In this article, I will be attempting to show readers my version of the discounted cash flow valuation for Apple (NASDAQ:AAPL). For those who are not familiar with this type of valuation, it essentially entails that a company is worth the total cash flow that it can produce in the future in excess of the debt that it carries.
With any sort of in-depth financial model, there will be model risk, which is the risk from inputting incorrect numbers or estimates. Unfortunately, I do not diligently follow all of Apple, hence there will be many aspects in the model that do not incorporate future results from all the company's activities. For instance, the recent investment by Apple into Didi is not something that I have incorporated into its earnings or cost structure. I will be walking step-by-step through the model for Apple's core operations and explaining some of my reasons for certain numbers.
Data sourced from the company's 10K and 10Q
In my projection period, I based revenue for each of Apple's core products by simply multiplying the number of expected units sold by the revenue price per unit. In the 10K and 10Q reports, the company indicates the sold units volumes for three of its products and the total revenue that each of its products generate. With these two numbers, you are able to backtrack and determine the approximate revenue per unit that each of its three products generate. For revenue per unit, we notice a pattern or trend with the direction of where Apple is setting the prices for each of its core products. For instance, the iPhone is started to become more expensive starting in 2015 (from the 6th generation) and the iPad and Mac are declining in price every year. For the simplicity of the model, I have assumed that the revenue per unit for each of its products will remain stagnant although the model could increase it over time for iPhones and decrease it over time for iPads and Macs. It is also possible to justifying that the revenue per unit can increase overtime with inflation, but I will exclude it for simplicity.
For the iPhone and iPad 2016E estimate, I assumed that the unit volumes for Q3 and Q4 will drop by 20% as it did in Q2 this year. Post 2016E, the proceeding years assume declining iPhone volume growth from 8% to 5%, and a 20% increase in 2019E to assume a revolutionary 8th generation that will substantially increase growth as it did with the 6th generation. Although the iPhone volume growth in 2019E is a substantial prop to the revenue projection, my rationale is such that the large population of 6th generation iPhone users in 2015 will eventually see a repurchase from the end of the product's life cycle. For the iPad and Mac, I assume that the volume growth is declining and winds down to 2% in perpetuity.
The risks to the revenue projection include incorrect future estimates of revenue per unit for each product, volume growth numbers and net revenues for all products. The biggest concerns for this model is that it assumes positive revenue growth in every year of the projection period and there is no guarantee for growth as we are currently seeing in 2016 results. Also, the 8th generation iPhone may not be revolutionary as I have assumed and thus there might not be an occurrence of the substantial volume growth that I have inputted into the model. On a qualitative perspective, growth is not guaranteed because the overall smartphone industry is very competitive and mature, and customer tastes can change over time. Please also note that there is not a reason why I selected these exact growth numbers (and they may be wrong), but the general direction of the numbers ties in with my future expectation of where the company is headed.
INCOME STATEMENT PROJECTIONS:
Data sourced from Morningstar and the company's 10K and 10Q
After projecting out future revenues, we must determine the expected future costs. Many of the costs are difficult to accurately project in the future; thus I have determined them to be mainly a reflection of what has occurred historically.
- Cost of Sales assumes a historical average at 60% of sales with the exception of 2016E to reflect the bad year the company is currently having by using the TTM amount. For the most part, Apple has a solid business structure for its manufacturing and has held a very consistent historical performance of stabilizing its product costs over time. It is definitely arguable that the cost of sales can increase over time as a result of different product ideas that the company is pursuing that are more expensive than what it currently offers. Ultimately, when Apple pursues ideas that do not garner higher overall gross margins or similar economies of scale as the iPhone, the cost of sales as a % of sales will increase for the company.
- Gross margins are stable at 40% of sales after reflecting the projections of the Cost of Sales.
- Research and Development assumes the current 2016 TTM amount of 4% of sales and will continue to be the basis of future spending. Overall, the industry remains quite intensive on research and development, and spends a substantial amount of money when hiring top talent. It is also possible that the company can reduce these expenses if they choose to outsource R&D and top talent at cheaper costs.
