Over-Hyped Apple Has No Real Value
My colleague Tom's article on valuing the QQQQ drew several comments about his target prices, particularly on Apple (AAPL), a favorite momentum play for traders of late. One of the more polite comments asked how a $131 fair value price for AAPL was obtained. The simple answer is "through discounted cash flow (DCF) valuation," but what does that really mean?
DCF valuation is my preferred way to value a business because the underlying principle is that a company (or stock) is worth the present value of future cash flows that can be taken out from it. There are a few parts that I'll walk through in great detail to show how the AAPL price was arrived at - free cash flow, discount rate, future growth projections, and terminal/exit multiple.
For Apple, the initial (t=0) free cash flow is $4.15 billion, which is simply the company's free cash flow in the last four quarters. No non-recurring items are readily apparent, so that figure is simply taken as-is. The next question that needs answering is "how fast will Apple grow FCF?"
There are two ways to do this: create your own estimate of Apple's cash flow growth, or do a reverse engineering of the current price to see what the implied growth rate is and make a determination of its probability of being accurate. I prefer the latter because it gives a target to adjust growth numbers to, so while it isn't the most academic exercise it is nonetheless more practical. Apple's current market cap is $141 billion, or $162 per share. So I'll fit the growth curve to that, which means taking into account analyst estimates for 34% growth in the current quarter (I'll put that as my full year-one growth even though growth estimates for the next quarter are 18.5%), and for years two through five I'll use 22.6%, which is the consensus five-year annualized growth forecast. I realize that I'm overshooting here, but this will be my "aggressive" assumption. Coming off that five year period, I should ratchet down expectations; a "bridge year" where the company transitions into a slower-growing company is appropriate, and I'll assume 15% growth for that year (year six, for those scoring at home). Keep in mind, this entire time the net growth figures are being discounted back to present, but we'll get to that later. Now we have Apple, the "maturing firm," as we move into the second half of 2013. For the next two years, let's say Apple grows at 10% per year, with 9% the year after that and 8% in the following year - solid, but not phenomenal, rates. There are two issues left: the proper discount rate, as well as the terminal (or exit) multiple, which is the inverse of the discount rate.
For the discount rate here, I'll use the Capital Asset Pricing Model (CAPM), which - let me hack a rather elegant theory apart here - basically states that the expected return of an asset is equal to the risk-free rate of return, plus some additional return that equals the risk premium multiplied by the risk of the asset. The average yield of the 1– and 3-month Treasury Bills is about 4%, and I get an expected market return of about 6.6% using the S&P 500 earnings yield and dividend. With AAPL's beta of 2.21, the CAPM gives an expected return of 9.49%. Take it for what you will, that is what I'm using for the time. Every year's cash flow is discounted at the appropriately compounded multiple of 9.49%, and the last year's cash flow is multiplied by 1/9.49% to give a terminal multiple of 10.53, which (as the name implies) is multiplied by the out-year cash flow and discounted back to present, along with the net current assets Apple has (carried on the books right now at $10.5 billion).
All of that nets out a value of $166 billion for the firm, about 18% above the current market cap for a value of $191.09/share. I consider this an aggressive set of assumptions because:
1. Growth estimates seem high, namely in the intermediate years
2. I think 9.49% is a very low discount rate to use for a stock like AAPL; and while discount rates are very subjective I think it is safe to say most people aren't in AAPL for a 9.5% annual gain.
The latter issue is strictly my view and has much to do with the difficulty of measuring "risk" in financial circles - I don't think that beta is close to perfect, but it has to suffice for the above example. On the former, however…
I realize Apple has a great growth story right now; I merely think the extent of the story is greatly over-hyped. Yes, the iPod is a nifty device from everything I hear, but that is Apple's only real successful product launch in their twenty-five years in business. The iPhone hadn't been out three months when they had to cut the price to move units - it is far too early to call the iPhone a success, but I digress… focus on the quantitative side of things. If Apple maintains the same FCF margins it does right now throughout this scenario (a big assumption, as margins usually come down), Apple will need to have 5x the sales next decade compared to right now. Sales in the last four quarters amounted to $22.6 billion, giving a target of $112 billion in sales. How impressive would it be for Apple to accomplish that feat? In the last ten years, Hewlett-Packard (HPQ) has gone from $42.9 billion in sales to $100.5 billion in sales; starting with nearly twice the base amount to work with compared to Apple, Hewlett-Packard fell short of the amount Apple needs to get to. Very few people realize what an immense and impressive feat $100 billion in sales would be; there are 21 publicly traded companies with that amount or greater. And yet, the implied assumption for people who think AAPL has moderate upside is that Apple will quintuple sales to break that mark in slightly under a decade.
