I'm not selling my Apple stock

Apple had a rough year; its stock price has fallen 25% since the beginning of the year. Apple also reported a weaker than expected outlook and shared that it will no longer report individual unit sales, which many consider a bearish signal within a saturated smartphone market.

It's no surprise that this has introduced some skepticism with current Apple shareholders. A friend recently asked me if she should hold or sell her Apple stock. Her financial advisor suggested she should consider selling. Knowing that Apple is the largest position in my own portfolio, she asked what I'm planning to do in light of the recent troubles.

Every time I make an investment decision, I construct a simple narrative based on my own analysis and research of the stock in question. I wrote down my narrative so I could share it with her. I decided to share it on my blog as well to give you a sense of how I develop these narratives. I've shared a few others in the past — documenting my "investment narratives" is useful as it helps me learn from my mistakes and institutes accountability.

As a brief disclaimer, this post should be considered general information, and not a formal investment recommendation. Before making any investment decisions, you should do your own proper due diligence.

Over the last five years, Apple grew earnings per share at 16% annually. This is a combination of about 10% growth in net profit, combined with almost 6% growth as the result of share buybacks.

Management has consistently used cash to buy back five to six percent of the company's outstanding shares every year. At the current valuation and with the current strength of Apple's balance sheet, buybacks are a good use of a portion of their cash. Apple will likely see similar levels of cash generation in the coming years so I expect Apple will continue to buy back five to six percent of its outstanding shares annually. By reducing the number of shares on the market, buybacks lift a company's earnings per share by the same amount.

Next, I predict that Apple will grow net profits by six to seven percent a year. Apple can achieve six to seven percent growth in profits by growing sales and improving its margins. Margins are likely to grow due to the shift in revenue from hardware to software services. This is a multi-year shift so I expect margins to slowly improve over time. I believe that six to seven percent growth in net profits is both reasonable and feasible. It's well below the average 10% growth in net profits that we've seen in recent years.

Add 5-6% growth as the result of share buybacks to 6-7% growth in profit as a result of sales growth and margin expansion, and you have a company growing earnings per share by 12% a year.

If Apple sustains that 12% percent earnings per share growth for five years, earnings per share will grow from $11.88 today to $20.94 by the end of 2023. At the current P/E ratio of 15, one share of Apple would be worth $314 by then. Add about $20 in dividends that you'd collect along the way, and you are likely looking at market beating returns.

The returns could be better as there is an opportunity for P/E expansion. I see at least two drivers for that; (a) the potential for margin improvement as a result of Apple shifting its revenue mix, and (b) Apple's growing cash position (e.g. if you subtract the cash per share from the share price, the P/E increases).

Let's assume that the P/E expands from the current 15 to 18. Now, all of a sudden, you're looking at a per share price of $397 by the end 2023, and an average annual return of 18%. If that plays out, every dollar invested in Apple today, would double in five years — and that excludes the dividend you'd collect along the way!

Needless to say, this isn't an advanced forecasting model. Regardless, my narrative shows that if we make a few very reasonable assumptions, Apple could have a great return the next five years.

While Apple's day of disruption might be behind it, it remains one of the greatest cash machines of all time. Modest growth combined with a large buyback program and a relatively low valuation, can make for a great investment.

I'm not selling my Apple stock and I'd be tempted to buy more if the share price were to drop below $155 a share.

Disclaimer: I'm long AAPL. Before making any investment decisions, you should do your own proper due diligence. Any material in this article should be considered general information, and not a formal investment recommendation.