Over-Hyped Apple Has No Real Value

My colleague Tom's article on valuing the QQQQ drew several comments about his target prices, particularly on Apple (AAPL), a favorite momentum play for traders of late. One of the more polite comments asked how a $131 fair value price for AAPL was obtained. The simple answer is "through discounted cash flow (DCF) valuation," but what does that really mean?

DCF valuation is my preferred way to value a business because the underlying principle is that a company (or stock) is worth the present value of future cash flows that can be taken out from it. There are a few parts that I'll walk through in great detail to show how the AAPL price was arrived at - free cash flow, discount rate, future growth projections, and terminal/exit multiple.

For Apple, the initial (t=0) free cash flow is $4.15 billion, which is simply the company's free cash flow in the last four quarters. No non-recurring items are readily apparent, so that figure is simply taken as-is. The next question that needs answering is "how fast will Apple grow FCF?"

There are two ways to do this: create your own estimate of Apple's cash flow growth, or do a reverse engineering of the current price to see what the implied growth rate is and make a determination of its probability of being accurate. I prefer the latter because it gives a target to adjust growth numbers to, so while it isn't the most academic exercise it is nonetheless more practical. Apple's current market cap is $141 billion, or $162 per share. So I'll fit the growth curve to that, which means taking into account analyst estimates for 34% growth in the current quarter (I'll put that as my full year-one growth even though growth estimates for the next quarter are 18.5%), and for years two through five I'll use 22.6%, which is the consensus five-year annualized growth forecast. I realize that I'm overshooting here, but this will be my "aggressive" assumption. Coming off that five year period, I should ratchet down expectations; a "bridge year" where the company transitions into a slower-growing company is appropriate, and I'll assume 15% growth for that year (year six, for those scoring at home). Keep in mind, this entire time the net growth figures are being discounted back to present, but we'll get to that later. Now we have Apple, the "maturing firm," as we move into the second half of 2013. For the next two years, let's say Apple grows at 10% per year, with 9% the year after that and 8% in the following year - solid, but not phenomenal, rates. There are two issues left: the proper discount rate, as well as the terminal (or exit) multiple, which is the inverse of the discount rate.

For the discount rate here, I'll use the Capital Asset Pricing Model (CAPM), which - let me hack a rather elegant theory apart here - basically states that the expected return of an asset is equal to the risk-free rate of return, plus some additional return that equals the risk premium multiplied by the risk of the asset. The average yield of the 1– and 3-month Treasury Bills is about 4%, and I get an expected market return of about 6.6% using the S&P 500 earnings yield and dividend. With AAPL's beta of 2.21, the CAPM gives an expected return of 9.49%. Take it for what you will, that is what I'm using for the time. Every year's cash flow is discounted at the appropriately compounded multiple of 9.49%, and the last year's cash flow is multiplied by 1/9.49% to give a terminal multiple of 10.53, which (as the name implies) is multiplied by the out-year cash flow and discounted back to present, along with the net current assets Apple has (carried on the books right now at $10.5 billion).

All of that nets out a value of $166 billion for the firm, about 18% above the current market cap for a value of $191.09/share. I consider this an aggressive set of assumptions because:

1. Growth estimates seem high, namely in the intermediate years

2. I think 9.49% is a very low discount rate to use for a stock like AAPL; and while discount rates are very subjective I think it is safe to say most people aren't in AAPL for a 9.5% annual gain.

The latter issue is strictly my view and has much to do with the difficulty of measuring "risk" in financial circles - I don't think that beta is close to perfect, but it has to suffice for the above example. On the former, however…

I realize Apple has a great growth story right now; I merely think the extent of the story is greatly over-hyped. Yes, the iPod is a nifty device from everything I hear, but that is Apple's only real successful product launch in their twenty-five years in business. The iPhone hadn't been out three months when they had to cut the price to move units - it is far too early to call the iPhone a success, but I digress… focus on the quantitative side of things. If Apple maintains the same FCF margins it does right now throughout this scenario (a big assumption, as margins usually come down), Apple will need to have 5x the sales next decade compared to right now. Sales in the last four quarters amounted to $22.6 billion, giving a target of $112 billion in sales. How impressive would it be for Apple to accomplish that feat? In the last ten years, Hewlett-Packard (HPQ) has gone from $42.9 billion in sales to $100.5 billion in sales; starting with nearly twice the base amount to work with compared to Apple, Hewlett-Packard fell short of the amount Apple needs to get to. Very few people realize what an immense and impressive feat $100 billion in sales would be; there are 21 publicly traded companies with that amount or greater. And yet, the implied assumption for people who think AAPL has moderate upside is that Apple will quintuple sales to break that mark in slightly under a decade.

