How Apple Stock Should Be Valued: P/FCF 29 comments
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A few of my readers have asked me to do a valuation and place price targets on shares of Apple, Inc. (Nasdaq: AAPL).
I continue to be quite cautious about publishing such an analysis for a number of reasons. First, a shrewd day trader once told me that issues touching on whether and when to buy, sell or hold a stock should be left to the individual investor to consider with their own professional financial advisors. My goal as a financial journalist is to contribute certain thoughts and insights which might help investors form their own opinions as to the merits of different investment strategies - it is not my purpose to make such recommendations in and of themselves.
Secondly, giving price targets is always good in theory, but fatal in fact. And the fact of the matter is Wall Street always seems to be preoccupied with some "looming disaster." Whether it's the rising price of oil, the credit crises, the inflation bogey-man, the slowing economy, the housing correction or the fictitious recession, Wall Street continuously hyper-inflates relatively minor issues and wallows in the inconsequential. This naturally paves the way for irrational decision making by "Wall Street's finest" not to mention the added bonus of wild market volatility. The endless stream of pandemonium underlying Wall Street's psyche makes it difficult for any reasoned analysis to navigate its way to the frontal cortex of institutional investors, and makes it even more difficult to give price targets within any reasonable range of confidence.
Furthermore, Wall Street has the habit of designating the narrow concerns of a particular sector as being the concerns of every stock in the entire market. Apple might as well have been called Apple Financial, Inc. for the month of January as Wall Street was dead set in believing that Apple was in the primary business of trading mortgage-back securities—or at least that's the impression it gave observers when it sold Apple off to the tune of 42% in one month. Tech stocks have slid as much as 15% in 2008 due to a credit crisis that has nothing to do with the tech sector. The tech bellwethers actually reported phenomenal earnings this past quarter demonstrating solid fundamental growth. Yet, tech stocks such as Google, Amazon and Microsoft are all down significantly since January—Apple is down 7.97% in 2008 despite posting a 45% yearly growth rate as of June 30, 2008 (and that's with the subscription accounting for the iPhone).
The bottom line is, who the heck knows what Wall Street will be concerned about a year from now not to mention which irrelevant sector's troubles it will attribute to Apple in the 2009? Given Wall Street's general unpredictability, it seems almost naïve to give price targets notwithstanding the market's fascination with the absolute. Apple could be trading at $150 or $250 a year from now depending on the market's conditions at the time.
That being said, I think something can be taken from the theoretical modeling of stock valuation. Stock prices trade on their own fundamentals in bull markets and trade on the market's fundamentals in bear markets. Keeping this concept in mind, valuation models should always contemplate a variety of different potential market conditions.
Furthermore, as a practical matter there is really only one way to valuate stocks in this particular market—the P/E method. While it is obviously not the most intelligent method used when it comes to valuating Apple, it's by far the most widely applied. While it is clear to any knowledgeable analyst that Apple ought to be valued on a price to free cash flow basis (P/FCF), many market participants continue to focus on Apple's GAAP-based net income and P/E multiple in determining Apple's valuation. Just yesterday, Mathew Ingram writing on Seeking Alpha notes, "From a stock point of view, Apple's shares are trading at higher multiples than Google's in most cases (price/earnings ratio, price to book value, etc.) but Google's profitability exceeds Apple's, with a profit margin of 25 per cent to Apple's 15 per cent, and an operating margin of 30 per cent to Apple's 19 per cent."
Financial writers continue to focus on Apple's P/E and write about it on a daily basis. Even analysts who should know better still remain transfixed on Apple's P/E: Steve Biggs, CFA at Zacks.com writes, "At its current price of $175.27 per share, Apple's stock is trading at 33.9x our fiscal 2008 estimate of $5.17. We set our six month price target at $184.00. This represents a P/E multiple of 35.6x our fiscal 2008 estimate, which is still a premium to the industry, but more accurately reflects the current outlook."
This analysis is plainly problematic. By saying that Apple is trading at a premium to the industry is to say that Apple's P/E is comparable to other companies similarly situated in the industry. Nothing could be further from the truth. Many of these other companies in the industry record all of their revenue from their primary operating activities (while Apple does not). Thus, Apple's P/E is not comparable to other companies similarly situated in the industry. Yet, this doesn't stop Larry Bellehumeur from making such comparisons. Bellehumeur, choosing to focus on Apple's P/E rather than its P/FCF, calls Apple's valuation "expensive" when compared to others in the industry.
The subscription method of accounting for the iPhone makes Apple's P/E artificially higher due to the fact that the iPhone's deferred revenue mechanism has the effect of lowering Apple's net income on a GAAP basis—thus causing the P/E to rise on the artificially lower EPS. In the "real" world, Apple has actually received about $2 billion in revenue from the iPhone over the past year that it has completely "deferred" and not recorded on a GAAP basis when arriving at net income—that's $2 billion "missing" from Apple's income statement.
One of the most intelligent, detailed and well-written articles on Apple's valuation over the past month was published by Turley Muller concerning the issue of valuating Apple on a price to free cash flow basis. Muller writes, "I believe investors have become overly fixated on Apple's expected accounting income, while ignoring Apple's impressive free cash flow generating ability. Free cash flow, not earnings reported in the accounting statements, determines the true value of a firm."
A slew of articles have been written on the subject by the more enlightened on Wall Street. Stephen Coleman, a known Apple bull and founder of Daedalus Capital in St. Louis, recently published an article entitled 'Replacing P/E in Valuating Apple Stock'. Coleman writes, "The price earnings multiple (P/E) is an increasingly useless metric when valuing Apple Inc.'s (AAPL) stock price"; further noting that "Apple's stock price is cheap, if you use CGM as your valuation metric," rather than the P/E multiple.
I completely agree with Muller's and Colman's analysis on Apple's stock valuation. Yet, I still think that Wall Street will continue to focus on Apple's P/E as long as the market is bearish, or until Apple's deferred revenue and cash generation have become so large that it can no longer be ignored. Yet, Apple investors should view this as a positive rather than a negative. The analysts who tend to focus on Apple's P/E are the same individuals who tend to overlook the future financial impact of the iPhone's deferred revenue system, and offer way off the mark consensus estimates.
The fiscal 2009 consensus estimates on Wall Street are so off the mark that it's almost comical. Analysts are generally looking for Apple to earn a mere $6.05 in EPS on $40.43 billion in revenue in 2009—growing at a relatively meager 16.12% over 2008. That's well below my expectations of about $7.50 in EPS on $43 billion in revenue. I expect that by Apple's fiscal Q2 2009 earnings report, one of two things will occur: (1) Apple's conservative guidance for fiscal Q3 will be well above consensus estimates leading to the first comprehensive blow out of earnings when it reports next April, or (2) Analysts will "wisen-up" after reviewing Q1 results and significantly raise their consensus estimates with consecutive upgrades.
Either way, Apple's stock price should benefit from analyst revisions or earnings blowouts in 2009. By that time, investors could reasonably expect to see the general shift in Wall Street's valuation of Apple. Yet, I do not expect Wall Street to change its general attitude towards Apple until well into 2009.
Disclosure: Andy owns 2009 and 2010 call options on Apple.
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This article has 29 comments:
Here is a list I keep of Apple's price targets.
Analysts ratings and changes as of 08/15/2008
Apple Price Targets
Daedalus Capital $600 Stephen Coleman
Citi raised target $248 to $287
WR Hambrecht $238 to $257
Piper Jaffay $250
Needham $235 to $240
Juback MSN Money $235
WR Hambrecht raised from $218 to $238
Deutch Bank raises from $225 to $235
Cowen & co. 235
Oppenheimer initiate cover
Scotia Capital raised target to $231
Pacific Crest raised from $225 to $235 (2 upgrades)
Cross Research $225
Thomas Weisel $195 to $225
Think Panmure $225 target price lowered to $200 on 7/22/08
Lehman $234 target price lowered to $220 on 7/22/08
Goldman $220 target price lowered to on $200 7/22/08
RBC Capital raised from $200 to $220
Amer Tecnlogy-Shaw Wu raised target to $220 (2 upgrades)
Morgan Keegan raised their outlook (Travis McCourt) $215 ( 2 upgrddes)
Morgan Stanley ***Upgrade $185 to $210
BMO Capital Market $205
S&P $200 to $210 ***Upgrade
Caris $200
Solei Securities $200
Credit Swise $200
RBC Capital from $190 to $200
Apple raised to Buy from hold by Kintisheff Research
B of A lowered from $190 to $180
Bernstein $165 to $175 (***Upgrade)
S&P $200 to $140
Note that only 4 price targets is less then $200
mrtaxx, Thanks for the list. Its comprehensive and very useful. The thing that's really interesting about these price targets is that the four analysts who know the least about Apple are the ones who have price targets under $200.00. That Bernstein research analyst is obviously an joke. Whatever happened to the Apple is not going to sell 10 million iPhones nonsense? Remember that debate he started in January? Where is he now? How can anyone listen to him after that? Bank of America has always been somewhat bearish on Apple with limited coverage. I think Scott Craig used to cover Apple at BofA but now some other analyst is over there (not sure).
