In fiscal year 2021, they did $34.2 billion in revenue, $2.4 billion in net income and $1.8 billion in free cash flow. Their PE ratio is around 24, and at the time of this recording, the stock is trading at around $240 per share. Large investors I’m aware of that own the stock include Chris Bloomstran who has a 3% position in Dollar General and Tom Gayner from Markel who has a 0.5% position according to Datarama. If you’ve ever analyzed any of the retailers, you’re probably pretty familiar with Costco. Charlie Munger has owned shares in Costco for over 20 years and he’s been on their board since 1997. I recently saw some interesting statistics comparing Costco to Dollar General. Costco has 834 stores while Dollar General has over 18,000 stores, so it’s quite the drastic difference in the store counts. The net sales per square foot, $1,380 for Costco and $262 for Dollar General. And the total revenue is $195 billion for Costco and $34 billion for Dollar General. So despite these two both being massive retailers, it’s very clear that these two companies are playing two entirely different games. They’re really targeting a different type of consumer. Costco is playing the volume game and making minimal profit on each item sold while Dollar General is selling much less items per visit, but making more profit on a percentage basis on each item sold.
Now let’s walk through Buffett’s principles around analyzing a business in Dollar General’s case. First, Buffett wants to purchase a company that is simple and understandable. Dollar General’s business model is very straightforward. It’s to provide a broad base of customers with their basic everyday and household needs supplemented with a variety of general merchandise items at low prices and conveniently located small box stores. Dollar General does not sell some obscure or new tech product. They are just a retailer, which is a business that has been around for a very long time. They sell simple everyday items that the majority of consumers need at an affordable price such as toilet paper, cleaning products, kitchen products, so on. Since they tend to target rural communities, they are able to place their stores at a lower price than many other retailers and they tend to lease their properties rather than buy them to keep costs really low. So the management team is very cost conscious when it comes to Dollar General in building stores and selling their products.
Next, we want to ensure that the company has a consistent operating history. Dollar General most definitely fits the bill in this regard. The company was founded in 1939 and just looking at their store counts over the past 10 to 20 years, it’s just a straight line up and to the right. In 2007, they had nearly 8,200 stores and now they have over 18,000 stores. Over the past 10 years, revenue has grown at 7.9% per year, and earnings per share have grown by 13.6% per year. These metrics have even improved in recent years though as the five year growth rate on their revenues is 9.3% and earnings per share is up 18.1% over the past five years. Their revenue growth comes from the growth of their store count, which is about 5% to 6% per year, give or take, and the growth of sales within those stores, which tends to be in the low single digits say 3% to 5%. Over time, Dollar General has proven that their formula for placing retail stores in pockets where large retailers aren’t at has been a successful strategy for them. They’re growing at a consistent pace and they’re not undergoing any major changes in their business, which is something that Buffett looks for and likes to see. Something that is stable so we can reasonably predict what the future cash flows will look like for the company.
I would expect Dollar General’s margins to improve over time as they increase their store counts, thus increasing their bargaining power with suppliers and achieve larger economies of scale. After looking back at the past, we want to ensure that the company also has favorable long-term prospects. This is another one of Buffett’s principles. So we want them to have favorable long-term prospects persisting into the future. Dollar General has a number of potential catalysts for future growth. First, we’ve all heard about the shrinking middle class and increasing wealth inequality in the United States. As much as I hate to say it, Dollar General is a beneficiary of such a trend should it continue. I’m definitely no expert, but with inflation being high, I think that this trend in fact will continue for the time being. High inflation means the cost of everyday goods are going up, thus someone who shops at a higher end retailer may consider switching to Dollar General because of the better prices they offer.
Additionally, the inflation pressures have led customers to spend more on consumable products such as food and household items and less on other items such as seasonal and apparel. This is good news for Dollar General relative to their competitors because over 75% of Dollar General’s revenue comes from consumables, so it is much better positioned to navigate through this period relative to their peers. Second, the company is continuing to open new stores as they have in the years past. For fiscal year 2022, which they are two quarters into, they expect to add a net of more than 1,000 stores, which is a 5.7% increase year over year in their overall units. Back in 2016, management stated that there was potential for over 25,000 Dollar General stores in the US alone, which again is at 18,000 today.
Management has also mentioned in a recent call that the demand and opportunities for new stores is outpacing their ability to fill that demand. This is fantastic as an investor that’s looking at their future growth potential. Additionally, around 80% of the stores they are opening are larger than their typical store, which should also contribute to sales growth as well. Third, they are continually investing in new business segments to further enhance their value proposition for the customer. These include DG Fresh, which is a push to sell more frozen, refrigerated and fresh foods to consumers. Their NCI initiative which seeks to expand their offerings of non-consumables, and their DGX expansion, which is their way of expanding to more urban areas. I believe that all of these are proof that management is creative in looking for ways to enhance their offerings to consumers as well as continue to expand their store counts. It’s a win-win for customers, shareholders, and for the employees that they’re hiring for these initiatives.
