Applied Portfolio Management

Dr. Weigand's Market Analysis





In this post I will analyze Amazon, Inc. (AMZN) from a fundamental perspective, and estimate how close the stock price is to fair value after its steep correction, which was triggered by slightly disappointing sales growth (see story on All the tools I use to write this article are featured in my recently-published book, Applied Equity Analysis and Portfolio Management, which also contains a more detailed case study on Amazon's valuation, and an interactive spreadsheet that allows users to study and model the company's metrics in even greater depth. As you read the following analysis, bear in mind that the process featured in the book focuses on whether or not a stock is suitable for a fundamentals-based buy-and-hold portfolio.
Amazon makes an interesting valuation case study because it continues to perplex professional analysts, as it has done for years. In a report dated Jan. 31, 2014, Michael Souers of S&P's Capital IQ downgraded Amazon all the way to "sell," with a 12-month target price of $350, while a team of 4 analysts at Credit Suisse left Amazon at an "outperform" rating in a report with the same date, estimating the fair value of the stock to be closer to $450. Even after its recent revenue miss and price decline, it is clear that analysts' opinions remain divided.
For both the past year and last 3 trading months (shown below), Amazon's stock delivered returns similar to another NASDAQ favorite, Google (GOOG), but Amazon's Jan. 30-31 price decline stands out:


In terms of valuation ratios, such as price/sales, Amazon even looks like a bargain compared with a stock like Google:


And, with all that fast revenue growth, Amazon is also competitive in terms of revenue/share:


But that's where the similarities end. From a fundamental perspective, investor concerns regarding Amazon's valuation can be seen by comparing 3-year growth rates (CAGRs) in key value-creation metrics:


Amazon's 3-year revenue growth is exemplary, but from Dec. 2010-Dec. 2013, earnings before interest and tax (EBIT), net operating profit after tax (NOPAT), EPS and free cash flow (FCF) all contracted dramatically. A multi-year record of selling more and earning less will make it hard for a stock like this to qualify for inclusion in a fundamentals-based portfolio.
Amazon's valuation problems can be traced to declining operating margins, which means fewer sales dollars get pushed into EBIT, and thus NOPAT and FCF, which hurts its per-share valuation. Amazon's operating margin compared to Google is vapor-thin:


and does not compare favorably even with a traditional discount retailer like Wal-Mart:


With such a low operating margin, and thus EBIT and NOPAT, Amazon's return on invested capital (ROIC) is lower than its weighted average cost of capital (WACC), and thus too low for it to create intrinsic value:


Thus, while Amazon has market value-added (MVA) per share that's comparable to Google:


and far superior to Wal-Mart:


Amazon does not measure up in terms of value-creation metrics such as economic value-added (EVA) per share:


or free cash flow per share:


A multi-year trend of soaring MVA and declining EVA is symptomatic of the type of overvalued stock we want to avoid including in a portfolio that's focused on fundamentals:


Credit Suisse's Jan. 31 report provides their analysts' per share estimate of Amazon's fair price using discounted cash flow (DCF) analysis. Their fair-value price of $449 is based on a WACC of 10.5% and perpetual growth of 3.0%. Next we will use the spreadsheet tools that accompany my book to forecast Amazon's future trajectory and run our own DCF analysis.
Several of Amazon's income statement items need adjusting in the forecasts; these are shown in the table below:


Revenue growth for the past 5 years averaged 31.2% per year; this is tapered from 24.0% in 2014 (per S&P's Capital IQ) down to 4.0% in 2018 and beyond, 1.0% more optimistic than Credit Suisse. Although operating margin averaged 2.6% historically, it's been in a downtrend, so we smooth operating margin back to 6.0% by 2018, which is 1.2% higher than the company has achieved in the past 5 years. Net margin is also smoothed upward proportionately, and we fix share growth at 0.0%, which will also help AMZN's DCF valuation. The only balance sheet assumption that I changed was property, plant and equipment (PPE) to sales -- Amazon has been investing heavily in recent years, and it's reasonable to assume that these investments will begin paying off, so their PPE/Sales ratio was tapered from 14.7% in 2013 all the way down to 8.0% in 2018 (lower capital intensity will increase pro forma ROIC and FCF, and thus per share valuation).
Amazon has a beta vs. the S&P 500 over the past 5 years of 0.90, but over the past 2 years their beta has been 1.47. To model an optimistic scenario, I leave their beta at 0.90 and estimate a WACC of 8.1%, considerably lower than Credit Suisse's 10.5%. This will also help Amazon's per share valuation.
As shown below, the optimistic forecast scenario restores Amazon's operating margins to 6.0%:


