The one Apple number that should scare investors

Since April 2013, Apple shares have gained some 68%. In that period, the company added $220 billion in market cap, $40 billion more than the worth of Pfizer (PFE) —and at $557 billion, the Cupertino, Calif., corporation is by far the most valuable in the world. If you’ve invested in a large company, cap-weighted index fund, it’s likely that Apple is the biggest holding. Other monster tech stocks, such as Facebook and Google, are also among the biggest forces driving the market, and the case that their earnings will mushroom mirrors the case for Apple.

So, not to be too coy here, what is the case for Apple? In the past, Apple has enriched investors by generating extraordinary returns on earnings it retains, and reinvests, each year. Big returns on invested capital are the metric that Warren Buffett most prizes.

But for today’s investors, what matters isn’t the returns that Apple has delivered in the past, great though they are, but rather what it earns on those retained earnings from now on. That’s the problem. Apple’s asset base has exploded, but it’s making less and less on the new assets it adds each year. Apple’s earnings have grown so big, in fact, that it appears it’s struggling to find highly profitable ways to invest the bounty. It risks suffering the same fate as Microsoft, which shifted in the not-too-distant past from the highest of high-flyers to a still-profitable slow-grower. That scenario won’t satisfy its highly hopeful investors.

Apple’s falling returns are best illustrated by a measure called COROA, or Cash Operating Return on Assets. It’s a yardstick developed by Jack Ciesielski, author of the Analyst’s Accounting Observer, an influential newsletter for money managers. COROA calculates all the cash earnings collected during the fiscal year (after adjusting reported cash flow for cash taxes and interest), a metric called Operating Cash Flows. It then tallies the cost of all the assets deployed to generate those cash earnings. The ratio of Operating Cash Flows to Total Assets (taken as an average for the fiscal year) is COROA. It’s the most basic measure of how much companies earn on the acquisitions, plants, fabs, cash and working capital entrusted to them by shareholders.

Today, Apple’s COROA is phenomenal, besting even the biggest names in tech. The figure for the fiscal year ended September of 2013 was 31.3%. That handily beats IBM (IBM) (15%), Google (GOOG) (19%), Facebook (FB) (22%) and the aforementioned Microsoft (MSFT) (23%). A great figure for a manufacturer is 11% or 12%.

Here, though, the key is the trend. Since fiscal 2011, Apple’s COROA has dropped 10 points, from an astronomical high of 41.3%.

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Another crucial figure isn’t the overall COROA, but rather what Apple earns each year on the extra assets it adds to the balance sheet, its incremental return on investment. Each year, those additional assets have expanded enormously because Apple has been making so much money and keeping most of it. From 2009 to 2010, Apple added $9.4 billion in average annual assets, and earned over $9 billion on them, a return of 100%. But again, look at the trend: That fabulous number has been falling fast ever since, as the tide of assets has risen. From 2011 to 2012, Apple gained $52 billion in average assets, and generated $13 billion on them, a 35% return.

Last year, Apple’s assets expanded by almost $50 billion, but it raised Operating Cash Flows just $4.3 billion, for an 8.6% incremental return. Why are returns falling so fast? It’s because Apple is parking most of its big profits from iPhones and tablets in low-yielding cash and investments. Since 2008, its balance sheet has swelled by $167 billion, and $123 billion of that money has gone into cash, bonds and other investments that, at today’s rates, produce little profit.

Apple’s future isn’t necessarily dire. It’s returning lots of cash to investors through share buybacks and dividends. In April, it expanded its buyback program from $60 to $90 billion, and it’s paying $10 billion a year in dividends. Those policies will limit the buildup of cash that’s reinvested for puny returns. And investors, it should be noted, aren’t expecting huge profit increases from these levels—as seen by the stock’s price-to-earnings multiple. On a P/E basis, Apple’s stock actually looks cheap. Based on the past four quarters of profits, its P/E ratio stands at a modest 15.

Even with a decent dividend yield (1.9%) and an attractive-looking valuation, however, Apple will need to grow its profits and cash flow steadily to hand investors, say, a 10% return. By my calculations, it would need to raise profits a bit less than 7% a year for the next decade (that calculation includes a modest rise in the P/E). So Apple would need to become the first $1 trillion company by the end of 2022.

And this is where even the most diehard Apple believer may want to take a few deep breaths and pause. Given how enormous Apple’s earnings and Operating Cash Flows already are now, how likely is it that the company will find enough blockbuster products to keep them growing, even modestly, years out? Adding to the challenge is that Apple will keep adding tens of billion of dollars in assets a year, and the combination of a growing asset base and flattening cash flow could push COROA even lower. That, ultimately, should cause a decline in the share price. “It seems like nothing can stop them,” says Ciesielski, “[but] then innovation burnout and the law of large numbers both work against you.”

Can Apple overcome those formidable barriers that trumped the likes of Microsoft? Sure, we have examples of companies that have done it before (and the best one, well, is Apple itself). But for investors, it’s best to handicap what’s probable versus what’s possible, inspired by the feats of the past. The odds are strong that Apple will remain a great company. They’re also strong that it’s stock is anything but a bargain.