Morgan Keegan analyst Travis McCourt doesn't know what he's doing. He may have a price target above $200, but I give him absolutely no credibility. He simply doesn't understand Apple's business. Go back and read some of his stuff in Appleinsider and you'll see why. Morgan Stanley's Katie Huberty is the worst technology analyst on Wall Street. Worse than Toni from Bernstein. Her estimates for fiscal Q2 missed by almost a cool billion. She was a huge basher during January-February disaster. For Q2, she made the worst call in revenue, iPods, iPhones, and Mac sales on Wall Street. Basically she made the worst call on anything important. She estimated that Apple would only sell 8.5 million iPods and 1 million iPhones in Q2! Apple reported 10.5 million iPods and 1.7 million iPhones. She also estimated that Apple would report only $6.634 billion in revenue. Apple reported $7.512 billion in revenue. I basically have her on ignore. She is analyst at one of the most reputable institutions and can't even calculate her run-rates.
The easiest call one could make in Q2 was that Apple would sell between 1.65 and 1.8 million iPhones. Steve Jobs came out and said that Apple sold 300,000 in the first two weeks of the quarter! How she arrived at 1 million in Q2 is way beyond me. Its her job as an analyst to be able to make simple calculations. Obviously there's no oversight Morgan Stanley because if I were her boss, she would be fired immediately.
Steve Biggs at Zack.com obviously has no clue as to what he's talking about either. Any analyst who focuses on Apple's P/E as its primary valuation metric simply doesn't know what he or she is doing. By the way, I was in no way trying to promote Steve Biggs in my article. I was using his flawed understanding of stock valuation as an example of the rampant stupidity going around on Wall Street. Thanks for the post.
Apple has all the necessary qualifying quantities to be a long term profit making stock: the moat is huge. even with tons of money, it will be hard for anyone else to garner the kind of respect Apple has. the company is financially secure, responsible and debt free with a huge cash reserve. innovation is the name of the tech game and Apple is the top innovative company, and they keep getting even better at it. they have multiple streams of income from multiple types of top rated products and they will be global within a year.
and at a time when retailers are dropping like flies, Apple continues to have the most profitable retail space around...they know how to do it and this story will keep getting better.
The other key point that continues to bother me is the "perception vs reality" idea that Andy makes so well. If conventional evaluation method don't work for Apple, why should we expect it's price to reflect it's true valuation? It will always been dragged down by the traditional method and there will always be many (I assume decreasing over time) that can't properly evaluate Apple. So it seems Apple investors' challenge is not understanding profitablity, but guessing when a critical mass of others figure it out. Ah...there's an easy task.
If last year Apple had said it could sell 12 or 13 million iPhones in a year, the stock probably would have been around $215 or so. Now if analysts say Apple may sell 17 million iPhones by the end of this year, the stock barely moves more than 2%. This past month has been great for Apple and investors alike, but whether the stock will skyrocket depends on many other factors that Apple has no control over.
Yes, Apple has a great long-term potential far better than many other tech companies, but all it means is that Apple should do better than most other tech companies, but whether it means the stock price will be in the mid $200 range is clearly just guesswork or maybe just wishful thinking. As often as I hear that WS just doesn't understand Apple's bookkeeping is a sign that maybe WS will never understand what Apple's value is worth.