Warren Buffett says that, “The key to investing is not assessing how much an industry is going to affect society or how much it will grow, but rather determining the competitive advantage of any given company and above all the durability of that advantage.” And I believe that Dollar General does have a sustainable competitive advantage or a moat as Buffett would call it. I was debating whether I should cover Dollar General or not on the show, given that there are a number of other retailers out there and a lot of competition and we’re really in the middle of this technological revolution with companies like Amazon and the like. However, Dollar General really seems to have built a moat that is immune to both of these forces. They practically have a monopoly in many small rural communities, but rather than exploit their customer base, they keep their prices within 3% to 5% of Walmart so customers can depend on them to consistently provide reasonable bargains on their products.
Additionally, Dollar General sets their prices 40% lower than two of their competitors, CVS and Walgreens. These are some stats I found in Adam Seessel’s incredible book, Where The Money Is. He is someone who I interviewed on the Millennial Investing show a couple times this year and he’s just a fantastic resource when it comes to value investing. Also, many customers claim that Dollar General’s locations are just too convenient to want to shop anywhere else. Their customers are so loyal to their business that same store sales for the company have increased for 31 years in a row. It’s very clear that Dollar General’s competitive advantage is low cost, convenience and the trust they’ve built with their customers.
Let’s move on to chat about the company’s management. Buffett looks for three things from the management of the companies he invests in. He wants managers that act rationally, that act candidly with shareholders and managers that resist the institutional imperative.
So I’m going to chat through some of the things I’m seeing from Dollar General’s management to help explain why I believe they are moving in the right direction. Taking those pieces a step further, we want to invest in companies that allocate capital effectively. That means if a company isn’t reinvesting in the business at a high rate of return, then they are sending the capital back to shareholders through share repurchases or dividends. Dollar General’s most recent quarterly dividend was 55 cents, which over the course of a year would bring the dividend yield to around 0.9%. Their dividend payout ratio over time has been around 20%, so they shouldn’t have any trouble continuing to issue their dividends. Additionally, management has been performing a share repurchase program. Since 2017 management has repurchased nearly 20% of shares outstanding. In 2021 alone they repurchased 5.6% of shares outstanding, which is great to see as our ownership of the company increases over time as more shares are being repurchased.
The share buybacks over the last 12 months have been nearly $2 billion. The dividends that are paid in the pretty aggressive share buyback tells me that management isn’t interested in reinvesting back into the business just for the sake of growth. Rational managers know that capital should only be reinvested back into the business if high return on invested capital can be achieved. From 2013 through 2019 return on invested capital tended to be around the 30% range, which is just fantastic. And from 2020 until now, return on invested capital has been in the 10% to 13% range. Over the years we’ve seen earnings continue to march upward. As I mentioned earlier, over the past five years, earnings per share have increased by 18.1% per year, which is just truly remarkable. The company is led by CEO Todd Vasos, who has been the CEO of Dollar General for nearly eight years and been with the company for nearly 15 years. Jeff Owen will be taking Todd’s spot as CEO later this year. Jeff has been with the company for nearly 30 years, which is also a really great sign for a new CEO.
After listening to the company’s most recent earnings call, it seems clear to me that they really have shareholders best interests in mind as for each new store they open, they expect to receive a 20% to 22% internal rate of return. So it’s very clear that they’re only going to build out these new stores if they’re really sure they can achieve a really high rate of return to the benefit of shareholders. Also, I’m seeing the out performance in the stock over the past five and 10 years, so that tells me that their formula for releasing new stores and appealing to customer demands is actually working. Annualized returns for the past five years is 25.7% per year and 9.1% for the S&P 500. So it’s 25.7% for Dollar General. Annualized returns for the past 10 years is 16.5% per year for Dollar General and 10.2% for the S&P 500.
Personally, I like to own companies that have outperformed the market over previous years as it’s much easier to find a company whose business formula is already working than to try and find a turnaround story that may or may not end up actually playing out. So really following that tune of looking for winners, buying winners and holding onto winners. Taking a quick look at the balance sheet, total assets sit at 26.3 billion and total liabilities are 20 billion. The company does have a decent amount of debt, but they are producing one to $2 billion in free cash flow, which should be sufficient to cover their liabilities and their current ratio is above one. So they already do have enough cash on hand should they need it. Their debt to equity ratio is currently 0.84, which seems a bit high. For reference, Costco’s debt to equity is 0.33. Walmart’s is 0.59. I believe some level of debt is good for a company, especially in recent years as companies like Dollar General have been able to take on debt at very low rates, say 2%, 3%, 4% and then invest that money into new stores, that will generate returns significantly higher than the cost of the debt.
