/A</p> </td> </tr> </tbody> </table>


With absolutely no debt on the balance sheet at all, Apple passes this test with flying colors. The balance sheet is strong, but the company's large investment in long term investments has made the Quick Ratio look only just sufficient, when it could be much stronger. Once again Buffett’s two original investments are still lagging behind, both have significant amounts of debt and the Quick and Current ratios look to be under pressure.

5. Do The Company's Products Rely on a Commodity? 

Not as such. Apple’s products do contain commodities, but only in the same way as Coke contains commodities.

6. Is The Stock Selling at a 25% Discount to Its Real Value? 

This is the deal maker. Unfortunately there is no definitive method to calculate Buffett’s perception of a discount to real value. If there was, then his style would be very easy to replicate.

There is one way of working out a guess, however, and that is through the Graham Number.

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Apple</p> </td> <td> <p>Coca-Cola</p> </td> <td> <p>American Express</p> </td> </tr> <tr> <td> <p>P/E</p> </td> <td> <p>11.9</p> </td> <td> <p>19.4</p> </td> <td> <p>13.9</p> </td> </tr> <tr> <td> <p><span><span>EPS</span></span></p> </td> <td> <p>$35.6</p> </td> <td> <p>$1.9</p> </td> <td> <p>$4.3</p> </td> </tr> <tr> <td> <p>Book Value Per Share</p> </td> <td> <p>$130</p> </td> <td> <p>$7.4</p> </td> <td> <p>$17.4</p> </td> </tr> <tr> <td> <p>Graham Value</p> </td> <td> <p>$323</p> </td> <td> <p>$17.8</p> </td> <td> <p>$41</p> </td> </tr> </tbody> </table>

With this rough estimate, at the mooment Apple seemingly does not meet Buffett's discount criteria; however, neither does Coke or American Express - thereby failing the most important test.

Conclusion

Overall Apple does meet most of the criteria for a Buffett investment. Although it only fails one criterion, it is the most important one. Although we do not know the exact formula Buffett uses to calculate his prospective real value, the Graham number does indicate that the stock is not attractive relative to book value. In comparison, Coca-Cola and American Express also fail to meet Buffett’s suspected buying criteria.

 

Data Sources: YCharts, Motley Fool CAPS


RupertHargreav has no position in any stocks mentioned. The Motley Fool recommends American Express Company, Apple, and The Coca-Cola Company. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus