Hello readers, the time has come for me to do a share valuation exercise of a company that is currently one of the leaders in the technology sector, Apple (AAPL). This analysis is based on 3 methods of share valuation: The discounted cash flow model, the Graham formula and EBITDAx7.
I will also review the most important financial metrics to analyze if Apple is generating or destroying value with the capital it has invested. Before we get into the share valuation, I present relevant information regarding Apple and its closest competitors to get a better understanding of the company.
First of all, their main market continues to be the U.S. and Europe, with Asia gaining importance as Apple continues to expand strongly in that region.
Revenue per Region
This information was taken directly from Apple's 2011 10-k table 33 (Excel version):
Revenue per Segment
This information was taken directly from Apple's 2011 10-k table 36 (Excel version): The iPhone is still Apple's number one money-maker. No surprises here, as every iPhone model has been a huge success.
The second biggest source of Apple's income is the iPad, already surpassing Apple laptop sales. As we will see later, the iPad is (and will continue to be) its fastest-growing product for years to come.
Investments are a big part of Apple's Balance Sheet
This information was taken from Apple's 2011 10-k table 12 (Excel version):
Apple purchased more than $102 billion of marketable securities in 2011. But it also sold more than $49 billion of marketable securities and another $20 billion matured, so the net cash flow from investing activities was $40.4 billion.
Apple's investments also include acquisition of property, plant and equipment worth $4.2 billion, along with acquisition of intangible assets for $3.2 billion.
Maybe Apple should bail out Spain. It surely is investing like it wants to take over the world.
Sales growth by product line
This information was taken from Apple's 2011 10-k table 36 (Excel version):
Look for the iPad to continue its impressive growth, as it is still relatively new and is expected to cannibalize PC sales.
Smartphone and tablet revolution
The number of smartphones sold has exceeded the number of PCs sold since 2008. Apple has found this quite profitable, as we can see in the the table below, which shows us its iPhone sales by quarter.
In the U.S., its best market, Apple has gained market share; going from 32% in 2010 to 43% in 2011. This was helped by two factors: Apple's release of the iPhone 4 and their broadened distribution to Verizon (VZ) and Sprint (S), instead of just selling iPhones through AT&T (T).
Apple should get another boost in its revenues once the iPhone 5 is released, which is expected to be around the fourth quarter of 2012.
A Research by Business Insider shows that tablets are expected to have sales of 2.5 million by 2016, surpassing smartphone sales of 2 million units a year.
This will work wonders for Apple, which has already established brand domination and loyalty so deeply into consumer's minds it will be truly difficult for them to turn to another brand for their perceived needs. This is psychology working along marketing at its best.
Business Insider shows how the global "smartphone" vs. "dumbphone" subscribers indicates the mobile revolution is still in its early phases, since only around 835 million users are using a smartphone, vs. around 5,600 million "dumbphone" users. Only 12.9% of cell phone users are smartphone users, so there is still a very large market to sell iPhones to.
The U.S. is the leader of the pack in terms of conversion to smartphones, since more than 46% of cell phone users in the U.S. have a smartphone, against 41% with "dumbphones."
The obvious conclusions are that the new smartphone sales will have to be directed at the rest of the world, and Apple will have to release a new iPhone every year or so to keep U.S. customers upgrading to the newer versions.
Cheaper, smaller-featured versions of the iPhone may have to be implemented to reach as many potential customers as possible, as the "dumbphone" conversion cycle is just getting started.
Globally, there are still less than 1 billion smartphone users estimated for 2012, while the forecast for 2016 is around 1.5 billion.
Smartphone market share
Currently, Android is winning the smartphone war with 56.1% of the market share. Apple is in second place with around 22.9% of the market share. The Symbian OS still has 8.6% of the market share. Blackberry's (RIMM) market share has been falling from around 20% to 6.9%, a sad story many have written about. Microsoft (MSFT) and others have not been able to get an important part of the market share yet.
In the next table, created by Gartner, we can see the smartphone sales by quarter and market share by operating system:
As we saw in the last graph (also created by Business Insider) the fastest growing market is tablets, their current global sales are around 150 million units a year, and are forecasted to grow to around 400 million units sold yearly by 2015.
Morgan Stanley was forced to make an upward revision in their tablet sales forecast:
"The latest report to clients on the tablet industry also includes a survey of purchase intentions and so it also resulted in the forecast of the tablet shipments a lot higher than earlier. According to their latest expectations 133 million to 216 million tablets will be shipped in 2012 and 2013 which is 57 percent and 122 percent higher than the earlier estimates."
Apple has redefined brand loyalty
In this graph, created by Asymco, we can see the break down of the launch performance for Apple:
This shows how every time Apple launches a product, it has become more popular by leaps and bounds, with customers camping outside its stores, lining up for hours to be the first to get the newest iPhone or iPad.
The 3 DCF scenarios
Now that we have seen some current information from Apple's 10-k, smartphone sales, market share and tablet sales forecast, we can dive into the DCF model to see how much each Apple share is worth today.
There are 3 basic scenarios in my DCF Model:
The "business as usual" scenario:
Apple continues operating as it has been for the past 4 years, growing at a slower percentage rate in revenues, but still greatly increases its revenue in dollars, mainly due to the continuing rise of iPad and iPhone sales. The iPhone will face some margin compression due to competition but the gross margin will have the help of the iPad's increased revenues and higher contribution margin per unit.
This is, in my view, a very conservative scenario:
Inputs include revenue increases of 57% for 2012, 12% for 2013, 10% for 2014 and 5% going forward. The gross margin was held between 37% and 40%, with 35% taken into perpetuity.
Investments were kept between $42 billion and slowed until perpetuity, where Apple "only" invested $23 billion per year. If that investment cash flow turns less negative, look out because Apple will be worth a lot more.
The "negative outlook" scenario:
In order to penetrate the lower-income markets, a "pricing war" scenario will be incorporated into my DCF valuation of Apple, where the iPhone and Android smartphones will be slashed in price in order to beat the competition in the lower-income segments and emerging markets; this will cause gross margin to compress from 40% down to 34%.
This will not be a problem, and as we will see later, Apple's margins are large enough to handle a pricing war. A recession is also included in this scenario, with sale increases dropping suddenly from 50% in 2012 to 5% in 2013 and forward.
The "positive outlook" scenario:
In this rosy scenario, Apple continues to be a hit among its loyal customers, recruiting even more on the way and gaining more market share, keeping its gross margin almost intact, going from 40% down to 38%. Its sale increase 57% in 2012, 20% in 2013, 15% in 2014 and 2015, 13% in 2016 and 5% into perpetuity.
Investments were kept between $42 billion and slowed until perpetuity down to $32 billion, if those investment cash flows slow down by $10 billion a year, the shares would be valued at over $2,500 per share.
I assigned an arbitrary 50% chance of the "business as usual" playing out, and 25% each for the other 2 scenarios.
Feel free to use the comment section if you have any questions regarding the inputs used.
These were the results:
In all honesty, I would have liked the valuation to come in lower (as I would not like feeling like someone that "pumps up" stocks), but the strong balance sheet and cash flows Apple presents are very impressive, to say the least.
An interesting fact that showed up when doing the EBITDAx7 valuation was that right now the shares are valuated as if Apple had around $80 billion of EBITDA.
It had $34.2 billion in 2011, and is on its way to $52 billion in 2012. The $80 billion EBITDA should happen, if the "business as usual" scenario plays out, around 2017.
So we can see the market expects Apple to keep growing its top and bottom lines for the medium and long term, any failure to meet analysts' expectations during any quarter will result in a big drop for Apple's share price.
We will now see some financial metrics for this technology giant.
Return on Equity, Assets, Capital structure and Liquidity
ROE (last 3 year average)
ROA (last 3 year average)
Liquidity: Current Ratio and Acid-Test
Capital Structure: Debt/Assets
1.61 (1.58 for the Acid-Test)
Apple shows very healthy returns on both their equity and assets, I see no problems in either liquidity or in their capital structure, as Apple has no interest-bearing long-term debt.
Their return on both equity and assets has been stable and rising for the past 4 years.
Margins (4 year average)
Cost of Sales/Sales
Margins have been rising at Apple, from 34.3% gross margin in 2008 to a 40.5% gross margin in 2011.
Its COGS have decreased from 65.7% in 2008 to 59.5% in 2011.
Its operating expenses went from representing 13.1% of Apple's revenue in 2008 to 8.9% in 2011.
Pretty impressive efficiency if you ask me.
Piotroski's F_Score & Economic Profit
Apple has a wide spread between its cost of capital and its return on invested capital. A 82.88% spread to be precise.
The economic profit for Apple is $43.3 billion for 2011. Not only is their economic profit huge, but very similar to Microsoft's. Check out my previous article on Microsoft for details.
Currently, investors are paying $5.04 for every $1 of Apple's sales.This puts some pressure on Apple's future earning releases, as Apple is expected to continue its prosperous path.
Apple scored 7 out of 9 in Piotroski's F_Score.
The two areas where Apple failed in F_Score were the equity offerings (as Apple increased their number of common shares) and liquidity (as measured by the current ratio). I would not call their liquidity a failure at all, as its current ratio is well above 1.5, which indicates it can cover all their current liabilities with their current assets.
The average price with the DCF valuation is $747.90. This represents an upside potential of 23.4% from today until the end of the year.
My price target, however, is more conservative, using the "business as usual" scenario. That target is $675.12.
Currently, Apple looks to be fairly valued to slightly undervalued by the market, trading very closely to its Graham Formula Share Value of $603.81.
Analysts that follow this stock have an average price target of $740 with a long-term growth rate of 18%.
As Apple may fall prey to the "expectations treadmill," failure to deliver its expected EPS will be a crushing blow to its shares. This should be taken as an opportunity by long-term investors to get into the stock.
If you are currently holding Apple shares, I advise you to write covered calls every month to generate income, as I explained in my last article.
If you have no positions but would like to own these shares, I would recommend waiting for a pullback at around $550-$570 to sell cash-secured puts at a level you would be comfortable owning these shares.
If I had to trade this stock soon, I would sell the August $550 puts, which are right now at $7 per contract, receiving $700 and tying up $54,300 in cash ($55,500 - $700), a 13.07% annaualized ROI.
I would much rather prefer to wait until the day before earnings, which is when volatility starts spiking higher, being able to sell these puts for much more than they are normally worth, and being able to either:
- Buy them back the week after earnings when volatility on the options is lower.
- Let them expire worthless.
- Be assigned the shares at a cost basis of $550 minus the price of the puts on July 23rd.
Apple reports on July 24th, keep that date on your agenda so you do not miss the conference call.