Return on equity (ROE) and ROIC expand robustly:


as do NOPAT and FCF:


Despite all the optimistic assumptions, Amazon still models up as overvalued using DCF analysis, however:

My per-share fair value estimate of $309.63 is closer to Mr. Souer's. Despite modeling an optimistic future trajectory for the company, Amazon's share price has risen faster than the company's ability to generate fundamentals such as EBIT, NOPAT, free cash flow and economic value-added.
Conclusion: Amazon's recent price correction is appropriate for its extended valuation, but the stock still has another 14% to go on the downside before it would represent fair value to a fundamentals-focused investor. The stock has an amazing investor base, however, so this is in no way a prediction of a negative price path for Amazon -- many investors appear unfazed by its current P/E ratio of 600+, and the stock has rallied a bit off of its recent bottom. While it may be appropriate for some investor's portfolios, Amazon does not meet the value profile for inclusion in a fundamentals-based portfolio at this time.
Disclosure: The author holds no shares of Amazon at the current time, and has no plans to initiate a new position.

Is Apple a Buy at $390? The Fundamentals are Compelling, But the Technicals Continue Weakening. [04.20.13] The market continues its fascination with Apple's downfall. The stock has now shed approximately 50% of its once record-setting market cap, which exceeded $700 billion in September 2012. Writing for Wall St. Cheat Sheet on April 20, Nathanael Arnold asked "Is Apple Down for the Count?", although his article concludes that "All Apple needs to do to reverse its fortunes is unveil another must-have product and it could very well once again become the darling of Wall Street." In this article I will take a detailed look at Apple's fundamentals vs. key competitor Google, with an occasional comparison to Amazon as well.
Let's start out with a quick tour of Apple's profile (all data are from S&P's Capital IQ, unless otherwise specified). With a market cap of $365 billion, the stock is still a major presence in the NASDAQ-100. Their ROIC of 232% is off the charts, and despite a Friday (04.19.13) closing price of $390.53, the analysts' consensus target price 12 months from now is $190 higher, at $580. Although the stock is not much to look at from a dividend yield perspective (1.4%), their P/E of 8.8 is lower than technology down-and-outers like Intel (9.4) and Cisco (11.4). Does Apple really merit a P/E multiple usually reserved for deeply troubled companies? We'll seek to answer that question with a thorough look at the company from a fundamental perspective.


The chart below shows the 3-year compound average growth rate (CAGR) for Apple's key metrics. The company looks great from a rear-view mirror perspective. Average annual revenue growth = 54%, with EPS growing an average of 69% per year. The company has grown free cash flows an average of 34% per year, and economic value-added (EVA) has grown at an average annual rate of 74%. Hard to think of another company that could compete with these results. Of course, the market is a forward-looking discounting mechanism, and after we complete the historical tour, we'll model Apple's future a little later in the article.


Apple's historical profit margins and yields look anything like those of a challenged company. Not only are operating and free cash flow margins large -- in the 20% to 30% range -- but the trend is up for both metrics. As a new dividend-payer Apple's dividend yield is unexciting, but at $390/share the stock has an earnings yield of 11.4%. Not a lot of double-digit earnings yields to be found these days.


Apple's stock performance chart looks like a horror movie. Despite a rough 12 months for technology stocks in general, Amazon and Google managed to post returns of 20-35% over the period. Apple is down 30% year-over-year, and 50% since its all-time high in September 2012. Without question, that is one ugly stock chart.


The fundamental process I follow first compares the level and trend of per-share fundamentals with a key competitor. We'll match Apple against Google in the following charts. In terms of revenue per share (the primary source of all fundamentals), Apple is the clear winner. They've grown revenue/share from $40 to $170, while Google's revenue/share has "only" expanded from $70 to $150 over the same period.


