Apple's Actual Value In Free Cash Flow Terms

Apr.26.12 | About: Apple Inc. (AAPL)

So much is being said about Apple (NASDAQ:AAPL). The bulls, and the analysts seeking press, set $1,000+ price targets. The bears say margins must collapse. However, rarely if ever have I seen an actual valuation analysis of Apple in free cash flow terms. (And Apple generates a ton of free cash flow.) So I am going to give you one.

Cash on Hand: We are not at the end of Apple's yearly fiscal reporting period, which is in September. But there is now $110 billion in cash and investments on hand. For my analysis of Apple, I typically discount cash on hand by 35%. This is conservative, and reduces Apple's valuation. I do it because so much of the cash is held abroad, roughly two-thirds of it. As current law stands, if Apple ever brings that cash back to the United States it will have to pay corporate tax of, by my calculation, 35%. It is of course possible there will be another corporate tax holiday, in which case Apple would not have to pay these taxes. And moreover the calculation is conservative because I discount all the cash by 35%, not just foreign cash. I do this just to show you I am trying to be conservative in my valuation of Apple.

Discount Rate: For my discount rate I am using Apple's weighted average cost of capital ("WACC"), which is about 10%. Note that like everything else, WACC calculations can vary, and they involve a certain amount of subjectivity. You can look up calculations of Apple's WACC on multiple websites, including Wiki Wealth. WACC, for all of its flaws, is the most appropriate discount rate to use in free cash flow analysis.

Assumed Free Cash Flow Growth and Rationale: I assume growth of 12% for ten years, plus 2% perpetuity growth. This is approximate, based on assumptions, which is required for discounted cash flow analysis. I use a 12% annualized growth rate for ten years. That is a blend designed to incorporate the idea that the five later years of this decade are likely to be much, much lower growth than the first five. Here is the thing: it is only a bit more than one-third of what Apple managed over the past two torrid years.

Results and Conclusions: This speadsheet, which I created, shows the estimated value, assuming my 12% growth estimate for ten years. This shows a worth of approximately $823/share. If I am in the right ballpark, it is a buy below $658/share, as of today, and a sell if it gets above $988/share. Keep in mind free cash flow analysis is "deceptively scientific," and actually involves many assumptions, which I have tried to lay out for you. So as of today it is more than 25% undervalued.

Why This is Conservative: This valuation is designed to be conservative, to create a margin of safety. First, as stated above, I am discounting corporate cash more than it likely needs to be discounted. Second, I'm using as my free cash flow starting point the numerical free cash flow of the last fiscal year, through September 2011. Since then, free cash flow has increased much more than 12%. Third, the 12% growth analysis is much slower than previous growth, and is designed to assume the maturation and margin compression that the bears are worried about. Fourth, Apple is buying back shares now. Over time, this will increase free cash flow per share, thus magnifying the value of free cash flow to remaining holders of shares.

A Caveat: I have not reviewed Apple's annual reports. I am not an expert in the industry. Microsoft (NASDAQ:MSFT) may rise again with Windows 8 phones, etc. Android is a formidable competitor. And Steve Jobs is dead and Apple may go the way of Research in Motion (RIMM) in two years. Who knows?! That is the danger of discounted free cash flow analysis. But I have tried to incorporate that into my valuation analysis by making it conservative.

Disclosure: I am long AAPL. I have been long since $365/share. During the recent market dip before second quarter earnings, I added marginally at approximately $577/share.