So, what does one buy stocks for? Generally, I think the answer would be along the lines of what Charlie Munger has said: "All intelligent investing is value investing - to acquire more than you are paying for." In the case of AAPL, I don't believe you are acquiring more than you are paying for unless one uses extremely aggressive assumptions, and what is the point of purchasing something on the most optimistic of forecasts?
As for the arrival of the $131 fair value; such a valuation uses a 12% discount rate, 34% front-year earnings growth followed by 19% annually through the fifth year, a bridge year growth rate of 15%, followed by 10% annualized growth for the next four years. I now see that in the initial estimate I did a bit of rounding, so this valuation scenario works out to a value of $130.33, or 20% less than Apple's last closing price. Given that one wants to buy a stock at a discount of somewhere between 30-40%, I'd very much like to see how others are arriving at the conclusion that AAPL is a great value right now.
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This article has 26 comments:
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top_tier
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57 Comments
Oct 15 08:47 AM"do a reverse engineering of the current price to see what the implied growth rate is and make a determination of its probability of being accurate. I prefer the latter because it gives a target to adjust growth numbers to"
1. Apple desktop sales over the last ten years were steady and anemic between 2-4% market share, there's evidence and every reason to believe they've broken out of this stale metric...I won't detail all the evidence here.
2. The iPhone impact can't be evaluated using a past metric of implied growth rate. And you imply way too much by highlighting "had to cut price".
The market doesn't make much of your opinion.
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jmmx
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266 Comments
Oct 15 03:07 PMI think people have not really comprehended the extent of the Mac revolution that is underway. As the basis for this point of view, I take not only the recent accounts of the growth in Mac market share, but also this very informative article:
Is Tech Support Getting Worse?
ARTICLE DATE: 09.13.07
By Eric Griffith
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www.pcmag.com/print_ar...
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Ostensibly on tech support, the article gives other info from their survey.
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Let me give a couple of findings reported:
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"Of course, no Windows machine comes close to Apple's 9.1 overall score... the 93 percent score for new desktops working right out of the box."
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"What's left to say? If you buy a Mac, not only will you in all likelihood love it, but you're also going to recommend it to your friends while enjoying all the time you can spend not fixing it."
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"And readers scored Mac notebooks a full 100 percent for ease of setup. Simply amazing."
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"And the numbers show that people already using Macs almost always recommend Macs. The score of 9.4 out of 10 for Apple is the highest ever seen in any of our surveys."
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This last quote is the most important of all - for here lies the crux of my argument. If 94% of Mac users are recommending them then they will have some effect on their friends and fellow workers. Let us suppose that ON THE AVERAGE each of these users convinces just 2 other people to buy a Mac. This does not have to mean that they become impassioned advocates - just adding in the final "I love mine" into a discussion might be enough. The two keys: 1- Ease of use, 2- Reliability.
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This is exponential growth! I can see Apple having 20% of new sales in 6 years (perhaps even in 4).
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And one last point - what will happen when industry discovers "...all the time you can spend not fixing it." ??? I.e - all the $$ you can save by not needing to fix it!
In my humble opinion. -- jmmx
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DutchMark
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16 Comments
My Website
Oct 15 08:48 AMAnd to state that the iPod is Apple's only successful product in 25 years is laughable. The concept of the original 1984 Mac is still alive and strong today. The first iMac revamped the company (not the iPod) and currently MacBooks are selling like hot-cakes. The Mac computers are still its core business, not the iPod or iPhone or iTunes. If you think Apple is only about the iPod you have no business investing in them indeed.
Watch the Mac OS gain market-share over Windows, look at the tiny market-share it has now and the potential must be obvious.
Mark
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Tom B
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1771 Comments
Oct 15 09:05 AM1) You misunderstand the motivation behind the iPhone price cut; it was a clever play to accelerate penetration of the technology.
2) Something like 90% of the population is still using Windows. If people don't get off their tails, in a few years they'll all be using Vista. I think Macintosh sales have huge potential upside, since the Mac seems to be getting cheaper and better all the time, whereas Windows never seems to evolve much: still slow, insecure, and unfriendly.
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thompson
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8 Comments
Oct 15 11:19 AM"Yes, the iPod is a nifty device from everything I hear, but that is Apple's only real successful product launch in their twenty-five years in business. The iPhone hadn't been out three months when they had to cut the price to move units - it is far too early to call the iPhone a success, but I digress… focus on the quantitative side of things."
Don't you get it? Everything ELSE is the digression! It is OK to begin with premises and assumptions, but they should be based on the profit drivers (have you heard of the Macintosh?) as opposed to being pulled out of some dark smelly place.
