It's no secret that Apple (AAPL) is one of the hottest stocks on the Street. Over the last year, it gained nearly 40% in value and surpassed oil giant Exxon Mobil (XOM) as the most valuable publicly-traded company. Many bears are urging the bulls to consider the "law of big numbers", but even if we assume that growth rapidly falls for Apple, it is still undervalued.
In this article, I will run you through my DCF model on Apple and then triangulate the result with a review of the fundamentals against Microsoft (MSFT) and Google (GOOG). I find all three companies to be meaningfully undervalued.
First, let's begin with an assumption about the top-line. Apple finished FY2011 with $108.2B in revenue, which represented a 67% gain off of the preceding year: acceleration. I model per annum growth trending from 19.1% to 9% over the next half decade or so. This is a drastic decline in growth but reasonable given market penetration.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 60% of revenue versus 8% for SG&A, 2.5% for R&D, and 4% for capex. Taxes are estimated at 28% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around -2.5% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 3% and discounting backwards by a WACC of 10% yields a fair value figure of nearly $700 for almost 25% upside.
All of this falls within the context of stellar back-to-back results:
"We're very pleased to report the results of our outstanding second fiscal quarter. We established new March quarter records for iPhone, iPad and Mac sales, leading to our highest March quarter revenue and earnings ever.
Revenue for the quarter was $39.2 billion, representing year-over-year growth of 59%. That's a new record for a March quarter and is second only to the all-time record revenue we reported in the most recent December quarter. The year-over-year increase in March quarter revenue was fueled primarily by very strong growth in iPhone and iPad sales".
From a multiples perspective, Apple is also attractive. It trades at a respective 13.8x and 10.5x past and forward earnings versus 11.3x and 10.2x for Microsoft and 18.1x and 11.8x for Google.
Consensus estimates for Microsoft's EPS forecast that it will grow by 1.1% to $2.72 in 2012 and then by 11.8% and 10.9% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $3, the stock would hit $42 for 35.6% upside. Microsoft is a great way to play the "cloud" computing era and is, accordingly, rated around a "strong buy" (source: NASDAQ). Microsoft is also attractive, since it is led by top management and has sustainable streams of free cash flow. I am very optimistic about Windows 8 stealing away some of Apple's artsy market and believe that the bar has been set fairly low for the firm. It's hard to imagine an argument that would justify saying this company's golden days are totally over. For a company with near monopolistic power in some markets to be valued at less than half of Apple is, frankly, eye opening. Technology has few barriers to entry and is thus hard to predict. But with such a brand, Microsoft has potential to catch up to it larger peer.
Ditto for Google. Google has done an excellent job in building a unified product. From Google+ to Android and Gmail, Google has locked in a loyal market. In fact, Android has more market share than Apple's iPhone - a fact that does not receive enough attention. Actually, Google has a majority (51%) of the market in smartphone platforms as of March 2012 - a lead of 20,300 basis points over Apple. For such a company to achieve this lead out of seemingly nowhere speaks volumes to management's ability to execute. I have little doubt that this company will continue to innovate in ways that the market fails to appreciate in advance.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.