The tendency for Apple to beat on per share fundamentals continues for the next several charts. They've overtaken Google in terms of EBITDA/share:


Earnings per share:


Net operating profit after tax (NOPAT) per share:


and Apple's per-share profits are well supported by free cash flow per share:


Apple's operating margin has expanded from 22% to 35% over the past 5 years, while Google's has compressed from 30% to 26%. Operating margin is a key driver of discounted cash flow (DCF) analysis, as it directly affects EBIT, NOPAT and free cash flow. Large and expanding operating margin is therefore a strong positive in any DCF analysis.


In terms of relative valuation, Apple's free cash flow yield has been expanding, climbing to 7.0% in 2011 and topping 9.0% in 2012, while Google's has never exceeded 4.5%.


Both stocks' price to sales ratios have been declining since 2009, with Apple's stock consistently providing better value based on this metric.


Next we'll look at the classic profitability ratios. Apple's ROA has expanded every year for the past 5 years, most recently topping 24%. Google's ROA shows a 4-year downtrend, compressing all the way down to 11% in 2012.


Return on equity shows a similar pattern. Apple's ROE of 35% is more than double Google's ROE of 15%.


Apple is an absolute killer in terms of ROIC, another key driver of value creation. Google's ROIC has never exceeded 50%, while Apple's ROIC has been well above 200% in both 2011 and 2012.


Economic value-added, or EVA, is one of the purest measures of value creation. While both companies generate large and growing EVA/share, Apple has also overtaken Google based on this metric.


Next we'll examine trends in Apple's key income statement drivers as we set up for our discounted cash flow analysis. Apple's 5-year revenue growth CAGR is 44.8%. Gross margins have expanded from 35% to 44%, with operating margin expanding from 22% to 35%. Net margin shows a similar trend. Common shares expand as stock options are exercised, but the average yearly rate of 1.6% does not dilute Apple's valuation severely.


Now that we've considered the trend in the income statement drivers, we'll forecast Apple's future income statement. Years 2013-2016 are explicitly forecasted, with 2017 representing our horizon forecast -- the values we model in perpetuity. I'm going to really stress Apple in the forecast to build in a solid margin of safety, as the general consensus is that the company's operating performance will begin to suffer from competitors like Google and Samsung. As the table below shows, I've tapered future revenue growth from 12.0% in 2013 down to 6.0% in 2016, and only 2.0% in perpetuity thereafter -- these are very conservative assumptions, and probably appropriate given the intense competition in mobile phones and tablets. I've gradually squeezed gross margins from 40% to 36%, operating margins from 31% to 27%, and net margins from 22% to 18%. This reverses half of the gains in margins Apple has earned in recent years. As a new dividend payer, Apple will probably devote a fair amount of energy to growing dividends. I taper dividend growth from 16% to 6%, and use a perpetual dividend growth rate of 4.0%, slower than slow-growing, large-cap dividend plays like J&J. Once again, all the forecasting assumptions are deliberately conservative.


To calculate Apple's weighted average cost of capital (WACC), I bumped their historical beta up from 1.03 to 1.20, which raises their WACC to 10.1% (very high in this low-yield market). The higher WACC will suppress Apple's per share intrinsic value in the DCF model.


The table below shows Apple's estimated per share intrinsic value each year from 2012 to 2017. Even with the conservative modeling assumptions, Apple has a DCF intrinsic value of $539/share, $149 higher than Friday's closing price of $390. Granted, the squeezing of the margins in the forecasts puts the stock on a very slow-growth trajectory, but a per-share increase of $200 over the next 5 years (with dividends also likely to grow) is not something too many investors would complain about. The stock models up as extremely undervalued at $390/share.


Let's turn our attention to some metrics typically associated with competitive positioning. In the exhibits that follow I use 3 stocks -- Apple, Google and Amazon -- and treat them as a 3-stock market. The graph shows that, based on the total sales revenue of the 3 companies, Apple is gaining market share while both Google and Amazon lose some share. This is just a fancy way of showing how much faster Apple has been growing, even against star stocks in the same sector.


Apple has certain cost advantages over Google and Amazon as well. Apple spends far less on research and development per dollar of sales, which is truly amazing when you consider that the company is still viewed as the greatest innovator of all time:


Apple has consistently spent less on CAPEX/sales than Google, and spent less than both companies in 2012.


Apple also dominates in terms of selling, general and administrative expense per dollar of sales.


The exhibit below takes a different look at Apple, using tools provided by EVA Dimensions, LLC. Their PRVit ("prove it") scorecard ranks Apple as a buy, based on a combination of intrinsic value (ranked in the 94th percentile of the Russell 3000), and actual valuation (ranked in the 48th percentile). EVA Dimension's PRVit system shows that Apple is fundamentally more attractive than 84% of the stocks in the Russell 3000.


Of course, Apple's technical chart looks like something out of a Freddy Krueger movie. The stock price has totally broken down, plunging ever-further below its 200-day moving average for the past 3 weeks. The MACD is increasingly negative, indicating that the negative price momentum is accelerating. The only small bright spot in the chart is the relative strength index (RSI), suggesting the stock is temporarily oversold.


Summing up, Apple's profound stock price decline of approximately 50% over the past 7 months has left it in desirable fundamental territory. It outperforms Google based on virtually every fundamental measure, and a discounted cash flow model using very conservative assumptions suggests the stock could be undervalued by as much as $190/share. Technically, the stock looks terrible, of course, so it's hard to pull the trigger and issue a full-fledged buy recommendation right now. The stock bears close watching, however. If technical sentiment turns, or Apple announces a significant reinvigoration of its product line, or a competitive resurgence in the iPhone/iPad space, or even Apple TV, the stock could easily regain $100 a share or more and still be fundamentally undervalued. Apple belongs on every investor's watch list.
Disclosure: The author owns no shares of Apple at the current time.

Coca-Cola: Fairly-Valued for a QE3 World [08.02.12] Let’s take Coca-Cola (KO) through the fundamental process. As always, we're looking for above-average dividend payouts backed up by a track record of tangible value creation. The comparison company is PEP, which pays a strong dividend, but is far less globalized. KO outperformed PEP over the past 12 months, and gained when YUM imploded in April.


KO shows good average growth, but they are losing efficiency somewhere -- total revenue grows faster than EBIT, NOPAT and dividends (although EPS growth is strong at 14.4%). The sharp contraction in free cash flow indicates a loss of intrinsic value in recent years. Note how the large buildup in assets and capital have not produced proportional growth in revenue, profits and free cash flow. Incremental return on capital should therefore be falling (see below). Moreover, the stock isn't as attractively priced as a few years ago (as MVA grows 17% per year, but EVA only grows 3%).


KO's strong 2011 total revenue result makes its 3-year revenue growth look stronger than it might be. Note the slip in KO's net income in 2011.


PEP generates more than twice as much revenue per share compared with KO.


KO's EBITDA and EBIT trend steadily higher.


KO closes the gap with PEP in terms of EBITDA per share, but PEP still maintains an advantage.


KO's EPS decline in 2011, but they still manage to grow the dividend.


PEP has paid slightly higher dividends/share compared with KO since at least 2007.


KO, having that stronger brand name and little or no exposure to low-margin snack foods, posts a higher operating margin than PEP every year.


KO also has a consistently higher net profit margin.


KO consistently trades at a small premium to PEP, but the gap in their P/E ratios grew in 2011. KO's price looks a little extended.


PEP has out-yielded KO for the past 2 years. Both firm's dividend yields are above average, however.


KO's ROA slipped to 10% in 2011, and their ROIC is in a multi-year downtrend from a high of 55% all the way down to (a still respectable) 30%.


KO's ROIC has compressed down to the same level as PEP. Note that both firm's ROICs have been trending lower in recent years.


KO's FCF/share has also been trending lower, a definite concern for value creation. PEP's FCF/share was negative in 2010, then rebounded strongly in 2011. (If you were modeling PEP, the elevated FCF/share might not be representative of what the company can generate in the future.)


KO's EVA and MVA expand proportionately.


PEP has consistently generated more EVA/share than KO for the past 6 years.


KO and PEP have had comparable MVA/share over time.


We always use conservative assumptions when forecasting companies' financial statements. For KO, we use the Capital IQ consensus growth for 2012 and 2013 of 3.4% and 4.3%, respectively, then taper to a long-term growth rate of 2.0%. We grow dividends slightly below the historical average of 8.7%. All pro-forma margins are compressed back to their 2011 levels.