Thompson
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jswede
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173 Comments
Oct 15 11:59 AM-
James Cullen
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142 Comments
My Website
Oct 15 03:14 PMIf you pull up last year's 10-K, you'll see that Mac revenues (that's both laptops and desktops) came to 38% of total sales... if Apple doubles the market share Mac has, it will grow revenues by about 40%, not 100%.
See the difference?
And note that nowhere in that article did I say Apple is not growing. My primary example shows Apple >quintupling< sales in >ten years< to >$110 billion<. Did anyone read that part, or did you draw your conclusions from the, ahem, title?
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DutchMark
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16 Comments
My Website
Oct 16 11:12 AMIf you pull up last year's 10-K, you'll see that Mac revenues (that's both laptops and desktops) came to 38% of total sales... if Apple doubles the market share Mac has, it will grow revenues by about 40%, not 100%.<<
Yes, the math is correct. But PC unit sales are growing 12% world-wide annually. Apple is growing unit sales three times that fast. Maybe it was 38% of total sales last year, but I believe it's already 50% or more today. So we'd expect to see 18% total growth just based on Mac sales for three to four years to double market-share. Growth of all the other components, (iPod, iPhone etc.) together must stay in the single digits to come in as low as 22.6%.
But maybe you don't see Apple doubling its market-share in 3 years? I do but admit it's a bit speculative. But a single-digit growth number of the rest of Apple's business is very, very low. And in 3-5 years I'd just as easily see Apple's market-share quadruple if Microsoft doesn't fix Vista's problems fast.
Your 34% growth for this quarter is exactly in line with what analysts are expecting. Look here: earnings.com/company.a...
and note that analysts haven't exactly been able to nail those estimates for the past years.
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DutchMark
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16 Comments
My Website
Oct 16 11:13 AMIf you pull up last year's 10-K, you'll see that Mac revenues (that's both laptops and desktops) came to 38% of total sales... if Apple doubles the market share Mac has, it will grow revenues by about 40%, not 100%.<<
Yes, the math is correct. But PC unit sales are growing 12% world-wide annually. Apple is growing unit sales three times that fast. Maybe it was 38% of total sales last year, but I believe it's already 50% or more today. So we'd expect to see 18% total growth just based on Mac sales for three to four years to double market-share. Growth of all the other components, (iPod, iPhone etc.) together must stay in the single digits to come in as low as 22.6%.
But maybe you don't see Apple doubling its market-share in 3 years? I do but admit it's a bit speculative. But a single-digit growth number of the rest of Apple's business is very, very low. And in 3-5 years I'd just as easily see Apple's market-share quadruple if Microsoft doesn't fix Vista's problems fast.
Your 34% growth for this quarter is exactly in line with what analysts are expecting. Look here: earnings.com/company.a...
and note that analysts haven't exactly been able to nail those estimates for the past years.
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User 113836
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1 Comment
Oct 15 01:15 PMStock value is about what people think of future growth. Obviously some, such James, take a few well know headline cases, and ignore the rest of the evidence, as such. The question is whether the rest of the show is worth the 18% difference he finds, assuming his analysis is basically correct.
Apple has done nothing but grow phenomenally in all its product areas since 2000. It has anticipated important markets better than its competitors, and produced vertical tools to deal with these far better. Most of its competitors seem to feel it is enough to have a solution ... Apple seems to be the only major player that searchers for the 'right' solution - right being defined as something that users can start based on their understanding, with tools that help them learn more about a task area without massive amounts of training.
Apple is one of the best placed platforms to benefit from the changes that will be bought about in future infrastructure as the most widely distributed Unix system - Microsoft will be unable to deal with the complexity of future services while they cling to the Windows OS model, which can only just cope with the present comparatively simple paradigms of the past.
Some notes:
1) 2-4% represents 100% growth, its actually more like 1.7 circa 1997 to 4.5 now, or 160% growth, with considerable accelleration in the past five years.
2) Most Apple product launches have been successful (other than the period between 1995 and 1998). There are flops, but even these were legendary flops that are still in use today - such as the Cube and the Newton.
3) In any case there is huge potential for market growth for the macintosh, and apparently some future for the iPhone and repositioning the iPod. Companies will cling to Windows even after they are forced to run it in emulation or as an embedded OS for a variety of reasons. Ordinary people will not.
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Eldernorm
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8 Comments
Oct 15 01:29 PMApple has multiple products and they each play off each other, making a large cohesive offering. As more people see Apple thru iPods, iPhones, etc, they are more in tune with Macs and the ease of use of the whole Apple matrix. Apple still owns OS X. If you want the great experience you HAVE TO BUY Apple.
