Apple (AAPL) has been on fire lately and big returns have caused current investors to consider cashing out and those on the sidelines to, well, remain on the sidelines. Icahn recently stated Apple should be worth twice as much. So the question is, how much is Apple really worth today?
In this article, we value AAPL using discounted cash flow (DCF) analysis in order to determine whether the shares are overvalued or undervalued.
Please note that for the sake of user experience, the article will not contain the full workings of the DCF for AAPL, but rather provide the main inputs and outputs and the justifications for using them. For more in depth and technical understanding of how DCF works and how we put it together, please see our previous calculations for (BRK.B - here), (DE - here) or (MSFT - here).
To begin, here are our main assumptions for constructing future cash flows for Apple:
Source: Created by author
Next, we construct free cash flows as seen on the table below:
Source: Created by author
Our output calculations are as follows:
Source: Created by author
As evident from the above DCF calculation, Apple's fair value appears to be $127.90, which suggests it is currently 20% undervalued. Despite being significantly off Icahn's $203 prophecy, more upside could be possible. Let's consider our main and most sensitive assumptions.
Our first important assumption is related to revenue and growth of revenue going forward. The 2014 revenue figure of almost $183bn is a real figure based on Apple's last report. Next year's revenue figure of $208bn is based on the average consensus analyst estimate. This represents a 14% year on year growth rate, which, given the already proven success of the iPhone 6, we believe to be a realistic and conservative figure. The following years after 2015, we use a diminishing growth rate, which drops by 1% every year and flattens out at 7%. To put these figures into context, Zacks research estimates the long-term growth rate (for the next 5 years) to be 12.8%. We are modeling considerably below this.
Our second set of assumptions relate to depreciation and investment rates. We model depreciation at 4%, which is closer to the recent 2-year average. The investment rate is also derived from the past 2-year average. Normally we would take the 5 or 10-year average, but since investment has been increasing, we believe it would be more prudent to use the more recent data to predict the future cash requirement for continued investment.
Icahn's $203 target seems unrealistic but there are several catalysts that may dramatically accelerate Apple's growth rate which could justify this valuation.
Apple Pay's potential for revenue increase is still uncertain but time will reveal the magnitude of this over the next 5-10 years.
Described by Tim Cook as "the perfect marriage", IBM's (IBM) partnership with Apple may be capable of disrupting the enterprise market. Apple could gain a large amount of share by catering products and services to businesses. Deployment could be effective and prompt due to IBM's largely mature network.
New product categories could significantly increase revenue beyond our estimates. Although Apple Watch is a new product category, we are far more interested in the product categories which are still unknown and that have the potential to disrupt entire industries (television and home are the most obvious ones).
CarPlay, which is being integrated by 29 major car brands, is taking shape nicely and further expanding the Apple ecosystem.
Apple's customer satisfaction levels are eye opening. For example, in a survey conducted in May by ChangeWave, iPad Air registered a 98% customer satisfaction rate, while iPad Mini with retina display received an astonishing 100% customer satisfaction rate (Apple June earnings report). This means competition may struggle to compete.
Swift, Apple's own programming language, allows developers to write code in a fun and interactive way. As it is easy to learn, it allows more people the possibility to dream big and develop entire new categories of apps. This once again, reinforces the Apple ecosystem by giving developers exclusive and superior ways of making their ideas into realities.
Apple's revenue growth is what will ultimately drive shareholder value in the future. If our assumptions are correct, then Apple may currently be 20% undervalued. Should new product categories or revenue streams emerge over the medium and long term, revenues could increase dramatically. As such, Icahn's $203 target may be more attainable than people dare to conceive…