So, what does one buy stocks for? Generally, I think the answer would be along the lines of what Charlie Munger has said: "All intelligent investing is value investing - to acquire more than you are paying for." In the case of AAPL, I don't believe you are acquiring more than you are paying for unless one uses extremely aggressive assumptions, and what is the point of purchasing something on the most optimistic of forecasts?

As for the arrival of the $131 fair value; such a valuation uses a 12% discount rate, 34% front-year earnings growth followed by 19% annually through the fifth year, a bridge year growth rate of 15%, followed by 10% annualized growth for the next four years. I now see that in the initial estimate I did a bit of rounding, so this valuation scenario works out to a value of $130.33, or 20% less than Apple's last closing price. Given that one wants to buy a stock at a discount of somewhere between 30-40%, I'd very much like to see how others are arriving at the conclusion that AAPL is a great value right now.

Comments

[Eldernorm:]

Sorry but I have to discount this article. The author seems to have litte understanding of what Apple is and what it is doing. Maybe he should by Microsoft stock and Hold it for the long term. :-)

Apple has multiple products and they each play off each other, making a large cohesive offering. As more people see Apple thru iPods, iPhones, etc, they are more in tune with Macs and the ease of use of the whole Apple matrix. Apple still owns OS X. If you want the great experience you HAVE TO BUY Apple.

Sorry, but I see Apple continuing to grow over the next 3-5 years. Its Google but slower on the uptake.

Elder Norm

2007 Oct 15 01:29 PM

[Shawnuff:]

Mr. Cullen could be right in his analysis of Apple's value, but his hubris is staggering and seems to prevent him from understanding the force Apple is in the consumer market.

Apple isn't only a "great growth story right now" but one that began in March 2004. The stock is now trading at 12.5 times its value of March 2004.

To Mr. Cullen the iPod is "is a nifty device from everything I hear". That "nifty device" along with iTunes DOMINATES the digital music mark. The "nifty device" put Tower Records out of business. iTunes is now the 3rd largest retailer of music after Wal-Mart and BestBuy. Target used to be number 3 - but that was last quarter.

To foolishly state that the iPod "is Apple's only real successful product launch in their twenty-five years in business" is again ignoring the bellwether that is Apple. Do you think there would ever have been Microsoft Windows without Apple developing the Macintosh? Apple's OS X is far ahead of Vista (the gap to widen soon), Apple's Desktops and Laptops sales are increasing dramatically (you can't use a 10-year time frame with this), and the iPhone has redefined peoples' expectations of a cell phone (woe be to cell phone manufacturers othe than RIMM).

Mr. Cullen would do well to remove his prejudices of Apple. He might even buy one of this nifty iPod devices and see what all the fuss is about.

2007 Oct 15 01:34 PM

[User 113885:]

KUDO'S ---EXCELLENT ANALYSIS----thank you for finally bringing some facts and calculations to the table---intead of all this hype and irrational cheerleading by these major brokerage firms!!!

2007 Oct 15 03:01 PM

[Dan Poarch:]

Clearly Mr. Cullen is sadly ill-informed about Apple and its products. I really wonder why he thought he could write an article on Apple without knowing a single thing about the company.

The point to be made against his and other nay-sayers is the crescendo that Apple is building. Apple has been steadily growing and improving over the past 30 years. They've seen good times and bad, and used all of them to learn and adapt. I simply cannot think of another corporation in the technology sector as successful at doing this.

We've seen nothing but ground-breaking products from them for the past 10 years since Mr. Jobs returned. That trend isn't changing as all signs point to further growth. If the iPod fails, they have phones, an unbeatable OS, iTunes, and laptops. If the phone fails, they laptops, ipods, unbeatable OS, iTunes, and laptops. Etc. As well, each of their products is at the top of its market sector [save for its enterprise unit, which can be argued]. Can anyone point to a company that has this much security or potential growth at the moment?

What Apple has that bothers the street so much is arrogance on par with the street itself. A clash of god-complexes.

2007 Oct 15 02:55 PM

[User 113884:]

Mr. Cullen,
Please SELL all your Apple stock immediately and buy some Microsoft; it sounds like they are more your style.
It is obvious that you are an "academic" that has absolutely no technical or computer knowledge what-so-ever. You also have no idea about the Apple sucesses over the years, the inovation nor the actual product sucess enjoyed by both the computer and iPod lines over the last many years.
I am shocked that the editors of Seeking Alpha would let such rubbish be published on their web site.

Fortunately, the world is able to see your writings for what they are; simply uninformed rubbish. You now can join the ranks of Jim Cramer ("sell all your Apple stock right now") and other analyists that have no real idea. Oh, Michael Dell is in that club also (Apple should liquidate and give the money back to stockholders).

