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How Apple became the world's most valuable company, explained

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Apple is the world's most valuable company by a wide margin, and on Tuesday it released financial results that demonstrated why its stock is valued so highly by investors. Apple reported profits of $11 billion for the quarter that ended in September on revenue of $51.5 billion. That's more than the combined profits of Google ($4.7 billion) and Microsoft ($5.8 billion) — two companies that are, by any normal standard, huge engines of profit. And the year's biggest profits are yet to come, as Apple always posts the best financial results over the holiday shopping season.

What has allowed Apple to deliver such spectacular financial results quarter after quarter is the staggering success of the iPhone, arguably the single most commercially successful product of all time. The iPhone allows Apple to stand in a class of its own in the smartphone world. Android-powered phones are, collectively, very popular, but companies making them have struggled to make a profit in the face of fierce competition and falling prices. Apple has actually seen average iPhone prices rise, allowing Cupertino to enjoy 39.9 percent profit margins — an unheard-of sum for a product in a competitive market.

And Apple expects to have many more quarters of strong economic performance. Not only will loyal customers in rich countries want to upgrade to the latest model every two or three years, but Apple sees big opportunities in China and other developing countries. Right now most Chinese consumers simply can't afford the high price of an iPhone. But Apple's Chinese sales have been growing rapidly — nearly doubling over the past year — and as China's economy develops, Apple is expecting the flood of new customers to continue.

Apple is mostly an iPhone company

To understand why Apple is such a huge and profitable company, you really only have to look at a single product: the iPhone. The iPhone accounted for 62 percent of all Apple revenue last quarter, and as Apple has become more successful, the phone has become more and more important to Apple's bottom line.

Apple sold 48 million iPhones in the quarter that ended in September, generating $32 billion in revenue. That's up from 39 million iPhones and $24 billion in revenue in the same quarter of 2014.

Not only is Apple selling more iPhone than ever, but it's making more money on them too. Apple has managed to raise the average price of the iPhones it sells — likely because customers are opting for models with bigger screens or more storage space. The average sale price of an iPhone during the last quarter was $670, up $67 from the same quarter a year ago.

Apple hasn't disclosed its profit margins on iPhones specifically, but teardowns have suggested that a $749 iPhone 6s Plus may cost as little as $236 to assemble. Andthe company disclosed that its overall gross margin — how much revenue is left after subtracting manufacturing costs for all Apple products — is 39.9 percent. That compares with 38 percent a year ago and 37 percent two years ago.

For any other company, Apple's other offerings — Macs, iPads, iTunes, Apple Watches, and so forth — would be considered big and successful products. Apple sold 9.8 million iPads and 5.7 million Macs. But this is a sideshow compared with the 48 million iPhones.

The iPhone stands in a class by itself

The rising price and profitability of iPhones is particularly impressive because the price of Android phones has been moving in the opposite direction.

The smartphone market is increasingly becoming two distinct submarkets. At the low end of the market — phones that cost $300 or less — Android phones are totally dominant. Indeed, because cheaper phones account for most smartphones sold, Android controls 82 percent of the overall smartphone market.

But at the high end of the market, Android companies have been struggling. While Apple has been selling more iPhones at higher prices, the sales and profits of high-end Android phones from companies like Samsung and HTC have been disappointing. Customers in the market for a luxury phone are increasingly opting for the most glamorous smartphone brand of all: Apple.

And there are signs that this bifurcation of the market — between iPhones for affluent customers and Android phones for everyone else — could become self-perpetuating. For example, I've owned Android phones for the past couple of years, and I've noticed that new apps are often developed for the iPhone first. On paper, there are a lot more Android users than iPhone users. But iPhone users are disproportionately wealthy, educated, and technologically sophisticated, so app developers have an incentive to cater to them first.

Apple also enjoys economies of scale that few of its Android competitors can match. Because Apple sells tens of millions of iPhones every quarter, it can commit to buying components at a massive scale, allowing it to negotiate big volume discounts.

You might expect that the impressive profitability of the iPhone would attract imitators, but creating a luxury smartphone platform is a lot harder than creating a luxury handbag or watch. Android-based vendors have trouble setting themselves apart when they're all based on the same software platform. And creating a new smartphone platform from scratch — and attracting the thousands of developers who would make it useful — is extremely difficult.

Apple is having huge success in China

(ChinaFotoPress/ChinaFotoPress via Getty Images)

(ChinaFotoPress/ChinaFotoPress via Getty Images)

North America continues to be Apple's biggest market, but most of Apple's growth has come from "Greater China" — which includes Taiwan and Hong Kong. Apple's sales in China last quarter were $12.5 billion, nearly double what the company made in China a year earlier.

Apple's status as a luxury brand is even more pronounced in China than it is in the United States. For an ordinary American, $670 is a lot to pay for a smartphone. It's an even bigger outlay for the average person in China, where the per capita income is only about $7,000. In China, an iPhone is a luxury item like a Gucci handbag or a Cartier watch.

In a call following Tuesday's earnings report, Apple CEO Tim Cook argued that Apple was well-positioned for further growth in China. He expects China's middle class to grow by a factor of 10 in the coming years, and as new customers enter the middle class, Apple will be able to sell them iPhones, iPads, and other Apple products.

Apple has more money than it knows what to do with

Apple has generated billions of dollars in profits every quarter for many years now. As a result, the company has accumulated a mountain of cash — $206 billion in total, largely held by Apple's foreign subsidiaries to minimize the corporate income tax bill. This is by far the largest cash stockpile in the world. For context, there are only 15 companies in the entire world whose total value exceeds $206 billion.

An obvious thing to do with that money is to give it back to Apple's shareholders. Earlier this year, Apple vowed to spend $200 billion on dividends and share buybacks, and it has already returned $143 billion in cash to shareholders. The more than $206 billion Apple has now is on top of money it has already pushed out to shareholders.

The other thing Apple could do with its cash reserves is to invest them in new products and services. And the company is doing some of that too. The rumored Apple Car is one such project. We don't know how far Apple has gotten in its development process, but if it does decide to bring a car to market, it could cost many billions of dollars to do so.

Still, there is an inherent limit to the number of innovative ideas Cook and his team can conceive and execute on. So as Apple's cash pile continues to grow, Cook will face pressure to give even more back to shareholders and to lobby for changes to tax law that will allow this to be done without giving Uncle Sam an enormous cut.