Another thing I’d like to point out really just to the debt that Dollar General has, the company seems to be a much more counter cyclical company than most other companies. For example, during 2008 and 2009, their revenue grew by 10% and 13% respectively. Their net income did dip slightly negative in 2008, but other than the temporary hiccup in the net income, their top line growth was business as usual. Same store sales during that period were up 9% in 2008, and 9.5% in 2009, showing that consumers still needed their products as much during a recession than they did prior to it. Store counts also increased during that period as well. So relating that to the higher debt they have, I think they are somewhat less susceptible to these downturns just due to the nature of their business in just offering consumers products that they truly need no matter if the economy is doing well or not doing well. Consumers need the products that Dollar General offers them.
Next, let’s turn to the financial tenants that Buffett looks at when analyzing a company, starting with the return on invested capital. As I mentioned earlier, from 2013 to 2019, this was in the 30% range. And from 2020 until today, return on invested capital has been in the 10% to 13% range. This is an adequate ROIC in my view, and it’s important to keep in mind that companies with a high return on invested capital can grow without needing to invest as much as an average company. This gives them an advantage over many other companies and will hopefully lead to continued out performance for the stock over the long run. Turning to their profit margins, their gross profit margin has been consistent over the past 10 years as it has hovered around 31%. Walmart’s gross profit margin is 25%, Dollar Tree’s has declined over the years but still sits at 29%. The gross margins for Dollar General look really strong in my view.
So from a business and management perspective, everything looks really good to me, but Buffett’s final check is to determine the intrinsic value of the company and only make the purchase if the stock is trading below that value, at least to some degree to provide a margin of safety. First we need to determine the owner’s earnings for the company to use in our valuation. I pulled Dollar General up in our TIP finance tool on our website and I see that the free cash flows for Dollar General have been a bit up and down over the past few years. Free cash flows steadily grew from 2013 to 2020 and the free cash flows in 2020 ended up being 1.4 billion, in 2021, $2.8 billion, and in 2022 the free cash flows were $1.8 billion. I’m going to use these free cash flow numbers to determine the reasonable amount we can use to project into the future.
Because of the issues with inflation, we may see a temporary pullback for fiscal year 2023, but I would expect that in a normalized environment that 1.8 billion is probably a reasonable free cash flow amount to use to project forward. Just so I had the flexibility in doing my own projection, I actually just built a quick little Excel model to project this amount going forward to help determine the intrinsic value. First, we need to project out the growth rate in the free cash flows for the company. Since 2013, the free cash flows have grown at a compounded annual growth rate of 13.8%. And because of the economies of scale they have achieved I would expect the profitability of each store to accelerate over the coming 10 to 15 years.
To try and build a little bit of conservatism I projected the free cash flows to start at 1.8 billion and grow at 12% per year for the first 15 years, then grow at 7% for the following 10 years and then level out at 3% into perpetuity. In my Excel model, I just extended it out to 50 years to try and keep it a bit simple. After projecting out these cash flows and discounting them back to today at a discount rate of 10%, I came up with an intrinsic value of 65 billion while the current market cap of the company is 55 billion. Meaning that if these free cash flow and growth rate assumptions hold true, then the stock is probably trading at around a 15% discount to the intrinsic value. Again, no model is going to be perfect in their projections for what’s actually going to happen. It’s just to get a good idea of where the intrinsic value sits at relative to the market price.
Another method in determining whether it’s worthy of an investment is to project out the cash flows and then compare that to the current price using an IRR calculation. Internal rate of return. So I used the IRR function in Excel to determine an expected rate of return of 11%, which is really pretty good for the market environment we’re currently in and the fact that stocks have really been up a lot over the past five, 10 years, which in turn pushes expected returns down. I believe that it’s likely that this stock will produce a decent return over the next decade, potentially double digits if the management executes effectively. But I think it’s very much a value play and not something you can expect to just get rich quick overnight. If international expansion is a success for them, then in my opinion, this company is just getting its footing. So in a sense you’re getting a great company at a fair price and on top of that, you’re getting a call option embedded into the company based on how the international expansion ends up turning out.
As right now, they are primarily focused on the US. That’s where almost all their stores are. If the company is able to expand internationally to a certain degree, this could lead to a lot of potential upside for the company. We would only consider buying this company for the success of their formula in the US and not have to rely on the international growth though. As I mentioned earlier, they’re really just getting started in Mexico and I’d expect their formulas work there as well really, but definitely no expert on that. In determining an appropriate valuation I also like to look at one or two of the multiples and see how it’s really changed over time. Sometimes you want to avoid buying a company if it’s trading at a multiple much higher than where it has been historically. Just using the EV to EBIT as an example to get an idea here, I see that this ratio is around 22.5 while over the past four years, it’s ranged between 13 and 25. I believe it’s on the higher end now because they’ve had a bit of a pullback in the earnings in recent quarters likely due to inflation pressures.
As far as major risks I see in the company, I think it’s certain that they will grow over time. It’s really just a matter of how much they will grow. Risks that could hamper that could be competition such as companies like Dollar Tree or Walmart tapping into their market share. But I’m not sure that competition is a huge risk as management mentioned that they are seeing more opportunities to open new stores than they can keep up with. But on the other hand, they’ve also mentioned that competition is intense, which I’m sure many companies just naturally say because capitalism is capitalism and there’s always profits out there to be made and chased after by a number of players.
The second risk I see in Dollar General is just the management’s ability to continue to execute on their business strategy and open new stores at that target return of 20%. History has shown that they’ve been really effective at doing that, but the risk is still present whether that can continue for the next five, 10, 15 years. I believe another risk may be pricing pressure from stores like Walmart or other small box stores to try and attract customers that are shopping at Dollar General. Again, not a huge risk. Just something to keep in mind whether they’re able to keep their prices lower than a lot of other places. This is by no means a recommendation to buy or sell Dollar General. It’s just how I would really analyze the company using Warren Buffett’s framework for analyzing and determining the value of a company.
All right. For the second company I wanted to cover today, I was going back and forth on what company I wanted to dive into. Recently, I had a couple interviews with Adam Seessel on the Millennial Investing Podcast, and after reading his book, I’ve had a fairly strong bias towards wanting to invest in technology companies, and this is for a number of reasons. First, tech companies have been able to build incredible moats that are able to grow very rapidly. And two, tech companies have the ability to be much more profitable than most other industries. This year I’ve really liked Amazon and Alphabet as value plays, but I’ve actually created some content around these two. I chatted with John Huber about why he made Amazon roughly 25% of his overall portfolio earlier this year. That is episode MI 165 on the Millennial Investing feed if you’re interested in hearing that conversation. I am bullish on Amazon over the long run, primarily due to the number of business units they have that just have so much potential long term upside.
Now, touching on Alphabet briefly, their PE ratio is below 19 at the time of this recording, and they are still growing at just an exceptional rate. I also did an intrinsic value analysis on Alphabet a few months back. That is episode MI 207 on the Millennial Investing feed If you’re interested in checking that out. I’ll be sure to link those episodes related to Amazon and Alphabet in the show notes for those that are interested. But today since we’re on the topic of Warren Buffett, I would actually like to talk about Apple today. According to Berkshire Hathaway’s most recent 13F filing, they bought nearly four million more shares in Apple. Assuming they paid around $160 per share, this would equate to a $640 million increase in his massive position. So even though Apple’s stock is up multiples from when he first bought shares in 2016, Buffett still believes that Apple is undervalued today, given that he is still purchasing shares.
According to their most recent 13F filing, Apple is 41% of Berkshire’s common stock portfolio. Additionally, I will also add that Berkshire also purchased more than 10 million shares of Amazon making their position in Amazon now worth over $1 billion. So let’s talk about Apple and run the company through Buffett’s framework. Starting with an overview of Apple’s business model. Apple was founded in 1976 by Steve Jobs and Steve Wasniak, and they’re headquartered in Cupertino, California. Apple is a global technology company that designs, manufacturers and sells smartphones, personal computers, tablets, wearables, and accessories. I’m a huge fan of Apple products myself, and I’ve used a MacBook Pro computer and the iPhone for years. I’m one of those people where I don’t really care that much about the price of Apple’s products. It’s what I really like. It’s what I’m used to. And I honestly know that they’ve just captured me into their ecosystem and I really don’t see myself leaving anytime soon for any reason.
Their main products are their iPhone, Mac laptops and PCs, the iPad, Apple Watch, Apple TV and the AirPods. In 2021, their iPhone sales accounted for over 52% of their overall sales at $192 billion. Just insane. That amount is up an astounding 39% year over year. Their rapidly growing services business accounted for nearly 19% of revenue, which came through at 68 billion in 2021. This segment grew by 27% year over year. It’s honestly pretty incredible to think about the value of the brand Apple has built. It’s been said that Apple reminds Buffett of a consumer product like Coca-Cola that people just simply use every day and they won’t ever consider switching to any of their competitors partially because of the emotional attachment that customers have on it. Buffett noticed that when he took his grandchildren to Dairy Queen, he could hardly get them off their iPhone to order ice cream in the store. Buffett stated, “I didn’t go into Apple because it was a tech stock in the least. I went into Apple because I came to certain conclusions about the value of its ecosystem and how permanent that ecosystem could be.”
Although Buffett didn’t just buy Apple because it was a tech company, he did understand that the world was changing. He stated, “This is a very different world than when Andrew Carnegie was building a steel mill and then using the earnings to build another steel mill and getting very rich in the process. Or Rockefeller was building refineries and buying tank cars and everything. I don’t think people quite appreciate the difference.” It’s pretty hard to put a value on such an emotional attachment, but according to statista.com, Apple’s brand alone is worth $355 billion, making it the most valuable brand in the world ahead of Amazon, Google, Microsoft, and Walmart.
When you look at the biggest winners over the last decade, it’s the companies with the biggest network effect that have scaled up extremely quickly, which is these big tech giants. Apple, Amazon, Google, Microsoft, so on. In today’s market, it’s practically impossible for any business to meaningfully compete with these companies and stop them from continuing to grow their top line and penetrate the moat they’ve built. What Buffett is really seeing in Apple is the incredible moat. This is the number one thing he’s looking for in a business, and Apple is absolutely no exception to that. Also, Buffett is seeing that they have a durable competitive advantage relative to their competitors because of their low capital requirements. Less capital needs to be reinvested back into the business in order to produce the same returns. I’ll touch on the return on invested capital in a bit, but the returns they receive on their business is quite high.
Buffett stated that, “Apple has $37 billion in property, plant and equipment. Berkshire has $170 billion or something like that, and they’re going to make a lot more money than we do. It’s a much better business than we have.” I think one of the most impressive aspects of Apple’s business is how they’ve been able to capitalize on the value of their brand by expanding into different consumer products and business segments. To use a few examples, in 2010, their services business did $2.5 billion in revenue. In 2021, this was $68 billion. In 2010, iPad sales were 4.9 billion. In 2021, iPad sales were 31.8 billion. And over the past couple years, sales for iPhone, Mac, iPad, wearables/home accessories and their service business are all up substantially. Over the past two years, total revenue is up an average of 18.5% per year annualized, which is remarkable just for how big Apple already is today.
As many listeners know, Apple has a really strong presence in the US, but they also have a strong presence in Japan, Europe, China, and the Asian Pacific regions as well. At year end 2021, 42% of revenue came from the US, 24% from Japan, 21% from China. Currently, the largest percentage growth is coming from China whose revenue was up 21% year over year. At the time of this recording, Apple trades at around $150 per share and has a price to earnings ratio of just under 25 and a price to free cash flow ratio of just under 23. So Apple has a similar multiple to Dollar General. Their market cap is a whopping $2.4 trillion, and the stock is currently down roughly 18% from its all time high of $182 per share. Apple has obviously been one of the huge winners over the past decade and over the past 12 years their average annual return excluding dividends is 24.9%. Operating income over that same period is up from 18 billion in 2010 to 118 billion in the trailing 12 months, which is a compounded annual growth rate of 16.7% for the operating income.
Turning to Buffett’s investment principles that Hagstrom laid out in his book, Apple’s product business for the most part is simple and understandable. They sell the iPhone, the iPad, Mac, Apple Watch, so on. The products I already mentioned. They’ve created this ecosystem in a brand that attracts more and more customers into it, and those customers willingly stick around for a really long time. That is fairly simple and straightforward to investors. The services business is where the really high margins are at because they aren’t having to constantly purchase new materials and ship them over China. The services really just become digital. The services business includes things like news plus, Apple Music, TV plus, iCloud, AppleCare, the app store, Apple Pay, Apple card, and the iTunes store.
Apple CEO Tim Cook has said that the company now has 745 million paid subscribers across its services, including in-app subscriptions. That’s up 160 million year over year and is also up five times in five years. The second business tenet is that the company has a consistent operating history. Apple most definitely has that. Their operating income has consistently grown over time. At this point, Apple isn’t really just a hot trend or a fad. They produce products that people use every single day and they’re almost emotionally attached to them. For me, I’m someone who works remote for my job and I use a MacBook Pro every day for work. They’re also taking their business model and continually expanding it to new markets to help fuel that growth as well. For example, China being a big driver as of late.
Three, we want the business to have favorable long term prospects. I would say that Apple most definitely has favorable long term prospects for investors. In 2021, just under half of their revenue came from the US. China in particular is growing extremely fast. In 2021 alone, revenue in China increased by 70% to $68 billion. I think that potentially we might see revenue and earnings normalize with macro headwinds and the covid boost all tech companies received, but I believe over the long run, I’d expect this business to be much larger 10 to 20 years from now than it is today. Because of the brand loyalty that Apple has, they have pricing power, so over time I expect them to be able to continue to raise prices on top of continuing to acquire new customers in new markets. Additionally, history has shown that they are able to invest into the business at high returns on capital, which has led to superior stock performance and I’d expect that to continue as well. Most importantly, Apple has a moat and a durable competitive advantage that allows them to fend off competitors and continue to grow their market share and reach.