The end-user benefit of a cellphone is experienced over the life of a service contract, and carriers subsidize the handset and receive relatively uniform payments from the user for the handset and service over the life of the contract. Carriers therefore use subscription accounting for the handset subsidy over the life of the contract. Apple's accounting is simply matching this carrier accounting; recognising revenue in step with actual end user payments, rather than doing its accounts like a subcontract manufacturer. Major cellphone brands doing their accounts like subcontractors is just one aspect of their ceding control to carriers.
One argument for the subscription accounting is that the carriers are an intermediary between Apple and their true customer, the end user, and if Apple ever removes that intermediary and provides the service too, there is no earnings impact on the handset business despite the loss of the massive carrier handset subsidy.
PEs are neither good nor bad, they are what they are, period.
Buyers and Sellers determine a stocks value, not Wall Street, so the equation of Price divided by earnings = PE should be altered to earnings X investor sentiment (PE) = price.
That puts the focus on the market's (investors) reaction to all sorts of variables. By tracking the market's past reactions you can make a reasonable assumption (sans superfluous and unrelated issues) as to what Apple's PE (I prefer referring to it as ISM - Investor Sentiment Multiplier) will be 4 times each year. Earnings report and conference call guidance.
That said I like valuing Apple by its FCF, but that requires real work on the part of Wall Street, and I'm not sure there is a lazier group of people, except when they're in pursuit of a commission, on the planet.
There is no mystery about subscription accounting. It is common and required in many circumstances by GAAP. The following is quoted from my book, "Sensible Stock Investing":
"It often comes as a surprise to new investors that cash flow is not the same thing as accounting earnings....Looking at the company on a cash flow basis gives you one view of the financial picture, and it is an important picture [because] ...cash is the oxygen of a company.
"...GAAP rules...[require] accountants to alter how they report the timing of money flowing through the [company]...GAAP does this in order to follow a basic accounting principle called matching: Money inflows and outflows are 'recognized' not at the time of the actual movement of cash but instead when the events that brought those dollars in or caused them to be used up actually take place...For example, revenue dollars can move 'down' the calendar, which effectively hurts current profits. If you own a subscription business--a magazine, say--you collect for a year's subscription up front. But your customer receives the magazines during the ensuing year, the last magazine getting to him or her about a year after it was paid for. From a cash flow point of view, you got the money when the subscriber paid. But from GAAP's point of view, the time when you can book that revenue is when the subscriber gets the magazines. So the accountant must spread the cash out over 12 months. Some of that revenue slips right into next year, and this year's profits look worse than they 'really are.' Similar timing alterations can apply to expenditures. Say your business buys a piece of capital equipment--a new PC for you. Under GAAP, your accountants must match the expense of the computer to the time when you are going to benefit from it. For a PC, that's typically three years. So the expense of the computer is 'depreciated' over three years, even though you paid cash for it now. This has the effect of pushing out an expense for which you've already expended cash, and that makes this year's profits look better than they 'really are.' "
Also a few additional price targets from analysts:
S&P (as of 8/9): $140 (not the $200 to 210 listed above)
Rochdale Research: $104
Market Edge Second Opinion: $165.15
Morningstar: $189
funding. This will continue until such practices are outlawed or until someone writes a devastating expose ( with names ) on the way it is used against Apple. I respect Andy's attempt to make sense of things but I've read tons of these 'rational'
explanations. The fluctuation of AAPL has become sicknenly
predictable and when based on the real factors of the case
utterly 'irrational' or should I say criminal ( the manipulation may actually become criminal soon- we can hope ). Iphonedied may be in a striped suite soon. It is he/she who
knows zip about investing based on reality. I hope you put plenty of that wealth aside to pay your legal fees. Run for the hills now troll.
1. The difference between AAPL's cash flow and earning is a difference in timing rather than magnitude (mostly). If they recognized all the earnings now they'd have a massive quarter due to the iPhone release, but earnings would look weak a couple years out as iPhone sales decline in anticipation of the next generation or another carrier's hot new phone. Subscription accounting is just a way to smooth out the earnings relative to the cash flow and to recognize the nature of the company's business (mobile phones are subscription-driven).