Sorry, but I see Apple continuing to grow over the next 3-5 years. Its Google but slower on the uptake.
Elder Norm
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Shawnuff
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1 Comment
Oct 15 01:34 PMApple isn't only a "great growth story right now" but one that began in March 2004. The stock is now trading at 12.5 times its value of March 2004.
To Mr. Cullen the iPod is "is a nifty device from everything I hear". That "nifty device" along with iTunes DOMINATES the digital music mark. The "nifty device" put Tower Records out of business. iTunes is now the 3rd largest retailer of music after Wal-Mart and BestBuy. Target used to be number 3 - but that was last quarter.
To foolishly state that the iPod "is Apple's only real successful product launch in their twenty-five years in business" is again ignoring the bellwether that is Apple. Do you think there would ever have been Microsoft Windows without Apple developing the Macintosh? Apple's OS X is far ahead of Vista (the gap to widen soon), Apple's Desktops and Laptops sales are increasing dramatically (you can't use a 10-year time frame with this), and the iPhone has redefined peoples' expectations of a cell phone (woe be to cell phone manufacturers othe than RIMM).
Mr. Cullen would do well to remove his prejudices of Apple. He might even buy one of this nifty iPod devices and see what all the fuss is about.
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User 113885
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1 Comment
Oct 15 03:01 PM-
Dan Poarch
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124 Comments
Oct 15 02:55 PMThe point to be made against his and other nay-sayers is the crescendo that Apple is building. Apple has been steadily growing and improving over the past 30 years. They've seen good times and bad, and used all of them to learn and adapt. I simply cannot think of another corporation in the technology sector as successful at doing this.
We've seen nothing but ground-breaking products from them for the past 10 years since Mr. Jobs returned. That trend isn't changing as all signs point to further growth. If the iPod fails, they have phones, an unbeatable OS, iTunes, and laptops. If the phone fails, they laptops, ipods, unbeatable OS, iTunes, and laptops. Etc. As well, each of their products is at the top of its market sector [save for its enterprise unit, which can be argued]. Can anyone point to a company that has this much security or potential growth at the moment?
What Apple has that bothers the street so much is arrogance on par with the street itself. A clash of god-complexes.
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User 113884
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1 Comment
Oct 15 02:57 PMPlease SELL all your Apple stock immediately and buy some Microsoft; it sounds like they are more your style.
It is obvious that you are an "academic" that has absolutely no technical or computer knowledge what-so-ever. You also have no idea about the Apple sucesses over the years, the inovation nor the actual product sucess enjoyed by both the computer and iPod lines over the last many years.
I am shocked that the editors of Seeking Alpha would let such rubbish be published on their web site.
Fortunately, the world is able to see your writings for what they are; simply uninformed rubbish. You now can join the ranks of Jim Cramer ("sell all your Apple stock right now") and other analyists that have no real idea. Oh, Michael Dell is in that club also (Apple should liquidate and give the money back to stockholders).
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Jon T
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330 Comments
Oct 15 03:10 PM-
BabeRuth
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1 Comment
Oct 15 03:24 PM-
mnguy
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1 Comment
Oct 15 03:36 PM-
User 113919
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1 Comment
Oct 15 04:55 PMWhile we're at it, how would the Apple II fit into that scenario? First shipped in 1977, and had millions sold with models being found in many schools up through at least 2005. How is that not a successful product?
Considering there's a note on Apple press releases that says "Apple ignited the personal computer revolution in the 1970s with the Apple II and reinvented the personal computer in the 1980s with the Macintosh." I'd say there some facts that don't wholly support your theories. And while I can give you the title as being the choice of the editors, you missed a few things in the substance of the story. But that's just my opinion, supported with a few moments in google.
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34% Huh?
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3 Comments
Oct 15 05:04 PMIn my spreadsheet, I have Apple growing their Net Income (YOY) in fiscal year 2007 at 78% in Q1, 88% in Q2, 73% in Q3...why do you think Apple is only going to achieve 34% in the current quarter? Apple has consistently beat the streets estimates, usually by a good amount, for the past few years. So why use the analysts numbers when the haven't even been close in the past?
We are just at the beginning of the Apple tornado. When all of the iPhone revenue sharing agreements come into play, along with current iPod growth and more importantly, Mac growth...I am estimating 54% growth for fiscal year 2008. And I'm taking the conservative route. I wouldn't be surprised by another 70% to 80%.
So really, adjust your growth rates by a good 60% to 90%. I think you'll come out far more accurate than depending on the street's lousy estimates, as proven the past few years.
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RT
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5 Comments
Oct 16 11:47 AM-
User 114266
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1 Comment
Oct 16 04:48 PM