2007 Oct 15 02:57 PM

[Jon T:]

What a really odd fellow this guy must be is all I can say.

2007 Oct 15 03:10 PM

[BabeRuth:]

When James Cullen says "Yes, the iPod is a nifty device from everything I hear, but that is Apple's only real successful product launch in their twenty-five years in business," I immediately dismiss him as an idiot. I don't care how much his number crunching in the article is meant to make him look smart and objective; I guess he likes to draw attention to himself by setting up a straw dummy, and knocking it down.

2007 Oct 15 03:24 PM

[mnguy:]

You may be the dumbest jerk on Wall Street. Good luck with the rest of your career because we'll all remind you of this article 1, 2 and 3 years from now.

2007 Oct 15 03:36 PM

[User 113919:]

No other successful product launches in their 25 years in business? The company was founded 1 April 1976 (the name was chosen so they would be before Atari, the leader at the time in the phone book). It's IPO was in December of 1980. Both of these dates mean more than 25 years by a decent amount.

While we're at it, how would the Apple II fit into that scenario? First shipped in 1977, and had millions sold with models being found in many schools up through at least 2005. How is that not a successful product?

Considering there's a note on Apple press releases that says "Apple ignited the personal computer revolution in the 1970s with the Apple II and reinvented the personal computer in the 1980s with the Macintosh." I'd say there some facts that don't wholly support your theories. And while I can give you the title as being the choice of the editors, you missed a few things in the substance of the story. But that's just my opinion, supported with a few moments in google.

2007 Oct 15 04:55 PM

[34% Huh?:]

I think here's your problem...only 34% growth in the current quarter.

In my spreadsheet, I have Apple growing their Net Income (YOY) in fiscal year 2007 at 78% in Q1, 88% in Q2, 73% in Q3...why do you think Apple is only going to achieve 34% in the current quarter? Apple has consistently beat the streets estimates, usually by a good amount, for the past few years. So why use the analysts numbers when the haven't even been close in the past?

We are just at the beginning of the Apple tornado. When all of the iPhone revenue sharing agreements come into play, along with current iPod growth and more importantly, Mac growth...I am estimating 54% growth for fiscal year 2008. And I'm taking the conservative route. I wouldn't be surprised by another 70% to 80%.

So really, adjust your growth rates by a good 60% to 90%. I think you'll come out far more accurate than depending on the street's lousy estimates, as proven the past few years.

2007 Oct 15 05:04 PM

[RT:]

I have to aplogize, James, for accusing you of the misleading title to your article. Your article was quite reasonable, though I have a difference in opinion. But your editors at seekingalpha should have better ethics than this. Trying to "bait" readership with inflammatory, inaccurate titles only denigrates the reputation of the whole web site.

2007 Oct 16 11:47 AM

[User 114266:]

Up to now, rumors, quoted in serious newspapers, seem to indicate that apple gets around 10% of the bill of every iPhone customer from each of the carriers for two years (USA, France, Germany, England). Now if we take into account that for next year, Apple is planning to sell 10 million, which every analyst seems to think is realistic. That would mean, that for the next two years, these ten million people would pay a tenth of their phone bill to apple. You can estimate around 80 to a 100 dollars per person for the first year. If Apple sells 10 million more the next year, you'd have already 20 million customers (since they are two year contracts), paying apple around 2 billion in pure profit. This is not taking into account that estimates for the iPhone in the second year of sale are much higher than the ten million. Also, it's not taking into account the profit apple will make on the sale of each of the mobile phones itself. Some analyst believe apple could sell up to 46 million iphones per year arround 2009-2010. That would mean that two consecutive years of iPhone sales would mean 90 million customers resulting in around 10 billion per year in profits for the phone bills alone, not counting profits from the iPhone itself, nor films, tv-show, games (that will certainly come for the iPhone too), music etc. Of course, this would be the most optimistic vision. But still, we're talking about the potential of around 10 billion in profits per year alone from the phone bills... but what about the iPhones, the iPods, the computers, the store etc... Very optimistic people... hum... as I said, very, could estimate, that computer, iPhone and iPod sales at that point in time could add another 10 - 12 billion... already right now apple earns more than 4 billion just on computers, iPods, store and software, so if you add hardware profits from 20-40 million phones, a growing computer market share, 10-12 billion doesn't sound that irealistic. In all, there's a potential of 15-22 billion of profits (if the rumor about the telephone companies is true and if apple can ask for the same conditions in 2009-2010). I admit, personnaly, I would tend more for the 15 billion than the 22. ;)

2007 Oct 16 04:48 PM