Why Apple Is Cheaper Than You Think

Today's Apple (Nasdaq: AAPL  ) is priced as if it were the next Microsoft (Nasdaq: MSFT  ) . Not the Mr. Softy of the mid-90s, but the Microsoft of today, the one that just finished with what might be the worst quarter in its history.

Really?
Yes, really. My math shows that investors price the iEmpire as if it were on track to grow free cash flow by roughly 6% annually till 2014, and 3% thereafter. Here are all the numbers as I entered them into the DCF calculator we offer to Motley Fool Hidden Gems subscribers:

Metric

Value

Discount rate

12%

Free cash flow

$10.3 billion

Assumed FCF growth for next 5 years

6%

Assumed FCF growth for years 6-10

3%

Assumed FCF growth after 10 years

3%

Shares outstanding

896 million

Excess cash and equivalents

$24.2 billion

All debt

$0

Debt equivalent value of operating leases

$1.7 billion

Estimated value of outstanding stock options

$1.5 billion

FAIR VALUE OF APPLE SHARES

$171.65 per share

Source: Capital IQ, SEC filings, and author's estimates.

There are a lot of assumptions cooked into each of these data points. Let's tackle the most important ones.

Discount rate. Sometimes also known as the required rate of return to hold a stock, the discount rate is the rate at which future cash flows are discounted to their present value. The higher the rate, the riskier the stock.

To some, 12% might seem more appropriate for small caps such as TASER (Nasdaq: TASR  ) or Palm (Nasdaq: PALM  ) than a $150 billion company such as Apple. Fair point. There's little risk of bankruptcy. Plus, we've seen the iEmpire survive just fine for six months without its iconic and once-believed-to-be-indispensable CEO Steve Jobs. I've set it this high merely to be conservative, to reflect the company's relatively volatile stock price movements, and because Apple's board hasn't exactly proven to be trustworthy.

Free cash flow. I've opted for the classic formula here. Why not be more conservative and take a three-year average? I think doing so would understate the impact of the iPhone and the huge subsidies AT&T (NYSE: T  ) provides.

What's more, we're now in year three of iPhone sales and are still seeing growing sales, even as Research In Motion (Nasdaq: RIMM  ) and Palm introduce new handsets. I suspect Apple's days of producing $10 billion or more in FCF annually are just beginning.

Debt equivalent value of operating leases. This number is calculated by the good folks at Capital IQ and is current as of Dec. 31, so it may very well be low. I include it in this calculation because Apple is more than just a seller of hardware and software, it's also an upscale retailer that, like Tiffany & Co. (NYSE: TIF  ) , leases a bounty of well-placed properties at fixed rates, much like interest on debt.

Estimated value of outstanding employee stock options. According to its latest 10-Q quarterly report, Apple had $1.5 billion in unrealized compensation expense related to stock options and restricted stock units. Exercises of these derivatives would have a dilutive impact on us as shareholders and, therefore, ought to be accounted for in the valuation equation.

Foolish final thoughts
The key drivers in this equation are free cash flow (FCF) and cash and equivalents. Reduce growth to zero -- that's right, zilch -- but preserve the FCF and cash numbers, and intrinsic value falls to $118.90 per share. The implication? Apple's existing FCF and cash assets account for over 70% of its market value at today's prices.

That's why I say Apple is still cheap. So do many of our Motley Fool Stock Advisor subscribers. But we could be wrong, which is why we want to hear from you. Please take a moment to vote in the poll below, and then leave a comment explaining your rationale.

Apple is a Stock Advisor selection. Microsoft is an Inside Value pick. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers had stock and options positions in Apple at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. The Fool's disclosure policy buys its apples by the bushel.


Read/Post Comments (3) | Recommend This Article (19)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 26, 2009, at 12:47 PM, misternl wrote:

    I'm not familiar with the valuation model described here, but the conclusion that aapl has high growth potential on a valuation basis confirms my own opinion based on product cycles.

    There is no company that has the velocity of release of important products that aapl has. The releases come so quickly that the individual products don't reach a 'maturity' point before the upgrade is announced. This creates a kind of pressure for accelerated growth.

    In the phone market, iphone growth was increasing from the app store, when growth was kicked up another notch based on geographic expansion, additional features and lower prices. It will still be growing when the new iphone iteration comes out next June, adding to the acceleration.

    Ipod touches are taking off because of the app store. Shortly there will be new cameras in the iphone touch making it a higher growth product.

    Likewise with macs: beautiful hardware upgrades followed quickly with lower prices both since January. This week Snow Leopard with Grand Central promises to take macs to a new level.

    And now the tablet, with jobs' own fingerprints on it. Potentially huge and completely new.

    The growth of apple is accelerating, which is especially notable in that apple has a relatively small part of most of the markets it is in. That is not being considered in most aapl valuations.

    imho

    N

  • Report this Comment On August 26, 2009, at 1:25 PM, danieleran wrote:

    Your figures seem to be oblivious to the fact that Apple's massive cash cow, the iPhone, has had the majority of its revenues deferred into the future via 24 month subscription accounting.

    You look at the last three years of cash flow, but that portrays the pre-iPhone Apple, because the first six months of iPhone sales in 2007 are only now just finally hitting the books officially.

    The iPhone really exploded in 2008 and continues to expand rapidly, but all those sales have still not hit the books. There's no end in sight for the iPhone, and plenty of fertile territory for growth in the rapidly expanding smartphone market.

    Apple is also rapidly expanding its Mac business, growing from .7 million/quarter in 2004 to over 2.6 million in the latest quarter. There's plenty of new growth potential there, too.

    The only core business that seems to be plateauing is the iPod, and that's only the case if you don't count the iPhone into iPod sales.

    Apple is rapidly creating and expanding into new markets, and has plenty of opportunity to continue rapid growth for the next half decade even if it tapers off its efforts to innovate. And there's no evidence that suggests any slowdown is happening.

  • Report this Comment On August 26, 2009, at 1:44 PM, TMFRhino wrote:

    Danieleran,

    He uses a cash flow measure, its earnings where the revenues are deferred. iPhone sales should be accounted for in the period of sale using this metric. If you pull up their cash flow statement in front of you, you'll see that deferred revenue is added back in when arriving at Cash Flow from Operations.

    Best,

    Eric

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