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 (NASDAQ:AAPL) case, we think the firm is worth north of $500 per share. Our full reports on Apple and hundreds of other companies are available on our website.
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.
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. We think our methodology and broad coverage universe is largely responsible for the meaningful outperformance of the portfolio in our Best Ideas Newsletter.
Our Report on Apple
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With every company in our coverage universe, we rate them on 13 unique measures. To get started, we show Apple's below:
Apple's continuous innovation makes it a standout versus peers. The firm has revolutionized many aspects of the land of tech, from the iPod to the iPad, and we expect the future to be just as robust as the past. We think the market is being too conservative in valuing Apple and view its shares as a bargin under $400.
Although we think the firm's DCF valuation indicates a potential attractive investment opportunity, we'd be most comfortable investing in the firm if it was more attractively priced on a relative basis versus peers as well. However, its peer group is not a perfect match, and we're less inclined to penalize the company on our Valuentum Buying Index because of this.
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 23.9% in coming years, and the firm had no debt as of last quarter.
The company's stock price has outperformed the benchmark during the last quarter, and its valuation still looks interesting at these levels. Investors could be accumulating shares, as the stock continues to trade at bargain-basement levels.
The firm is nearing support levels based on its 10-week moving average. We'd pay close attention to see if it bounces from here or breaks through support for an indication of its future price trend.
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 3-year historical return on invested capital (without goodwill) is 240.2%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart to the right, 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
We think Apple is worth $531 per share, which represents a price-to-earnings (P/E) ratio of about 35 times last year's earnings and an implied EV/EBITDA multiple of about 24 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 22.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 39.5%.
Our model reflects a 5-year projected average operating margin of 35.4%, which is above Apple's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Apple, our model uses a 9.8% 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 $531 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 $398 per share (the green line), but quite expensive above $664 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 $531 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 $704 per share in Year 3 represents our existing fair value per share of $531 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
Disclosure: Apple is included in our Best Ideas portfolio.