The beauty of using a discounted cash flow analysis is that it already captures the cash flow paid to shareholders in the form of dividends or share buybacks in the future forecasts of a company's enterprise cash flow, as well as the net impact on the balance sheet. The discounted cash flow model is unlike using a short-cut price-to-earnings multiple or other valuation variables/ratios, which are misleading at worst and applied incorrectly at best. In our view, Apple (NASDAQ:AAPL) will be generating significant economic value within the discounted cash flow framework when it scoops up shares under its expanded buyback platform. The net result of the reduction of cash on the balance sheet and the reduction of shares outstanding is an upward adjustment to its equity value per share, which could lead shares to the higher end of the valuation range (depending on the buyback purchase price). The discounted cash flow process gives those that use it a much better understanding of the moving parts behind a business. Let's evaluate the upside potential in Apple's shares and evaluate the firm via the Valuentum style.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, 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. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. 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.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Apple posts a Valuentum Buying Index score of 7, reflecting our "undervalued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. This is a strong rating, and with Apple representing a large position in both the Best Ideas portfolio and Dividend Growth portfolio, we like the company quite a bit.
Shown below is how the Valuentum Buying Index helped us time our entry and exit points in Apple in the Best Ideas portfolio. To provide perspective, we also include a technical projection anchored by our updated cash flow-derived fair value estimate ($715 per share) at the high end of that range. The fair value estimate is unadjusted for Apple's impending 7-for-1 stock split.
Apple's Investment Considerations
• Apple's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders, with relatively stable operating results for the past few years, a combination we view very positively.
• Apple is as much a brand as it is one of the most innovative companies. The firm's traditional computers continue to gain market share, particularly in the US, 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 23.8% in coming years. Total debt-to-EBITDA was 0.3 last year, while debt-to-book capitalization stood at 12.1%.
• Apple continues to impress. The firm's rollout of the new iPhone 5 (and future iterations) should propel its fundamentals ever higher. Though we're not embedding another blockbuster hit in our model, we wouldn't be surprised if Apple delivers another one from its pipeline. Mobile payment initiatives and/or Apple TV could offer a material boost to earnings.
• Apple's cash hoard is more than some of the market capitalizations of the largest companies in the S&P 500. The company retains tremendous flexibility in this regard, and we continue to expect dividend increases and share buybacks. The company pays a safe and growing dividend.
The firm recently put up excellent fiscal second-quarter results. As the quarterly headline suggests, strong iPhone sales in emerging markets [thanks, in part, to China Mobile (NYSE:CHL)] drove record March-quarter revenue and 15% earnings-per-share expansion. The $11.62 per share quarterly earnings number exceeded the consensus estimate by more than 14%, so it was a large beat. During the period, the company generated $13.5 billion in cash flow from operations and returned almost $21 billion in cash to shareholders through dividends and share repurchases. Apple also guided revenue in the fiscal third quarter to the range of $36-$38 billion, bounding the consensus view. The quarter was solid across the board, with gross margins advancing nicely due to higher-margin iPhone sales (nearly 60% of revenue). The company ended the quarter with a staggering cash balance of $150.6 billion.
The quarterly report wasn't all the news, however. In a separate press release, the board announced that it has been very busy. First, it authorized another significant increase in its plan to return cash to shareholders. Apple's share repurchase authorization has been raised to $90 billion from $60 billion previously, and the company approved an 8% increase to its quarterly dividend, to $3.29 per share ($13.16 per share annually, 2.5% annual yield). The company's Valuentum Dividend Cushion score indicates that the firm's dividend still has significant room for growth. In our view, Apple may become one of the best dividend growth gems over the next few decades (a Dividend-Aristocrat-to-be). The company also announced that it may access the public debt markets during 2014 to help manage the large cash stockpile domiciled overseas. International sales, for example, accounted for 66% of the fiscal second-quarter's revenue. All-in, Apple expects to utilize a total of $130 billion of cash under its capital return program by the end of calendar 2015, even as it remains open to large acquisitions. If that weren't enough, Apple also announced a 7-for-1 stock split, which will go into effect June 9.
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 with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Apple's 3-year historical return on invested capital (without goodwill) is 269.4%, which is above the estimate of its cost of capital of 10.6%. 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 26.8% during the past 3 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. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Apple, cash flow from operations increased about 43% from levels registered two years ago, while capital expenditures expanded about 22% over the same time period.
Our discounted cash flow model indicates that Apple's shares are worth between $586-$844 each. This range will be adjusted following the company's 7-for-1 stock split. This fair value range assumes that Apple will continue to innovate and hold its ground across its existing product portfolio, growing modestly along with the mobile market. The higher end of the fair value range is reserved for the value created by the execution of Apple's share buyback program, coupled with the likelihood of the firm using its strong brand and product presence to roll out yet another ancillary product, such as wearable devices or other. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $715 per share represents a price-to-earnings (P/E) ratio of about 18 times last year's earnings and an implied EV/EBITDA multiple of about 9.6 times last year's EBITDA. This fair value estimate will be adjusted following the company's 7-for-1 stock split. Our model reflects a compound annual revenue growth rate of 4.7% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 37.9%. Our model reflects a 5-year projected average operating margin of 29.8%, which is below Apple's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.8% for the next 15 years and 3% in perpetuity. For Apple, we use a 10.6% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings (PE) ratio and price-earnings-to-growth (PEG) ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Apple to peers Hewlett Packard (NYSE:HPQ) and IBM (NYSE:IBM).
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 $715 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 $586 per share (the green line), but quite expensive above $844 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 $715 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 3 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 $915 per share in Year 3 represents our existing fair value per share of $715 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
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
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. AAPL is included in both the Best Ideas portfolio and Dividend Growth portfolio.