Next, the three management tenets. I don’t see anything that is too much of a red flag for Apple as far as management goes. Tim Cook has been the CEO since 2011. The best things that I see from management as far as capital allocation is one, very high returns on capital and two, an aggressive share repurchase program. Apple’s average return on invested capital has been 26% over the past decade. And just in 2021 alone, they’ve repurchased $85.5 billion worth of shares. So they’re reinvesting back into the business, achieving extraordinarily high returns on capital, and then they are taking the remainder of the cash and repurchasing substantial amounts of shares. In 2021 alone an investor’s stake and Apple would’ve increased by around 3% to 4% just from share purchases alone. From 2017 through 2021, which is the past five years, Apple’s outstanding shares have decreased by roughly 5.3% per year with the highest drop being 6.8% in 2019 and the lowest being 3.8% in 2021.
From what I can tell, management acts rationally and in shareholders’ best interest and they resist the institutional imperative and they are candid and communicate to shareholders effectively. Touching on the financial tenets, I mentioned that their return on invested capital has been exceptional. It’s been over 18% for the past 15 years with the exception of 2009, which was 16%. In 2019 ROIC was 25%, 2020 was 27%, and in 2021 ROIC was 43%. Since I just love this quote from Munger, I think it bears repeating. “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.” So if an investor purchases Apple shares at a reasonable price and they’re able to reinvest back into the business at high rates of return, we should expect the stock over the long run to follow suit and compound at a high rate of return as well.
All right. So I’ve talked about Apple’s business and their management, but no investment is worth an infinite price no matter how great it is. So let’s dive into the valuation. Apple’s free cash flow is over $107 billion over the trailing 12 months, which is really just hard to even fathom. The free cash flows are up substantially over the past few years. I’m going to use that amount as my starting point in the projection of my free cash flows. To try and estimate how much these might grow into the future I like to look at the company’s history to try and come up with a conservative figure here. Free cash flows have grown by 11.7% per year over the past five years and 8.4% over the past 10 years. Earnings per share have grown at around 21.9% per year over the past five years and 13.5% over the last 10 years. But that growth has accelerated in recent years as EPS has doubled since 2019.
Now, let’s run through a couple of different scenarios to see if Apple is trading at a fair price today or not. I’m going to break this growth projection down into a number of parts. For years one through five, I’m going to project 12% annual growth in the free cash flows, which is substantially lower than the recent growth as I wanted to be somewhat conservative in my assessment of their intrinsic value, but also somewhat reasonable as well. From years six through 10, I projected 9% growth, from years 11 through 20, 6% growth, in years 20 plus, I set it at 3% as it’s really difficult to really project that far. Projecting out those cash flows for 50 years in my model and bringing them back to today at a 10% discount rate I come up with an intrinsic value for Apple at $3.05 trillion today and the market cap of the company is around 2.47 trillion. So if these assumptions hold true, then Apple today is trading at a 19% discount to the price that is offered by the market. We will call this my base case scenario for what we conservatively expect the cash flows to end up being. This base case gives us an expected internal rate of return of 11.5%.
Now, since there is a decent amount of growth in the assumptions for Apple, let’s tweak these a little bit and see how that changes our intrinsic value. Let’s say there’s a pullback in the free cash flows due to whatever reason. Macro factors or a slowdown in growth this year. I’m going to call this our more pessimistic projection. I’m going to take the free cash flow starting point, which is $107 billion and multiply that by 0.8 to try and bring it down by 20% and consider the possibility of going into a major recession and seeing the earnings contract. I left all the other assumptions the same, and this would put an intrinsic value at 2.44 trillion, which is about equal to today’s market price. This gives us an expected return of roughly 10%.
One other projection I wanted to do was to consider what if for whatever reason, we sold the stock after 10 years? So the first five years, we use a 12% growth rate in the free cash flows. In the next five, we use a 9% growth rate, and then let’s assume we sell our shares at the end of 10 years at a 15X multiple. I’m going to use the $107 billion starting point for the free cash flows. After projecting those out and discounting them back to today, I came up with an intrinsic value of 2.83 trillion, which is roughly a 13% discount to the market. I would say this is a slightly lower intrinsic value than our base case because a 15X multiple is fairly conservative considering that Apple today has a PE multiple of 25, but who knows what the market conditions will be like in 10 years so it’s good to try and be a little bit conservative when you’re doing these projections.
As value investors, oftentimes we might only purchase a stock when the intrinsic value is trading far less than the market value. But I think this approach really depends on the style of investor you are. For me, I would rather opt for a great business that is positioned to continue to grow over long periods of time rather than purchasing a cheap business that might appreciate quite a bit over say the next two or three years as the market realizes it was trading below its intrinsic value.
