I've noticed that several people take issue with my stance on Apple's (AAPL) valuation. So I thought I would take it upon myself to fully state my current view on Apple. I have always been and always will be completely open minded to others' thoughts on this subject and I'm amenable to changing my mind when good arguments are presented in support of contrary opinion. I recently changed my stance on Apple's fundamentals upon reviewing my math on the current tradgectory of Apple's earnings in 2009. I've given careful thought on what I think Apple could earn in each quarter of 2009 and this is what I have arrived at (pardon the preposition).
Q1: $10.167b (rev); $1.78 (eps)
Q2: $8.318b (rev); $1.19 (eps)
Q3: $8.728b (rev); $1.29 (eps)
Q4: $9.378b (rev); $1.52 (eps)
FY09: $36.591b (rev); $5.78 (eps)
Q1: $9.608b (rev); $1.76 (eps)
Q2: $7.512b (rev); $1.16 (eps)
Q3: $7.464b (rev); $1.19 (eps)
Q4: $7.895b (rev); $1.26 (eps)
FY08: $32.479b (rev); $5.37 (eps)
I generally don't have much of an opinion with regards to earnings estimates that are more than 1 year out because I do not have enough information with which to make any sound or objective conclusions. At least that's my opinion on drawing estimates for more than 1 year from now. I'm sure that even a year ago, many (including myself) have drawn estimates for 2009 that well exceeded $40 billion in revenue. Hell, I was at $44 billion prior to this financial crisis. So I'm going to shy away from drawing estimates for 2010, but I openly welcome thoughts on what 2010 might bring and the supporting arguments leading to such conclusions.
Now onto the issue of valuation… Everyone here knows or should know that I have been one of the biggest supporters of valuating a company based on its cash generating abilities rather than its GAAP-based growth rate. GAAP-based growth rates tends to hide a company's true performance when the underlying companies are required to take massive write downs on unrealized losses or when they have to defer revenue due to GAAP-based measures that require the product or services to be fully delivered before being fully recognized. I could understand why such GAAP measures are in place so as to not mislead investors, but on the other hand, such measures make it difficult to fully valuate a company's true performance. The more revenue that is deferred the more difficult it is to valuate a company based on GAAP based earnings and future estimates.
However, the market, which determines the actual value of assets, has yet to come around to the notion of valuating equities based on looking at FCF nor is there any indication that they intend to come around any time soon. I wrote on this topic almost a year ago and still see, hear and read about people talking about P/E ratios with respect to valuation. Thus, for this reason I choose to draw my valuation models based on how the market chooses to valuate Apple rather than on what I think ought to be the correct valuation model. You have to invest within the confines of the rules presented in the market you have, not the market you wish existed.
That being said, stocks will often trade at high premiums to the market and relative to other companies within a sector when such companies do generate massive amounts of cash or when those companies have prospects for future outstanding growth. Thus, one must not overlook such considerations when drawing his or her valuation models. When it comes to Apple the obvious considerations are the prospects for future massive growth in the iPhone, its outstanding cash generating abilities, its outrageous cash on hand, its ability to weather the current economic downturn and prospects for renewed explosive growth in the future once this recession is behind us.
To determine price targets, the actual valuation model I employ is the forward P/E ratio after discounting cash from the market cap. I expect Apple to end the year with approximately $33 billion in cash. Below are the pertinent numbers I use to valuate Apple based on 2009 estimates.
Current Market Capitalization: $110 Billion
Premium Market Capitalization ($33 Billion in Cash): $77 Billion
Forward P/E Based on Current Market Cap: 21.37
Forward P/E After Discounting Cash: 14.96
Premium on the Stock: $86.46
Cash Per Share at end of 2009: $37.05
2009 GAAP-Based Growth Rate: 7.63%
Price Target Based on a 20 Forward P/E After Discounting Cash: $152.65
In arriving at my $152.65 price target on the stock I consider all of these variables and the amount of premium the stock deserves given the growth prospects in earnings post recession, the potential explosive growth of the iPhone, the cash generating abilities of the company and the potential for renewed growth of the Macintosh computer. If the stock received absolutely no premium on a forward P/E basis after discounting for cash on hand, the above price target based on my estimates would put Apple at $81.15. $37.05 in cash at the end of 2009 plus ($5.78 x 7.63) = $81.15. So as one can see, Apple is already trading at a substantial premium to its growth rate and expected cash flow for 2009. Now the question becomes whether Apple deserves that premium and whether a further premium ought to be added to stock price? I think the answer to that question is yes for the reasons I've already stated above.
But the real question is how much of a premium should be added to the stock price? And the answer to that question forms the main intersection of disagreement between myself and several in the Apple community. Personally, I think Apple shouldn't receive anything higher than a 20 P/E after discounting for cash, which would put Apple at a 26.41 P/E before discounting for cash. And the main reason why I do not believe Apple should receive higher than a 20 P/E after discounting for cash is chiefly because we don't have enough information to determine just how much of the current slowdown in Apple's growth rate is due to this recession and just how much of that slowdown is due to the inherent growth rate within the company's primary operations.
By the same token, I am not completely ignoring the fact that Apple's growth rate will return to some degree of normalcy post recession otherwise I wouldn't be giving Apple a 20 P/E after discounting for cash when its current growth rate is expected to be at around 7% this year. I think 2010 will be significantly better than 2009, but I'm not so sure that Apple will sustain that 50% growth rate we saw in 2008. That will depend on how receptive the third iteration of the iPhone is with smart phone uses, and how well Macintosh growth picks up once this recession is behind us.
Disclosure: At the time of publication of this article, the author holds no position (short or long) in Apple. Yet, that could change at any time.