KO's 2- and 5-year betas are both 0.53, which is quite low. We therefore bump up their pro-forma beta to 0.70. With a risk-free rate of 1.49% (yield on the 10-year T-note on 08.01.12) and a market risk premium of 7.0%, KO has a weighted average cost of capital of 6.0% (which is quite low). KO's FCF is also assumed to grow 2.0% in perpetuity beginning in year 2016.


Based on these modeling assumptions, KO models up as slightly undervalued at its current price of $81/share.


KO shows a profile of an undervalued stock whose price has been corrected back to fair value by the market since the financial crisis. In other words, KO's price was taken down during the severe bear market of 2007-2008, despite the fact that the company suffered comparatively little interruption in its ability to grow revenues and generate fundamentals.


KO's price of $81 remains solidly above its 50- and 200-week moving average. The relative strength indicator of 69 and MACD of 2.6 both corroborate that KO remains in a long-term uptrend.


KO's price is also above its 50- and 200-day moving average. It's currently trading right at the top of its most recent price channel. We like the stock at prices closer to the low- and mid-range of the channel, say $77-$78 per share. We think the last several dollars of KO's price action has been juiced by central bank chatter regarding a possible third round of Quantitative Easing.


Conclusion: KO has settled into a solid, if unspectacular, rhythm. In the choppy, correction-prone markets of 2010 and 2011, KO has produced steady positive results, earning it a below-average beta of 0.53. This low beta fuels an extremely low WACC of 6.0%, which helps KO's intrinsic value, making it appear fairly-valued at its current price of $81. This earns KO a HOLD recommendation for existing owners. For prospective buyers, KO looks a little pricey compared with PEP. Selling in-the-money puts might be a good strategy for acquiring KO. Writers collect short-term option premium and can wait for the stock to come back into the mid- to high-70s, where it becomes more attractive.
Data from S&P's Capital IQ and The author currently holds no positions in KO.]

Apple’s Big Earnings Miss [07.24.12]. So Apple finally had their big revenue and earnings miss on July 24, 2012. What's an investor to do from here? The following article will take you through a fundamental-oriented analysis and valuation process of AAPL, which has been an incredible value creator over the years. The process will contrast AAPL's metrics with AMZN's, a stock whose lofty price has little in the way of a firm foundation. The bottom line is that, in the pre-market action on July 25, AAPL's stock has declined into a range of fair value. The caveat: This miss is likely to be AAPL's inflection point -- I expect it's stock price to grow much more slowly from here on for the next several years. AAPL is more likely to join the Dow 30 in the next few years than it is to soar above $700 a share.
As the graph below shows, AAPL's stock has outperformed AMZN's and GOOG's in the past 12 months:


AAPL has grown both Total Revenue and Net Income significantly in the past 5 years. The 3-year compound average growth rate (CAGR) for Total Revenue is an amazing 42%.


Notice that AAPL and AMZN have similar Revenue/Share each year:


Operating  Profits, measured as AAPL's EBITDA and EBIT, have also grown significantly. The 3-year CAGR for EBIT is an astounding 60%:


Here's where a value-creator like AAPL begins to separate itself from a "concept stock" like AMZN. AAPL flows a far greater percentage of its per-share Revenue to EBITDA:


And all the way to bottom-line EPS as well:


AAPL's Operating Margin is not only large, it's expanded every year for the past 5 years. By contrast, AMZN's Operating Margin is evaporating, having shrunk to a puny 1.8% for FY 2011:


In terms of Relative Valuation, AAPL's stock has become more reasonably-priced per dollar of earnings, while AMZN's rising stock price is not not nearly as well-supported by rising profits:


AAPL's ROA also expands every year, now topping 20%. AMZN's ROA fell to 2.5% in FY 2011:


Of course, ROA = Net Profit Margin x Total Asset Turnover. AAPL's large advantage in Net Margin, shown below:


more than overcomes AMZN's advantage in Asset Turnover (AMZN sells many more small items at low, and often negative, margins):


Operating Profit and Margin (EBIT) is particularly important because Net Operating Profit After Tax (NOPAT) equals after-tax EBIT. In other words, NOPAT = EBIT x (1 - tax rate). AAPL grows NOPAT per share every year:


AAPL thus earns far more Free Cash Flow/Share than AMZN (Free Cash Flow = annual NOPAT minus any change in Total Capital Invested for the year). Because discounted cash flow analysis values a firm's stock as the present value of expected future Free Cash Flow, AAPL's stock price will be far better-supported by fundamentals than AMZN's (analyzed in greater detail below).