Putting it in Buffett’s words, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” I also wanted to touch on some of the potential risks investing in Apple. As with purchasing any individual stock, there’s what is called idiosyncratic risk, which is the risk in owning one particular company rather than owning something like the S&P 500. For example, Apple depends on factors really outside of their control which could significantly affect the performance of the stock, such as supply chain risks and their ability to continue to get the raw materials they need. Just the scale they’re at, there’s just this risk around supply chains and raw materials I think. Another risk is their dependence on iPhone sales. Currently iPhone sales account for 52% of overall sales. If this slows down or even reverses, then the stock may not perform as well as we would expect. I’m by no means an expert on this, but potentially governments in other countries such as China say they don’t want Apple doing business in their country or we’re not going to produce these parts for Apple, so they incentivize consumers to buy some other phone other than Apple, for example.
Like I mentioned earlier with regards to Dollar General, inflation might not be a good thing for Apple. They may be able to raise prices on a lot of customers, but maybe some customers won’t be able to afford a price increase. With many Americans not able to afford a $400 emergency, it’d be hard to believe that almost all of them would accept a $100 or $200 increase in the price of their iPhones. However, their website shows that they currently have the iPhone 13 priced at $600 up front, or you can do monthly payments of $25 per month. So maybe inflation won’t end up being a huge risk for them. That’s a question mark in my eyes.
Part of me also wonders whether their formula for releasing a slightly different iPhone each year will continue to work well into the future. It certainly has worked well up until now, but I do believe there may be a risk that a new type of phone comes out in the future that ends up disrupting the iPhone. Maybe it lasts a lot longer than iPhones, because most people replace theirs after a couple of years. Then again, I’m sure this would be a trend that Apple will likely be aware of if it does occur, so they would likely be able to continually adapt to the market taste and preferences, but I don’t want to act like there are no risks investing in Apple outside of the overall market and the macro risks. Since Apple isn’t the only big tech name in town, I think it would be foolish to think that none of the other big tech players won’t be trying to eat their lunch and bite into some of their profits that Apple is getting today.
With all of that said, I do like Apple as a stock pick today for long term value investors. But just because my base case has a stock trading at 19% below its intrinsic value today, it doesn’t mean the stock can’t go lower or it can’t trade sideways for quite some time. Also, you should look at my assumptions and see if they’re reasonable. Maybe you think that Apple will grow at 10% over the next five years or 8%. 12% might be a little bit too optimistic, so you have to come up with your own conclusions to what a reasonable assumption might be for Apple or Dollar General specifically. Also, keep in mind Benjamin Graham’s quote that markets are a voting machine in the short run and a weighing machine in the long run.
This means that during certain periods, markets can be pretty irrational, but if Apple continues to increase their earnings over time and continues to allocate capital effectively, then we should see the stock price continue to march upwards over a long enough timeframe. Again, this isn’t my way of saying that you should go out and purchase Dollar General or purchase Apple. I’m not a shareholder in either of these companies currently. Really, I just wanted to show you what I would look for when analyzing businesses like these. In Buffett’s framework, you want a great business with honest and competent management that is trading at a fair price. Additionally, it’s really important that it has a durable competitive advantage so the company’s cash flows can persist well into the future. I remember when I first started investing one of the first stocks I bought was Apple. I bought it in 2015 after it had a pretty big run up and I remember every day at work I would check the stock price and get nervous or worried if it had dropped that day.
This reminded me of a brilliant interview that Buffett had in which he talked about Apple. He was asked how closely he follows the stock since he has a substantially large position in them. And he mentioned that if you need to follow a stock closely, then you shouldn’t own it. He compared it to buying a farm. When you purchase a farm, you know that some years are going to be really good, some years are going to be not so good in terms of the yield the farm produces and what commodity prices are in any given year. When it comes to Apple, he identified a great business with worthy managers and it was trading at a fair price is what he thought. You make the purchase and you just hang onto it for a really long time and you check on their quarterly or annual results to see how they performed each year and see if that drastically differed from what you originally expected and understand the drivers of that.
It also reminded me of my conversation I had with John Huber back in May of 2022. For those who aren’t familiar, I hosted TIP’s Millennial Investing Show for the past year prior to joining the We Study Billionaires feed just recently. I asked John what edge or advantage individual investors might have over the large institutions with all this data, computing power and human capital. He mentioned to me that the biggest edge he has as an investor is his ability to think long term. If you’re able to have a time horizon that is longer than most other market participants, that can serve as an advantage to you. To use Apple as an example, an investor might conclude that it’s very likely that Apple’s earnings per share will be substantially higher 10 years from now. If most market participants only have a one or two month or one or two year timeframe, then that can give you as a long term investor an advantage because you have that low time preference and you’re able to sit on that investment for a really long time. I just loved that answer that John gave me on the Millennial Investing show for our audience.