- Selling General & Administrative at 6.4% assumes the same assumption as R&D. The argument against the projection is similar to that with what I mentioned with R&D as well.
- Other Income/Expenses assumes a historical average of 0.6% of sales
- Provision for Income Taxes assumes a historical average of 27% of Earnings before Taxes
CASH FLOW PROJECTIONS:
Data sourced from Morningstar and the company's 10K and 10Q
I will be using the firm method (FCFF) to project cash flows for the valuation model. Relative to the equity method of free cash flow, this version of the model simply shows the total value of the firm owed to both debt and equity holders. Proceeding with projections:
- The tax used to determine after-tax EBIT are the effective rates from the income statement projections. However, the effective tax can change with certain actions that the company can maybe take. For instance, many companies are trending with tax inversions to reduce their overall tax cost structure.
- Depreciation and Amortization assumes a % rate from the previous year Net Property, Plant & Equipment amount. For my projection period, I assume that the actual rate increases linearly over time, thus increasing the relative depreciation amount that the company incurs. The actual Net Property, Plant & Equipment amount is simply the previous year's number plus the current year Capex less current year Depreciation and Amortization. The growth is primarily caused by higher Capex spending as I will explain below.
- Non-Cash Adjustments is assumed to stay at the historical average at 3% of sales.
- Changes in Working Capital amount is a historical average at 5.4% of sales. The argument on this is that it is able to substantially increase over time from efforts by the company to pursue different products and operations that are more expensive that what it currently offers.
- Capital Expenditures of Capex is based on % of sales that linearly increases over time. This is to reflect higher future spending due to the competitive and demanding nature of the industry. The company has also shown signs of investing more on new ideas, which implies higher than normalized capex spending.
Data sourced from Morningstar and DamodaranLastly, to determine the discounted cash flow valuation, the projected free cash flows and a terminal value must be discounted by a WACC. The present value free cash flow and terminal are combined to be the company's enterprise value. The enterprise value is reduced by net debt to get the company's equity value. The equity value is divided by the total shares outstanding to determine an intrinsic value per share. The margin of safety implies the suggested upside or downside from the current market price. From my model, it suggests that Apple is undervalued by 37%.
The Weighted Average Cost of Capital or WACC is calculated based on a target capital structure and the implied equity and debt costs. For the cost of debt, it is essentially the debt yield of the company (0.12%) less the effective tax rate (26.4%). For the cost of equity, I applied the CAPM method, which I incorporated:
- Risk free rate is the 10Y yield of a U.S Bond
- Equity Risk Premium of 6% as suggested by Damodaron
- Adjusted Beta of 1.33
- Country Risk Premium of 0.7% as calculated from the chart. The Target Debt-to-Equity of 0.39 was determined by a historical and TTM median average of major companies in the industry. The Terminal Value is determined based on the Target TEV/EBITDA multiple, which is a historical and TTM median average of major companies in the industry. This multiple is 8.1x.
Table is independently generated
I have also included a sensitivity chart to show the intrinsic price of Apple when there are changes to the Target D/E structure and Target TEV/EBITDA multiple. The ranges for both the D/E and TEV/EBITDA measures are based on what the comparable companies currently trade at. Based on my model projections, Apple appears to be undervalued in many different scenarios.
The obvious risk to the overall model is that the company is not static and my projections can be way off from actual results. They will pursue actions that can be either more passive or aggressive than what I have projected or do something out of the ordinary that cannot be anticipated. Furthermore, there are many aspects that are almost impossible to estimate or have not happened yet. For instance, the creation of an Apple car product that works and gains significant traction would provide an unexplained upside to the valuation.
Although I am not a relatively a big fan of using the discounted cash flow valuation, it is a powerful mechanism for investors who have a more defined vision for the company and can put their estimates into a model. It is also a great mechanism to compare what a company's perceived market expectations are from what it is on a fundamental basis. The discounted cash flow valuation method often implies what an investor currently knows about the company and what it might do in the future. However, in most cases, the company is dynamic and can move opposite of investors' expectations.
Disclosure: I am/we are long AAPL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.