2. AAPL is not guaranteed the right to sell some ever-increasing number of iPods or iPhones at high prices every year. You can't just predict that they'll grow x% every year based on historical data. Take a look at Palm sales now compared to the late 90s/2000. Take a look at Sony profit margins now compared to the earlier days of their TVs. Current explosive growth is driven by penetration of new markets, fickle consumer perception of the iPhone as one of the best phones, and the current status symbol aspect of expensive phones. New markets could dry up, consumer could prefer the next hot thing next year, and phone prices could come way down as they become more of a stable and less of a luxury display good.
3. AAPL is not a diversified company (as someone suggested up there). The iPod, iPhone and their various computers all have a core function in common (playing videos and music). All are luxury consumer discretionary products. All sell to a similar type of consumer. All are supported by the same creative teams, style, and brand image. All are vulnerable to general reductions in consumer spending, style shifts, competitor imitation/competion, or decay in the quality of AAPLs creative employees. This is not the same sort of company as GE, MMM, WMT, or a diversified bank.
AAPL has been a great investment and may continue to be a great investment. But when a stock has had this kind of run-up and commands a high price, holders take on a lot of risk. A lot of events could knock off AAPL's stock prices
That's the whole point of the article and other associated articles mentioned; Apple is NOT being valued correctly, and does NOT 'command a high price'.
The stock is at a bargain if compared correctly on its fundamentals, cloaked to some extend by the subscription accounting.
And to say AAPL is 'not guaranteed the right ...' is being Master of The Obvious.
The point made over and over again is that the GROWTH POTENTIAL is there. Apple has penetrated some 8% of the computer market, some 1% of the mobile phone market, and now making a play for the living room, which it probably has a miniscule percentage of the market.
Care to name ANY other company with similar growth potential and the tools in place to capture that growth?
No company will grow at 40% a year forever, including Apple, but if you feel safer with GE, MMM and a diversified bank - all which got slaughtered and do not have a fraction of the growth potential as AAPL - be my guest and buy those companies.
That said,Apple has something special that does'nt show up on the quarterly report...SALESMANSHIP.... have the ability to make people want their products,regardless of price.I believe this to be one of their most important assets.
Most everyone who owns a Windows machine really wishes they had a Mac,including me.I'm ordering one as soon as the new offers come this fall....and guess what I'm paying with...profits from my latest aapl trade!!
This is the elephant in the room for AAPL. Everyone I know under the age of 30 uses a Mac. MSFT stumbled badly with Vista, and has left AAPL an opening to take a lot of market share from Windows, especially in a demographic where a lot of the growth will come from. And while MSFT's software-only business model leaves them open to rampant piracy, AAPL's hardware/software combo is harder to get round. IMO the lofty valuation on AAPL anticipates a considerable amount of share increase at the expense of Windows.
In addition to this, his website is a joke: www.daedaluscapital.co.../
Of course AAPL might manage to take some huge percentage of the global phone, computer and music market, and in that case they would prove to be a phenomenal investment going forward. On the other hand, their margins and their product differentiation are going to face massive competition as other companies look at the huge profits AAPL is making and try to get their piece of the pie. AAPL is hugely vulnerable to someone else generating the next hot PC, music player or phone. They are hugely vulnerable to a loss of key creative personnel who generate these ever-improving products. With the potential great rewards of investing in AAPL come great risks, and no matter how you mess with the numbers to justify your own investment, you have to understand those risks.
I once lived in a place and social circle where everyone I knew shopped at Whole Foods and half of my friends worked there. That doesn't mean everyone in America shops at Whole Foods and Whole Foods is a great investment - on the contrary, in fact. Most of America resents Whole Foods because they don't like high prices and they don't like the people that work and shop there.
Your argument against Dougm is exactly why Apple is a good stock, they have lots and lots of room for growth on the Mac side and the gadget sales are driving more and more people into the Mac camp. If Apple had a 30% share of the PC market I probably wouldn't like the stock.
To me, you lost all credibility when you stated Apple "cannot expect with any strong degree of certainty to continue recent blockbuster sales". That comment is a joke. Apple's gains in market share in the computer market are accelerating dummy. Your opinion is great chief, now look at the actual numbers.