Valuing Apple Inc: Pricing the "Jobs Put Option"

Overview

Today's article in Bloomberg got me thinking about how investors are dealing with the uncertainty surrounding Steve Jobs, namely the possibility of his removal in the wake of the options backdating scandal.  However, I think this mis-characterizes the true underlying fear investors have (and which is the real risk facing the stock): the negative impact on Apple's share price given Job's departure, regardless of reason. It just happens that the backdating scandal is currently in the forefront of most investors' minds, yet this is a man that has fought cancer, and faces that same risks that any of us do who buy insurance to protect our families and loved ones given an unexpected adverse event. Yet I'm not confident that this is how investors are valuing Apple's shares, and pricing in the array of risks facing Jobs (and, therefore, Apple investors) in an insurance oriented, value-weighted, probabilistic manner.

Apple's shares have behaved like a yo-yo as different interpretations of the SEC and DoJ's likely actions concerning Job's role in options backdating have come to light:

Jan. 17 (Bloomberg) -- Apple Inc. may find its most valuable asset is something it can't protect through patents or secrecy: Chief Executive Officer Steve Jobs.         

If Jobs were to leave, shares of the Cupertino, California- based company might drop 25 percent or more, analysts say. That would erase about $20 billion in Apple's market value.                

``It would be a disaster,'' said Gene Munster, an analyst with Piper Jaffray & Cos. in Minneapolis, who's had an ``outperform'' rating on Apple's shares since June 2004. ``He would be almost impossible to replace.''         

The computer maker's dependence on its CEO was illustrated the last week of December, when the stock dropped as much as 5.8 percent after the Recorder, a San Francisco-based legal publication, reported Apple had faked documents to backdate stock options.                 

On Dec. 29, the company said its own investigation, led by Apple director and former U.S. Vice President Al Gore, cleared Jobs of any wrongdoing. That eased concern Jobs may have to step down and sent the shares up 4.9 percent.   

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When "analysts" say the shares might lose $20 billion in value, how are they quantifying this amount? Are the oscillations of Apple's share price when each piece of news concerning the options investigation come to light reflective of shifting probabilities of his ouster, or something on a more visceral level? I don't know. But I'd certainly like to know.

Analysis

As an ex-derivatives guy, it seems to me that the rational investor would value Apple's shares in the following fashion:

Fair Market Value of Common Shares (Apple) = PVFCF (Apple) - Put (Impact of Jobs' departure)

And to value the "Jobs Put" correctly, one needs to consider the following three factors. And this analysis needs to be run for each of the different risks that could give rise to Jobs leaving Apple's helm:

1. The timing of an adverse outcome
2. The likelihood of an adverse outcome
3. The negative payoff associated with an adverse outcome

These are all complex issues, but the negative payoff is certainly the most difficult to quantify. How much of Jobs' DNA has been embedded in the organization? How deep is the creative bench at Apple? What is the real value of his PR glamour status? How long would it take for his departure to impact the fundamentals of the stock? Is he the single most valuable executive in the U.S. today? All hard yet critical questions to consider when seeking to quantify the absolute impact of his not being the CEO of Apple. But, of course, this number needs be discounted by the probability of his not being CEO together with the timing of when this outcome might occur. What the rational investor should probably do is construct a matrix of possible scenarios by flexing factors 1-3 above, and build a range of values for the Jobs Put that is netted against Apple's discounted free cash flow projections.

Conclusion

The Apple situation is very interesting. I'm not sure I can think of another firm whose share price is so inextricably tied to its CEO, a person whom is facing an array of serious risks that could be of great consequence to the firm. And it is precisely because of this unique dynamic that Apple's share price subjects itself well to an options pricing framework, essentially bifurcating the value of the firm into two distinct pieces: Apple (with Jobs) - Apple (without Jobs) = Value of Jobs Put, or by shifting terms;

Apple (without Jobs) = Apple (with Jobs) - Value of Jobs Put

Whether Apple investors are aware of it or not, they are short an option - a big, valuable put option, which they should be attempting to value. If not, may the force be with them. And be careful out there.

Comments

[Jason Wood]

Yaser...to be clear, I agree with you that Apple's fundamentals are well and good. There are a lot of ways to get to the 10mil iPhone number and they're not very daunting.

60mm Cingular subs...1.7 year device churn rate, as long as Cingular subsidizes the device a bit, AAPL could hit the mark in the U.S. alone.

There is the iPod cannibalization issue, but that's neither here or there in today's conversation.

Roger, absolutely I believe the market isn't properly valuing the Apple put. But then again, I've been far more skeptical about the options backdating issue than my brethren, to my detriment thus far. So what do I know...

