3 Steps to Calculating if Apple Is Fairly Valued

Apple’s (AAPL) stock is fast approaching its 52-week high of $177.50, set almost exactly 1 year ago, and seems within striking distance of its all-time high valuation near $200. I wrote at the beginning of the year about Apple’s intrinsic value and recommended buying the stock when it hit $89/share amid rumors of Steve Jobs’ declining health and Apple’s inability to continue to make hit products. The stock has appreciated almost 90% since and it would seem a good time to revisit the Company’s valuation.

My method of determining whether or not a stock is trading at a “value” is to determine the market’s implied valuation. Rather than attempt to model and predict a company’s operating performance, I use the current market value to back into implied growth rates. Then, I try to make a decision as far as how realistic the market implied growth rate actually is. In the end, we retail investors - lacking the ability to control the companies we invest in - are merely trying to determine reasonable prices at which to “buy growth.”

Calculating Apple’s Market Implied Growth Rate

Step 1: Excess asset value
The foundation for a stock’s value is the intrinsic value of the Company’s assets. Not all of the Company’s assets are distributable. Obviously, some baseline level of assets are necessary in order for the Company to operate as a going concern. As such, we’ll leave long term assets alone and focus instead on current assets and working capital.

As of June 27, 2009, Apple reported negative net working capital (exclusive of cash) of -$5.8 billion. This implies that the Company is able to generate cash through its operations. As such, it is possible that the company could finance its growth through operations and this would mean that, as a going concern, Apple has no immediate need for cash on its balance sheet. Thus, the $24.3 billion in cash and short term equivalents on the Company’s balance sheet is effectively distributable.

To be conservative, however, let’s discount this cash. After all, management has shown no intention of distributing cash to shareholders and as long as this value held at Apple, there is risk to investors' ability to realize it. Most conservatively, Apple should hold enough cash to cover the entirety of its liabilities in excess of other current assets. This implies $11.4 billion of the $24.3 billion should be reserved. Thus, Apple’s excess distributable asset value is between $12.9 billion and $24.3 billion.

Step 2: Value of Cash Flows
Now, we begin a “reverse” DCF analysis on Apple. Over the trailing twelve months, Apple has generated free cash flow (defined for simplicity as operating cash flow minus capital expenditures) of $10.3 billion.

At zero growth and a 12% discount rate, the present value of cash flows is worth $85.5 billion.

At zero growth, Apple’s cash flows in addition to excess distributable asset value would be somewhere between $85.5 billion and $109.8 billion.

This implies upwards of a 27.5% downside to Apple’s current valuation ($151.5 billion market cap) if its growth were to stall indefinitely.

Step 3: Market implied growth rate
This is where the analysis can get tricky. I typically like to make the simplifying assumption that most companies will have about 5 years of additional growth before slowing to a growth rate closer to GDP (2-3%).

Assuming that Apple will mature in five years and reach a baseline 2% growth rate, the 5-year implied growth which would justify Apple’s current $151.5 billion market cap would be 14%.

Does 14% seem like a reasonable year-over-year cash flow growth rate for Apple’s next five years? That would be the “over/under” necessary if you’re willing to invest new money in Apple today. Next time someone tells you Apple is “fairly valued,” you’ll know they don’t think significant performance beyond this level is likely.

Full Disclosure: Long shares of AAPL at the time of writing.

Comments

[Jon T:]

14% hey?

Apple is hitting cash flow growth of 57%.

Here is Turley's chart:

1.bp.blogspot.com/_kaO...

Aug 25 08:30 AM

[Techtrader10:]

To: The Curious Investor

Interesting analysis, have you used this model on other stocks, if so how did it work out for you? How long do you normally carry a position using this model?

Aug 25 01:29 PM

[The Curious...:]

I use this analysis as part of many different analyses whenever I make an investment. I'll admit that over the past year I've held some positions "too long" and gotten caught in the downturn. I, in fact, purchased my first position in Apple at $150/share only to watch it rise near $200 and fall to $89 where I purchased again.

I'm not advertising this model as the be all and end all for your investment. I think it gives you a baseline for which to compare your assumptions. That is, I shouldn't buy the stock if the model shows that implied growth rate is greater than something realistic. Or, I should look to sell whenever market values imply a growth rate beyond something I'm comfortable with. The time frame, unfortunately, is difficult to pin point. Discipline is also another factor. I, personally, think that 14% year over year growth rate for the next five years is bordering on "reasonable" for Apple. Should I already have sold? Or, should I wait until the market implies something even greater than my comfort zone? (20% perhaps? which would equate to ~$180 - $200/share)

Aug 25 03:44 PM

[Tom B:]

I'm holding my AAPL at least until people figure Apple COULD overtake Windows in PC market share. I don't know that they WILL, but they're, like, 20 years ahead of Windows, technology-wise-- Apple definitely COULD take over, as people get more sophisticated about computers and put more demands on their PC's-- things like multimedia that tend to give Windows indigestion.

Aug 26 09:38 AM

[shutterbug70:]

I like your comment, Tom. I switched home machines to macs in 2004. Today, a lot more people consider macs for home purchases. The corporations are still unwilling and that may be the biggest bottleneck.

Aug 26 01:07 PM

[Tom B:]

"The corporations are still unwilling and that may be the biggest bottleneck."

That IS the big bottleneck, but the IT people who grew up on DOS are getting older, just like everybody else. The kids growing up will be unimpressed my MSFT's tired "wait til the next version" refrain.


On Aug 26 01:07 PM shutterbug70 wrote:

> I like your comment, Tom. I switched home machines to macs in 2004.
> Today, a lot more people consider macs for home purchases. The corporations
> are still unwilling and that may be the biggest bottleneck.

Aug 26 01:56 PM

[manuel:]

sorry but you do not mention apple P/E, it seems high, 30 on Reuters, so Peg would be more than 1 if your growth is 15%, seems overvalued,

Aug 27 09:38 AM

[manuel:]

If Jon T is right is seems undervlued......., they say 50% year over year growth, seems sustainable

Aug 27 09:50 AM

[The Curious...:]

P/E multiples are merely a "shortcut" in the attempt to determine the "value" of cash flows. When it comes down to it, fundamental value lies in cash flow and not GAAP earnings. In the case of Apple, GAAP earnings are misleading because of the accounting treatment of iPhone sales which are booked ratably over the two year contract that most iPhone buyers purchase under. As such, with the iPhone growing at astounding rates, GAAP earnings (the number your P/E ratios are based off of) will understate true cash flows since they will lag actual iPhone sales by over eight quarters.

This topic has been covered by bloggers for months and was what many believe was the source of the massive undervaluation earlier in the year. People, like yourself, avoiding the Company due to perceived "high" valuation based on a mythical P/E instead of real cash flows. Unfortunately (or fortunately for those of us who bought the stock), the market and Wall St. analysts seem to have caught on and nearly anyone who follows Apple now focuses most of their attention on the non-GAAP earnings numbers which they report (adjusting for the iPhone deferred revenue accounts).


On Aug 27 09:38 AM manuel wrote:

> sorry but you do not mention apple P/E, it seems high, 30 on Reuters,
> so Peg would be more than 1 if your growth is 15%, seems overvalued,

Aug 27 12:30 PM

[manuel:]

ok thank you, and what about the P/B af almost 6? Seems that nobody cares about P/B, anyway what counts is earnings and they seem strong.......

Aug 27 01:51 PM

[manuel:]

the P/to free cash flow is 15, so you are right

Aug 27 01:52 PM