Justifying Apple's Valuation: Is It Too Late To Get Back In?

Feb.12.13 | About: Apple Inc. (AAPL)

Is it too late?

This is the question the whole world is asking now. Have I missed my chance to buy Apple at an incredible discount? The stock has bounced almost 10% since its lows at the end of January.

We're going to do this in two parts. First we're going to look at why Apple (NASDAQ:AAPL) dropped the way it did. $200 billion disappeared -- poof! -- in a matter of months. It's a mystery worthy of Sherlock Holmes. Then we're going to calculate some target prices for the stock. Just how much is this business worth?

So let's put on our deerstalkers and get to work.

Theory 1: The Technical Sell-off

Apple is the most-owned stock in the world. Not only did it make up over 5% of the S&P 500 (NYSEARCA:SPY), but nearly every hedge fund on the planet owns it as do all their red-headed step-cousins in the mutual fund industry.

I've worked in the hedge fund industry for the last decade. Wanna know a dirty little secret about how a lot of them buy stocks? They take a look at whatever has gone up the most and then they buy it. I know, crazy, right? Who does that? Plus, the Apple narrative is compelling and it's an easy to sell to their investors -- trust me, you do not want to be the fund manager who under-performs because he doesn't own Apple.

Anyway, it could be that the herd, or a big enough chunk of it, is all pulling the plug together.

One of the things that I write about repeatedly is that the headlines follow the market, not the other way around. A lot of what happens in the market is just noise or technical buying and selling pressure. Then we make up headlines to explain what happened and why. As humans, we have a really difficult time dealing with things we can't understand.

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It's possible the same thing could be happening with Apple right now. Huge investors start pulling the plug, creating a cascade of selling pressure. The selling creates more selling which creates margin calls and more selling along the way. Funds start unwinding their long Apple / short [whatever] trades as they slowly spiral out of control. Buyers, meanwhile, sit aghast on the sidelines, avoiding what they are convinced is a falling knife.

In the meantime, we and our friends in the media start inventing new narratives about Apple. How they can't grow anymore. How their cash is holding them back. How they're doomed by competition and on a death march toward lower margins.

That brings us to the next theory.

Theory 2: The Fork in the Apple (It's Done)

If you don't buy into the theory that the headlines follow the market, perhaps there really is something fundamentally wrong with the company.

It's possible that the smartphone space is tapped out and that Apple is looking at flat or declining growth in this segment. It's possible that the tablet space is finished too. It's possible that margins on those products steadily trend lower. It's possible they're done growing the desktop/notebook lines of their business. It's possible they won't find any international growth either. It's possible that iTunes and its 80% margins is done growing at a meaningful rate. And it's possible that Apple will never enter the TV market in any meaningful way. It's possible they will never again release a new product that gains meaningful traction.

I know this sounds like an impossibly dire scenario, but I'm being serious. This is exactly what happened to Microsoft. You would have been politely asked to leave the room in 1999 if you suggested that Microsoft would lose all of its mojo and turn into one of the most boring companies on the planet, failing at essentially every new endeavor for a decade straight.

But that actually happened. And you're crazy if you think it can't happen to Apple. I think that when we look back on these last few years in Apple's history, we will regard the back-to-back iPhone/iPad double whammy as a magical thing indeed. It was a retail miracle. It was not the norm.

Somewhere in all these drama-queen narratives is a normal company. A simple business makes stuff and sells it. Perhaps this is what Wall Street is struggling with right now.

Whatever is going on, the magic is all gone. Both in the stock and in the company. (Which, ironically, suggests that the risk is now to the upside, in the event they get it back.)

What is the business worth?

There's certainly no shortage of analysis on what Apple's business is worth right now.

With value stocks like Apple, I like to start with a simple valuation using the Benjamin Graham equation:

For Apple, I'd rather use a more conservative multiplier instead of 2x. And let's assume that they can match a conservative growth rate of inflation + GDP. Even Microsoft (NASDAQ:MSFT) has beaten that in the last decade, and surely the path ahead for Apple can't be that dire? Can it?

In any case, Mr. Graham would calculate an intrinsic value up around $750/share. Using a margin of safety of 25% -- which is probably fair for a company with as large a moat as Apple -- you should be buying this business so long as the price is under around $560.

Is Apple one of those "ignore the price and collect the dividend" stocks?

I think so.

With a yield of 2.2%, it's competitive with Treasuries and high quality corporates. We buy those for yield, why not Apple? Apple has a better balance sheet than the U.S. government or any company in history. And with a 12% payout ratio, that dividend is a near lock to be raised at some point in the future.

As we move to discounted cash flow analysis, a new range of outcomes enters play. By my calculations, fair value for the stock is somewhere between $500-550, and that's assuming zero growth and an aggressive discount rate. In fact, if you make sensible assumptions like "I think Apple will grow at rate equal to inflation" you can argue that the stock is fairly priced back at $700, more in line with what the Graham equation suggests.

But most of the world seems convinced that there isn't much more top line revenue growth to be had. In order to justify a fair value of $480, you have to figure a long-term earnings decline of around -3%.

Maybe that happens, maybe that doesn't. Just keep in mind that that's the sort of thinking that a strong earnings call could completely re-write. Consider what happened with Netflix (one of my predictions for 2013). Stocks as big as Apple tend not to jump so far so quickly, but if Mr. Cook shows us the money, they could easily tack on a hundred billion or so of market cap in a matter of weeks.

Again, this is further suggestive that the risk lies to the upside in Apple right now. You have to construct some fairly catastrophic scenarios to justify further collapse in the stock.

I've never had a dog in the Apple fight before. But I do now. I just bought it in one of my Alpine Advisor portfolios (the Dividend Income portfolio). Never in a million years would I have expected this portfolio to contain Apple. I've hated on Apple stock for what seems like forever. But things change. Now it satisfies the criteria I seek: clean balance sheet, reliable dividend with room for growth, systemically important business, predictable cash flows, etc.

The point is that, once the emotion of the last few months wears off, I believe this is a very safe stock. The world is re-aligning its expectations right now, and as The Buddha teaches us, a lot of psychological suffering can happen when reality fails to conform to our expectations. We thought Apple was one thing. Now we see it's another.

It changed from growth stock to value stock in just a few months. I'm cool with that.

Are you?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.