The reason it’s an advantage to have that long time horizon is because many people invest emotionally. They want results today, so when a stock goes down, they might get out of it because they want to make money today. And you can’t do that with a stock that’s going down. In a society that thinks so short term, it can pay to be that person that is able to think on a longer timeframe. On top of that, we are constantly being bombarded with new information from news headlines or what’s going on Twitter. It can be easy to get influenced by something like that to sell your position for short-term reasons, thinking that you can predict what is going to happen, so I think that plays into it as well. If you ever want to learn from an investor other than Buffett who is able to have such a long-term mindset, I recommend checking out Nick Sleep.
William Green actually covered Nick Sleep in his book, Richer, Wiser, Happier, and I just had a lot of admiration for the way Sleep invested. He is known in my mind as the guy who recognized the potential in three fantastic companies in the early 2000s or late ’90s. Amazon, Costco and Berkshire Hathaway. All three were just huge winners for him, and I believe he was heavily concentrated in each of them. Sleep invested the majority of his own net worth in these three companies according to William’s book. If you haven’t read William Green’s book, Richer, Wiser, Happier, I no doubt recommend you do. It is definitely one of the best investment books I’ve ever read. William just has a knack for writing, and as the listeners of his podcast know, he has just an obsession with quality. So I enjoyed going back and looking at what William wrote about Nick Sleep in his book.
Nick Sleep’s fund, Nomad Investment Partnership achieves a total return of 921% versus the world index’s 117% during the 13 year period of the fund’s tenure. Nick Sleep’s partner Qais Zakaria said that everything changed for him when he had discovered Warren Buffett and how he invested. He had been working on Wall Street for many years and knew that many of the companies on Wall Street don’t do business in an honorable way. They’re just simply out to make a profit even if it means screwing over somebody else. Yet, Buffett had these annual meetings in Omaha where thousands of people would get together to hear how he was purchasing stocks that he planned to own for decades. According to William, Buffett struck Zakaria as the embodiment of quality. Buffett completely changed everything for him. It wasn’t just the depth of his thinking around businesses, but the honorable way in which he treated Berkshire’s shareholders.
I think Nick and Zakaria’s story along with Buffett’s is so important in a world that thinks so short-term in the way so many people think about what’s in it for me? The way that Sleep, Zakaria, Buffett and Munger invest is a way in which people can invest and store their money in companies and investments that do business the right way and do right by their shareholders, which is the complete opposite of many firms on Wall Street that are just out to make the maximum profit no matter what it takes. If it means screwing over employees, screwing over customers, whatever it means. It’s just all about that max dollar profit that they can get. And Buffett just flips that idea on its head as, I only need a $100,000 salary. I don’t need these yachts and jets and whatever else these CEO and Wall Street execs are buying.
William also dives into the thinking of Nick and Zak and their questions around destination analysis. When they analyzed a business and interviewed CEOs, they sought to answer questions such as, what is the intended destination for this business in 10 to 20 years? What must management be doing today to raise the probability of arriving at that destination? What could prevent this company from reaching such a favorable destination? Is this company strengthening its relationship with customers by providing superior products, low prices and efficient service? Is the CEO allocating capital in a way that will enhance the company’s long term value? While Wall Street is worried about the earnings three months from now, long term investors think about where the business will be 10 to 20 years from now. These guys even went as far to require their investors to sign a document acknowledging that nomad was inappropriate for anyone with a time horizon less than five years.
William stated that, “Sleep and Zakaria played what they viewed as a long, simple game, which involved buying a few intensively research stocks and holding them for years. In a world that’s increasingly geared towards short termism and instant gratification, a tremendous advantage can be gained by those who move consistently in the opposite direction. This applies not only to business in investing, but to our relationships, health, careers and everything else that matters.” I think this is such an important and vital lesson that we can all really learn from because with the way the world works nowadays, it’s just so easy to chase what we want now in order to sacrifice what we most in whatever area of life that may be. It’s natural to be drawn towards whatever feels good now, despite what that might mean for us down the road, whatever sacrifices are given up in later years for what we’re doing today.
In regards to the stock market in particular, this might mean having the tendency to trade too frequently, to make emotional decisions based on alarmist news or stories, to chase the next hot stock or cryptocurrency, to sell quality stocks that have temporarily lagged the market or to sell a winner prematurely instead of letting it compound over years. Sleep says that the ability to resist such urges is one of those big superpowers. So the way to really benefit in the long run is to make those sacrifices today that might seem a bit unappealing. I don’t do William’s book any justice in regards to explaining this long term mindset and house Sleep invests. If you haven’t read his book yet, I can practically guarantee you will benefit from reading it. Not only to become a better investor, but to become a better individual as well. We will be sure to link that in the show notes for those who are interested in checking it out and learning more.
All right. That is all I had for today’s episode. I really hope you found this analysis of Dollar General and Apple to be of some use to you. I certainly enjoyed putting it together for the audience and got a lot out of it, so I hope you did as well. Thank you so much for tuning in, and I look forward to seeing you all next week.
Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.