In this article we attempt to interpret Apple's (AAPL) recent price movements, in terms of the market's view of average long term growth prospects. Following the success we had with the "expected dividend growth" model, for Intel (INTC) and Advanced Micro Devices (AMD) stock, we apply a similar analysis to Apple. This provides an alternative explanation of Apple's recent share price movements. To derive a trading range, rather than using technical indicators such as Moving Average Convergence Divergence, one can also use expected growth in company revenues. As investor's expectations of growth changes, fundamental moves in the underlying shares occur. We do not intend to deal with the actual sales and product views. Here we will interpret the new $500-$540 share price.
The Gordon growth model, which we derived in an earlier article, will be reused. We do not think the model was wrong: only our original assumptions were probably not accurate.
The chart shows a proprietary model of CAPM and the related WACC, allowing for growth and discounting dividends to derive a share price. Assuming an expected market return of 5%, Apple's WACC is 4.52%. We used this WACC to discount future income, resulting in the growth vs share price curve shown above.
Implied Average Growth
At around $500 this model predicts an expected (long term average) growth rate of 4% or 3.2%, if you back out the cash per share. Given the relatively good uptake of the iPhone 5, we would be extremely surprised if this growth is not exceeded in Q4 2012. However, this model operates on average expected growth. Apple needs to grow an average of 4% over the next several years to maintain its current trading price. So, what is the problem? Isn't Apple easily able to achieve this?
Apple's Growth in Saturated Markets
The answer lies in the little explained secret. The USA, Apple's largest market, and parts of Western Europe are nearly saturated for those that can afford and want iPhones. Jefferies agrees with us in the latest analysis. My friends in LA have their entire families on iPhone 4s and 5s. In the developed world Apple's growth can soon be limited by this saturation. That is Apple's main problem. Without a smaller and cheaper iPhone to take emerging markets, and in particular, China, by storm, in the next few years Apple's growth in developed markets could approach 0-2%. No, we are not forgetting the Apple cash pile. The cash pile will provide $100-$200 support. For sake of simplicity we omitted cash in our dividend growth model. Thus, the bottom in our view for Apple in the foreseeable future is a valuation close to $420. To arrive at that, we use a 2% average sales growth, implying a discounted present value of approximately $300 , along with up-to $120 cash per share which adds 1% to dividend growth, over the long term. Thus, at only 3.2% dividend growth, Apple could be valued at $420. (see chart).
Apple is Still Growing Fast
Apple accounts, for the last few years, are consistently showing 50% growth. How does our model work? Obviously you have to assume the market is not pricing Apple for 50% growth, year on year. If it did, the price would be phenomenal. Apple's growth needs to be split over tens of years.
|Period Ending (USD)||Sep 29, 2012||Sep 24, 2011||Sep 25, 2010|
|Cost of Revenue||87,846,000||64,431,000||39,541,000|
|Selling General and Administrative||10,040,000||7,599,000||5,517,000|
|Total Operating Expenses||-||-||-|
|Operating Income or Loss||55,241,000||33,790,000||18,385,000|
In our opinion, the upside from the $420 lower bound is sustained 5% growth. That is around $6 billion in revenue and $2.7 billion in profit. In other words, a profit of $80 billion in 2016 (inflation adjusted). A recent Seeking Alpha author predicts a gross profit and cash flow around $82 billion. The author claims that would be just 2.56x current market price.
"Operating cash flow in 2012 was $50.9B (74.2% of gross profit) - using the same calculations in 2016, Apple would generate $64.3B in operating cash flow."
That would imply a growth rate of little more than 6%. If he is right, then our model implies a fair current price of $720-$980. Incidentally, $800 is the target set by Jefferies, right in the range of our model.
With the above assumptions and our growth versus price model, Apple should trade between $420-$720. On the most optimistic prediction it can still exceed $720, but we doubt it will due to technical reasons. If this band proves as accurate as the assumptions we made previously for AMD (AMD) and Intel (INTC), then Apple is more a buy than a sell for the next 6 months. The model also implies $700 is more likely than $420, since there are no big short term catalysts that could cause sudden growth expectations to drop. After all, it is Christmas and New Years soon. We will definitely buy if it dips below $500.
Disclaimer: Always do your own diligence before investing.