When assessed in terms of market capitalization, Apple (NASDAQ:AAPL) is presently the world's most valuable company. For the financial year ended Sept. 30, 2001, Apple's worldwide revenues were $5,363 million. At this time, the iPod, iPhone, iPad, and iTunes did not even exist. But 11 years later, for the financial year ended Sept. 30, 2012, company revenues have skyrocketed to $156,508 million. This quite remarkable transformation was possible because Apple has been instrumental in precipitating deep structural change to several major, global industries: music, mobile communications, and personal computing.
The key products that have driven these changes -- the iPod, iPhone, iPad, and iTunes -- did not contain any genuinely new technologies or features at the point of launch, but this did not matter. What mattered was that Apple found a way to combine a range of existing technologies and product concepts in a way that, when viewed as a whole, represented a major step forward.
Quite apart from the scale of this achievement, Apple managed this transformation without issuing any debt, without selling equity and while building a mountain of cash and cash equivalents that, according to the company's balance sheet at the end of June 2013, totaled over $150 billion. With each quarter that passes, one question is becoming more and prominent: Just how long can the company continue to grow at this rate?
Apple is already subject to the law of big numbers: With company revenues of $156 billion in 2012, 20% growth means adding another $30 billion to the top line. This is about the same as the value of the worldwide movie industry. As Apple approaches $200 billion, the bar is higher still. Eventually, of course, mathematics means that percentage growth must slow down -- or, put another way, planet Earth is not big enough to allow Apple to continue to grow at its recent rate for much longer.
Recently, we have seen two very different perspectives on Apple's future prospects: Larry Ellison takes the view that Apple will not be able to repeat the success of the past without Steve Jobs at the helm, while activist investor Carl Icahn thinks that Apple is undervalued and has taken a significant equity stake in the company. With such divergent views and ongoing debate about when Apple will introduce its next major new product, we thought that it would be a good time to undertake a bottom-up analysis of the company's value based on a detailed look at all of the company's products and operating markets.
We have undertaken separate analyses of each of Apple's major existing products, as well as two new products that do not at present exist, but which are widely anticipated:
- Mac (desktops and portables);
- Apple Smart Watch;
- Apple TV set.
Each product and each constituent market has been analyzed over a 10-year period, from 2013 to 2023. For all products except iTunes, we have then looked at Apple's market share, based on unit shipments and the average selling price (ASP) of each product. This then provides a value for the company's top line.
We have assumed that the company's overall gross margin (GM) drops from 42% in 2013 to 33% in 2023. Apple's actual reported GM between 2009 and 2012 ranged between 39.4% and 43.9%. However, because the company's biggest market (smartphones) is approaching maturity and because of increasing competition, mainly from Chinese smartphone vendors who are using Android-based devices to target the low end of the market, we think that Apple's historically high GM will be placed under increasing pressure. These same forces will also affect the company's second largest product segment, which is the iPad. Indeed, in Apple's 10-K annual filing for the year ending Sept. 30, 2012, the company cites GM as one area which will experience a downward trend in the future.
Our assumptions for R&D and SG&A expenditure track historic actuals, but assume a slightly increasing profile because of the increasing scale of the company making it harder to achieve the historic levels of efficiency in operating costs:
- R&D: We assume 2.2% of revenues in 2013 rising to 2.6% in 2023 (actual expenditure in 2012 and 2013 was 2.7% and 2.2% of revenues, respectively); and
- SG&A: We assume 6.5% of revenues in 2013 rising to 7.3% in 2023 (actual expenditure in 2012 and 2013 was 8.5% and 6.4% of revenues, respectively).
As far as corporate tax is concerned, we have assumed that the company's liability between 2013 and 2023 will be flat at 25% (historic tax deductions noted in the company's income statements between 2010 and 2013 range between 24.6% and 25.3%). The above process then allows us to estimate the company's net income (bottom line profit, net of tax and interest) between 2013 and 2023, which we have taken as a reasonable proxy for free cash flow (the numbers are so large that the contributions of depreciation, amortization and capex are quite small).
We have then discounted back these assumed cash flows to the present time (August 2013). Finally, we have estimated a terminal value of the company at Dec. 31, 2023, looking into the future and have discounted that back to August 2013 as well, although this only contributed about 5% to the total valuation and so is not that critical.
In order to carry out the valuation in August 2013, we have used a discount rate of 17%, as shown below:
We feel a figure of 17% is about right for Apple as we look into the far future: If we look back at the period between January 2012 and July 2013, then the total gross return for the S&P 500 was about 13% per year, while an investment in the Nasdaq 100 would have returned 14.5% per year.
As explained earlier, we do not think that Apple's historic annual return on equity is sustainable, at least not over the period 2013 to 2023. Even if we ignore the peak in Q4 2012, when the Apple stock price soared above $700, the company's current stock price, relative to that in January 2010 still implies an annual return of 27%. It is for these reasons that we have assumed a 17% discount rate for the future.
This approach results in an equity valuation of $313 billion. Because Apple's cash and cash-equivalent assets are so large (circa $150 billion) it is important to include these in the company's valuation, which means that the company's value is around $460 billion. This compares with the company's market capitalization on Aug. 26, 2013, which was $455 billion.
Detailed Analysis of Apple's Key Product Segments
The following table summarizes how we see Apple's key product segments developing between 2013 and 2023.For most segments, this table includes the size of the total market (in terms of unit shipments) and the ASP:
According to Bloomberg and Yahoo Finance, Apple's market capitalization on Aug. 26, 2013, was $455 billion. Our analysis suggests that figure makes sense: Our bottom-up analysis suggests a valuation of $460 billion.
However, in order to get to a valuation of $460 billion, we have had to make some very aggressive assumptions. Based on the company's history, its present skills and experience and almost unlimited resources, we think that these assumptions should be regarded as "aggressive but achievable."
However, we would underline what these assumptions mean in practical terms, for example:
- iPhone: Although facing increasing pressure from low-cost Android devices, we assume that Apple will be successful in maintaining growth in what is, and will remain, its largest and most important product segment. Our projections indicate that Apple's iPhone business will be worth $93 billion this year and $115 billion in 2023, representing a market share based on unit shipments of 20.5%;
- iPad: We project that the worldwide tablet market will ship 206 million units in 2013 rising to 456 million units in 2023. We forecast that Apple will ship 98.3 million units in 2013 (calendar), representing a market share of 47.8%. Facing increasing pressure from Asian vendors who will offer low-cost tablet models, but on the other hand being supported somewhat by continuing growth in the higher-value market segments, Apple's share of the worldwide tablet market will fall to 33.3% by 2023. The value of Apple's tablet business will grow from $53.3 in 2013 to $75.1 billion in 2023;
- Apple Smart Watch: We assume that Apple will launch a smart watch product in 2014 which will offer a set of features roughly along the lines of what we outlined in our recent report on the Smart Watch market. Apple's smart watch business, which we think will catalyze another wave of innovation in the mobile device industry, will be worth around $43 billion by 2023, up from zero today;
- Apple TV Set: We further assume that Apple will launch a TV set in 2015 at a price of $1,400. We also assume that Apple's "TV business" will grow to be worth $81 billion in 2023, up from zero today.
Our assumptions imply that Apple's revenues for 2013 (calendar) are likely to be around $190 billion and that Apple's revenues will double in size over the next 10 years to reach $382 billion. This is an extremely aggressive increase: It is one thing for a company to plan to double revenues over a 10-year period, but quite another when the company's top line is already $190 billion and has a market capitalization that exceeds any other company.
While we think that Apple's present valuation is likely to be about right, we also think that that there is no rational basis for believing that the company is significantly undervalued. Specifically, the hike in share price last year -- when Apple's market capitalization reached over %800 billion -- was in our analysis an anomaly: what we were seeing was an example of how markets can become disconnected from reality.