NOPAT is also the numerator of Return on Invested Capital (ROIC), which expresses NOPAT relative to Total Invested Capital (ROIC = NOPAT/Total Invested Capital). AAPL has earned ROIC greater than 100% in the past 3 years, while AMZN's has fallen to 16%:


AAPL also earns far greater Economic Value-Added per share compared with AMZN. EVA is a measure of economic profit, calculated as NOPAT - (Cost of Capital x Total Invested Capital):


AAPL grows EVA each year. Further notice how AAPL's Market Value-Added grows proportionately with EVA, suggesting that, despite AAPL's incredible run-up in stock price, the stock is not necessarily overvalued (more on AAPL's per-share valuation below):


We will next forecast AAPL's financial statements and conduct a discounted cash flow valuation (DCF) analysis. The historical values of the key income statement variables are shown in the table below.


AAPL has averaged 41% Revenue growth per year, and grown its margins steadily. To build a margin of safety into the forecasts, we'll taper the growth rate from 15% down to 3%, and squeeze all of its margins back towards average. (Note that the Operating Margin assumption is particularly important because Operating Margin determines the size of projected EBIT, which in turn affects NOPAT, which in turn affects FCF, the variable we discount in a DCF analysis.)


Other key forecasting assumptions pertaining to AAPL's Cost of Capital and long-term growth rate are shown in the table below. I'm using a market risk premium over bonds of 6.5% (note the incredibly low 10-year yield of 1.52%, used as the risk-free rate). I also eased back on AAPL's beta -- although their 5-year beta was 1.21 (Capital IQ), their 2-year beta has fallen to 1.01. To keep the resulting valuation conservative, I also use a long-term growth rate of 3.0%, which applies after the first 4 years of growth of 15%, 12%, 10% and 8% shown above. This results in a Cost of Capital for AAPL of 8.7%, which is the discount rate we'll use in the DCF analysis (to take the present value of AAPL's projected Free Cash Flow).


The analysis shows that AAPL has been a chronically undervalued stock until recently:


After their after-hours price decline on their earnings miss on July 24, 2012, AAPL is now trading in a range of fair value (based on conservative forecasting assumptions) at $573/share:


The table below shows AAPL's fair value range for 2011-2012 as $564 to $583 share. Further note the tepid trajectory of future per-share prices, however:


Conclusion: AAPL's stock has grown fundamentals like EBIT, NOPAT and Free Cash Flow dramatically in recent years. The stock has been chronically undervalued for a significant period, but finally surpassed fair value with its price run above $600/share in 2012. Following it's earnings miss on July 24, 2012, when the stock price fell to $573/share (8:00 a.m.  in the pre-market on July 25), AAPL's stock is now fairly-valued, but priced for much slower future price increases (at least price increases supported by fundamentals). Traders may turn AAPL into a high-volatility plaything for awhile, but fundamental investors should wait for entry points below $550 to earn above-average returns in future years. AAPL's stock is no longer "good at every price," as investors became accustomed to for most of the last 10 years, so pick your spots carefully. If you're a seller, expect AAPL to drift lower for awhile before rallying to better exit points.
All data provided by S&P's Capital IQ. The author currently holds no AAPL stock.]

Markets Remain in “Risk-on” Mode in Early 2012 [02.14.12]
Despite a slow start to the week, US equity markets remain in "risk-on" mode thus far in 2012. The performance of the top sectors (Financials, Technology and Telecom) are shown in the graph below. These sectors have posted total returns of 9-10% in the first 6 trading weeks of 2012.
The next set of sectors, Consumer Discretionary, Industrials and Materials, have averaged about 8% over the same period:
Lagging behind for the year are Energy, Health Care, Consumer Staples and Utilities, with those last 3 being the classic "risk-off" defensive sectors.
Will the market's preference for the risk-on trade be the story for 2012, or will 2012 repeat the pattern seen in 2011, where the risk-on sectors led the way early, with the defensive sectors taking control in the second half of the year?

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