As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Apple's (AAPL) case, we think the firm is significantly undervalued. This article is the only one that showcases the value of Apple through a robust three-stage discounted cash flow model. We think the company is fairly valued at $744 per share, representing 60%+ upside from today's levels based on our point fair value estimate. However, as we'll outline below, as Apple continues to generate cash (it continues to create value), we expect its intrinsic value to approach $1,000 in the next three years (well $955 by our current estimates).
At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Valuentum followers know that more interest = more buying = higher stock price.
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If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Apple posts a VBI score of 3 on our scale, reflecting our "undervalued" DCF assessment of the firm, its neutral relative valuation vs. peers, and bearish technicals. We compare Apple to peers Dell (DELL), IBM (IBM), and Hewlett-Packard (HPQ).
Our Report on Apple
- Apple earns a ValueCreation™ rating of Excellent, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 304.6% during the past three years.
- Apple's traditional computers continue to gain market share, particularly in the U.S., and particularly with younger consumers. The company's execution remains top notch, and it should continue to take market share in that segment.
- Apple has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 24.5% in coming years, and the firm had no debt as of last quarter.
- Apple continues to impress. The firm's rollout of the new iPhone 5 should propel the firm's fundamentals ever higher. Though we're not expecting another blockbuster hit (Apple TV, etc.) in our valuation model, we wouldn't be surprised if Apple delivers another one from its pipeline.
- Apple's $137.1 billion cash hoard is more than some of the market capitalizations of the largest companies in the S&P 500. This amounts to roughly $145 per share, making relative value comparisons vs. peers much more attractive.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Apple's three-year historical return on invested capital (without goodwill) is 304.6%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of Excellent. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Apple's free cash flow margin has averaged about 26.5% during the past three years. As such, we think the firm's cash flow generation is relatively strong. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Apple, cash flow from operations increased about 173% from levels registered two years ago, while capital expenditures expanded about 343% over the same time period.
Our discounted cash flow model indicates that Apple's shares are worth between $566.00-$922.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $744 per share represents a price-to-earnings (P/E) ratio of about 16.9 times last year's earnings and an implied EV/EBITDA multiple of about 11.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 10.5% during the next five years, a pace that is lower than the firm's three-year historical compound annual growth rate of 53.9%. Our model reflects a five-year projected average operating margin of 31.6%, which is above Apple's trailing three-year average. Beyond year five, we assume free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For Apple, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $744 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Apple. We think the firm is attractive below $566 per share (the green line), but quite expensive above $922 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Apple's fair value at this point in time to be about $744 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Apple's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in year three represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $955 per share in year three represents our existing fair value per share of $744 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements