Apple (AAPL) shareholders probably aren't too happy with how the stock has performed over the past few months. After hitting an all time high of just over $700 per share in September it began a downward descent which continues today, most recently trading at $528.38, a decline of about 25%.
As Apple stock was making the climb to $700 people started throwing out price targets like it was going out of style. $1000 per share seemed conservative compared to what some people were saying. Determining how much Apple is worth requires you to project future earnings. And because Apple has grown by so much in such a short amount of time forecasting becomes very difficult. In 2008, Apple recorded $32 billion in revenue. In fiscal 2012, which ended in September, revenue sat at $156 billion, nearly a factor of 5 increase. During the same period, free cash flow rose from $8.4 billion to $41 billion, again nearly a factor of 5. Clearly this level of growth can't continue forever. The question is: how fast will Apple grow in the future. The answer - I have no idea.
A Guessing Game
I could spend countless paragraphs attempting to project what iPhone sales will be in 2014 or what gross margins will look like in 2016. But I won't bother because it would be pure speculation, plain and simple. No one knows how fast Apple is going to grow. We can all guess, and the sheer number of people wagering an estimate would almost guarantee that someone is right. But I have no reason to believe that I'm that person.
When a valuation relies on extremely high growth rates to justify an investment, there's very little room for error. So I'm not going to even try to come up with an estimate. Instead...
What if Apple Stops Growing?
How much is Apple worth if it only grows at the rate of inflation, let's say about 3%? This is, of course, outrageous compared to the average analyst estimate of about 20% annual earnings growth over the next 5 years. And in all likelihood Apple will grow much faster than my lowly 3% rate. But let's see what the 3% scenario yields.
Apple has about $120 billion in cash and investments on the balance sheet and no debt. With 945 million diluted shares outstanding, this amounts to $127 per share of cash. This means that the market is currently valuing all of Apple's future cash flows at just a hair over $400 per share.
Apple's $41 billion free cash flow in 2012 equates to $43.4 per share. This puts the adjusted P/FCF (after backing out cash) at around 9.2.
I'll use a discounted cash flow analysis to estimate the value of a share of Apple assuming my almost absurd 3% growth rate. I like to use a discount rate of both 12% and 15% and use the results to define a fair value range. Using these parameters my fair value range is:
$482.35 - $600.80!!!!!
I believe the five exclamation points are justified. Apple is a company which grew FCF at a rate of about 33% from 2011 to 2012 and nearly doubled it the year before. And yet, the market is valuing the company as if not only growth will slow in the future but that growth will essentially cease. Apple doesn't need to grow earnings at 20% per year to justify its valuation. It barely needs to do anything at all. As long as Apple can maintain its current earnings, the stock is currently a steal.
There Are Risks, Of Course
There is apparently quite a bit of pessimism surrounding Apple, given my calculation above. Perhaps the fact that companies like Nokia (NOK) and Research in Motion (RIMM), who were once global leaders in the mobile phone business, quickly and painfully collapsed to near irrelevance could be giving people pause when it comes to Apple. When the iPhone first launched, it was far and away the best smartphone on the market. Now it faces fierce competition from both Android phones, powered by Google's (GOOG) operating system, and Windows phones, powered my Microsoft's (MSFT) new phone operating system. It's impossible to predict what the smartphone market will look like in five years, especially considering the market barely existed five years ago. This heightened uncertainly when it comes to any tech company may be a culprit in the pessimism surrounding Apple.
If you believe that Apple can at least maintain current earnings levels going forward, then the stock is an undeniable bargain at today's prices. It seems to me that the pessimism has gotten to near-ridiculous levels, which is unheard of in the stock market (if that were true, I'd have nothing to write about). Apple doesn't need to maintain the extreme growth rates of the past to be a good buy. The fact that analyst expectations are still quite high means that the stock could fall even further if the company misses those expectations. Of course, that would just make the opportunity even better.