[Roger]

Yaser, I don't think you got the texture of my last comment. I agree with you about Apple's fundamentals. My point is that it appears that the investment community (you included) might be mispricing the Jobs Put, which needs to be factored into today's stock price. So don't confuse "richly valued" with my perception of Apple and Jobs's excellence - it simply has to do with the pricing of the downside option.

[Yaser Anwar]

RE- I don't think its good karma that Jobs & Apple have with iPod, iTunes and iPhone. They are excellent products selling for a reasonable price, but that's a given.

Too richly valued you say? I don't think so. AAPL has been growing at a clip of 30%-ish for about two+ years now and still trades at a forward multiple of 25 and current multiple of 37-40 (depending on which source you use).

Last year 1 billion phones were sold, if AAPL can have just 1% of that, 10 mill units, will add considerably revenue. And I think they can get at least 2-3% in first 2-3 years.

Also, I think Jobs has trained people incase he leaves. Look at Pixar and his other start-ups/investments. He left Pixie in 98, if my memory serves me right. It has done just phenomenal.

Finally, a company like AAPL deserves to trade at a significant premium because of its excellent management aka Steve Jobs. I don't think he's going anywhere.

The stock has been up close to 50% since July, a little consolidation is good. If you look at its historical trading pattern, you will notice a lot of -ve news floats in the air and then it dies down. Then again, thats what creates opportunities in the market.

Like we discussed a few months back about Warren Buffett and his successor and how the culture is ingrained into Berkshire. I think AAPL is a company like that.

If you have some AAPL, route it to my ECN when it hits 87 aka the 50-day MA ;)

[Roger]

Jason, I hear you. I just wonder if investors are rigorously considering these risk elements in arriving at an appropriate value for Apple's shares. Based upon where it is currently trading, would you say that the market is discounting a very small likelihood of his being removed as CEO, given that the preceived and actual impact of his departure would be extremely large? Or are we alone in thinking that the impact would be substantial if such an eventuality were to occur?

While I think Apple is likely a solid fundamental long with Jobs, it may be trading too rich given the implicit value of the short put relating to his possible departure. Investors sporting rose- colored glasses, maybe? If he has good karma with iPod, iTunes and iPhone, maybe this translates into good karma with iOptions backdating? iNquiring minds want to know.

[Jason Wood]

Roger,

Spooky as one of my partners and I were just talking about this today; trying to quantify the "Jobs factor" relative to current valuation.

Boiling this down to fundamentals (how can I not since that's the way I invest)...

1. Likelihood...higher than most CEOs [for various and sundry reasons]

2. Impact of his departure...tremendous, Apple is perceived (and rightfully so in my estimation) as a highly top heavy organization

I would suggest to you that Jobs leaving Apple would be PERCEIVED and would, in fact fundamentally BE more damaging to Apple than the departure of any other well known current tech bellwether's CEO...

[MSFT] Gates has already prepared the Street for his departure

[ORCL] This would hurt, but he's had Chuck and Safra in place to run things for years

[CSCO] Chambers' departure wouldn't be received well, but Cisco's management structure is much flatter as the senior level

[SAP] Henning's departure would be viewed quite negatively, but unlike Jobs, his replacements are already in house (Shai Agassi or Leo Apotheker)

[IBM] Palmisano would be missed, but how many non techies or investors could even name him?

[GOOG] Schmidt, Sergey and Larry aren't expected to go anywhere, so their departures would hurt, but as much as Jobs?

[YHOO] Plenty would cheer if Semel was replaced

I could go on and on, but if there's another tech CEO whose departure, for any reason, would be met with more negative stock price action, I can't think of them.

[Roger]

Nishant, I am using the put option concept as a metaphor, but you can also think of my analysis as follows. I am positing that an investor in Apple is really making two discrete decisions: (1) to be long a zero-strike call on the Apple operating business with Jobs as the CEO and (2) to be short an at an-the-money put on the risk that Jobs is no longer Apple CEO. That is my thought process.

The investor in Apple is inherently an owner of the call and a seller of the put, with a seller of Apple being in the opposite position. Depending upon one's assessment of Apple's business prospects with Jobs, the likelihood of Jobs not being CEO, the volatility of the likelihood of his not being CEO, the timing of when this might occur and the potential cost of his not being CEO, a buyer and a seller of Apple shares may have two very different views of its fair value. That is my point.

Thanks for the comment, Nishant. Hopefully this helps.

[Nishant]

Can you please elaborate on the put option here ? While I understand the uncertainty of the shareholders' pay-offs associated with the presence/absence of Jobs, I am unable to classify the shareholder position as that of shorting a put (as you have mentioned).

Thanks,