Apple (AAPL) is now a cult. Similar to any Revolution, the commentary will remain polarizing, as some yahoos are certain that Apple will take over the world, while ba-hum-bug misers warn us all that Apple shares will implode towards zero tomorrow.
As intelligent investors, it is critical that we take a step back from the shock and awe of this spectacle and focus directly upon the hard numbers of Apple's underlying business. To do so, we must first address the hysterical chorus of Miss Cleo naysayers who are hell bent upon sparking flagging careers through controversy.
From there, we will work through a simple discounted cash flow model that sets Apple's price tag at $815 per share.
Haters Gonna Hate
"Experts" who warn us that Apple shares are overvalued - must also be willing to discuss detailed plans to combat a looming Financial Apocalypse. We cannot afford to take these people seriously, unless they have stashed the majority of their assets into gold bullion, wear tin hats, raise chickens out back, and have converted their garages into warehouses for food storage. Smug Apple bears writing inflammatory articles and booking time on CNBC to scream at each other, can only defend their thesis by suggesting that our entire Industrial Complex is set to go up in flames.
At $600 a share, Apple trades for 15 times trailing earnings, despite the fact that the corporation is averaging annual 65-percent net income growth over the past five years. Super investor Peter Lynch favored a price/earnings to growth ratio of one - to describe a stock that is fairly valued. According to this metric, Apple should then trade at 65 times earnings, which would mean that this corporation is fairly valued at $2,600.
I do recognize that at $2,600, we may be getting a bit ahead of ourselves, because our PEG scenario assumes 65-percent income growth into the near future. Instead, let's break the numbers down in a manner that any kindergartner can understand. Stodgy Altria (MO), Coca-Cola (KO), Duke Energy (DUK), and Procter and Gamble (PG) all trade between 16 and 20 times earnings.
Apple, a consumer electronics corporation on the cusp of opening up China, is less expensive than our established (relatively) zero-growth tobacco, soft drink, utility, and toilet paper businesses. If you tell me that Apple is overvalued, I may question your credentials, unless you tell me to short the entire market.
That being said, perhaps we should simply write off this fear mongering as mere jealousy. I bet that half of these "crusaders" got burnt during the dot-com bust and were shellacked amid our latest housing debacle, prior to missing the boat on Apple.
Haters Gonna Hate.
Discounted Cash Flows
It's now time to get down to business. We should run a basic discounted cash flow model on Apple - in order to set a proper valuation target. If you are not familiar with discounted cash flows, we are effectively calculating the present value of perpetuity. In other words, how much should we be willing to pay now for a future stream of earnings in perpetuity? Apple's discounted cash flow price target, or present value of perpetuity, can be calculated through an earnings per share (payments) divided by the discount rate minus the growth in payments, or earnings growth [(EPS) / (Discount Rate - Growth)].
Of course, we recognize that our model assumes that Apple will not go bankrupt.
For our discount rate, we will use 10 percent, and for our growth rate, we will use 3 percent. These figures represent historical markers for 10-year Treasury Bonds alongside the global growth rate. Both of these estimates may be described as conservative, considering the fact that today's interest rates are effectively zero, while we should also assume that any sustainable consumer electronics company would generate profits that outpace the global growth rate over the long term.
For earnings per share estimates, we can leaf through Apple's latest quarterly report, which was released on April 25, 2012. For Q2 2012, Apple posted $12.45 in earnings per share, during a quarter that is traditionally weak. If we simply multiply Q2 earnings times four, we arrive at roughly $50 EPS for the year. Mind you, at $600 per share, our $50 EPS estimate would also land Apple at a bargain bin twelve times forward earnings price.
Now, let's go back to our / (Discount Rate - Growth) equation. Our estimates now leave us with ($50) / (.10 - .03) or ($50) / (.07) = $714. According to our highly conservative and simple model, we should therefore value Apple's future earnings at $714 a share.
But wait, we are not done yet.
Right now, Apple is carrying $110 billion in cash and investment securities on its balance sheet that covers 933 million shares outstanding. Apple's cash and investment securities therefore translate into $120 per share. A sudden spike in interest rates, however, would likely trigger a loss in credit security value. With that in mind, we will grant Apple a $101 per share cash position, as related to our model.
At these levels, we feel comfortable with an $815 price target ($714 for future earnings plus $101 in cash) for Apple. At $600, Apple shares carry at least 35 percent more value to the upside.
A Monopoly on Cool
Certainly, bears will argue that Apple's obscene 40 percent gross margins will fall over time. Within the normal business cycle, it is inevitable for competition to sweep in, steal share, slash prices, and commoditize product. Already, Microsoft, with its deep pockets is riding to the rescue at Nokia to partner up and shove the Lumia into our faces, as the latest in a long line of supposed iPhone killers. Meanwhile, these very same people would also lead us to believe that Amazon's Kindle Fire is marching in on Apple's iPad flank - to eat into sales and eventually dominate a Chinese market of more practical consumers.
Again, the fact of the matter remains, that the typical Wall Street suit may easily break down reams of financial data on paper, but he will never understand the meaning of "cool." "Cool" is a certain je ne sais quoi that represents the difference between South Beach and Ft. Lauderdale, Magic Johnson and Larry Bird, Nike and Reebok, and Apple and Microsoft. Today, and into the near future, hipsters, young professionals, students, and celebrities will happily pay a premium for their iMacs, iPhones, and MacBooks to lead us all into Apple's closed circuit Revolution of goods. Next, the rank-and-file set will open up their wallets to fork over cash and remain a part of the "in" crowd right alongside the cool kids on the back of the bus.
Right now, Apple has the monopoly on cool, or goodwill, as you blue-bloods would call it. At $600, adding goodwill to our already conservative price target is like taking candy from a baby.