Well, we've been writing about Apple (Nasdaq: AAPL ) all week, covering topics like:
- Should it pay a dividend? (I say, yes!)
- Is the iPad a big opportunity or overrated?
- Is it time for Apple to be broken up?
- Can the iPhone live up to expectations?
And many more. All in all, we hope you've learned quite a bit about the company, its products, and what it has to do to succeed.
Which just leaves one question. What's a fair price for the whole thing?
I'm going to try to answer this using a discounted cash flow approach. That is, the value of the company is the sum of the cash flows that the company can produce over its future lifetime, discounted back to the present at a reasonable rate. For a quick look, I like to use a simple model where I grow the cash flows at some rate for five years, half that rate for the next five years, and then at a terminal rate from then on out.
Here's the model
The terminal rate I'll use is 2.5%, about what long-term inflation is. For a first cut, I'll use what analysts are expecting for five-year growth, which is 16%. That makes the second five-year period 8% growth. And for a discount rate, I'll use the rate of return for the next best opportunity, here the S&P 500's long-term growth rate of 10%. Using $10.81 billion of trailing net income as the cash flow input (free cash flow and net income are reasonably close to each other for this company, so I feel comfortable using the latter for this rough-cut look), I get a value per share of $336.
Is that a fair price? Well, not for me. I think a 10% discount rate is too low for Apple. Despite also having the benefit of high amounts of cash sitting on the balance sheet, I really don't like that huge cash balance doing nothing. It earns a piddling amount of return and it isn't being paid to shareholders (a DCF valuation exercise assumes that shareholders will be paid at some point). Finally, it could tempt management to do some really stupid things by either launching products that flop (remember Apple TV?) or acquiring companies that really don't fit the Apple model, like Peter Lynch's "deworsification," which can destroy a company.
So, if I raise the discount rate to 12% to reflect these concerns -- in other words, requiring a higher return before I'd be comfortable investing -- the value per share drops all the way down to $257. And if I bump it up just another point, the value drops further, to $229.
What's the growth?
Now the question is, "What should the growth rate be over the next five years?" Well, considering that the company grew net income by 71% per year for the past five years, you might be tempted to use 30% or 40% as a compromise. At 30% for the first five years, 15% for the next five, and my 12% discount rate, that kicks out a value of $539 per share.
Wow! Better than a double from here. Woo-hoo!
But before getting too excited, you should ask yourself, "Are those growth rates really doable?" Companies can rarely achieve such growth levels and just because Apple did so for the past five years doesn't mean it can do the same for the next 10.
Turning it over
Rather than trying to guess what growth rate should be used, I like Legg Mason's Michael Mauboussin's approach, which he outlined in Expectations Investing. Instead of guessing on the growth rate, choose a discount rate and then figure out what the market is expecting the growth rate to be at today's price. Use the DCF model upside down, so to speak.
For instance, in early 2009 when Apple was trading at about $88 per share, doing it this way would have shown that the expectation was that Apple would never grow free cash flow again, using my aforementioned 12% discount rate. Was that reasonable? Well, that was just after the trailing-12-month free cash flow had grown by 70% over the prior period (December '08 vs. December '07). Obviously, 0% was too pessimistic. As it turns out, that was a great time to be buying shares.
Today, nearly a year and a half later, at $272 per share, the expected growth rate has expanded to 17% for the next five years, which is essentially what analysts are expecting. Is that unreasonable? I would argue "probably not" considering that it is extremely difficult to keep up the torrid pace of 35% growth, especially as the company gets bigger.
- Google, at $500 per share, has 7.7% growth expected over the next five years, compared with18.3% expected by analysts.
- Microsoft, at $26, has 4.2% growth expected over the next five years, compared with the 8.6% expected by analysts.
- And, of course, Apple's 17% at $272 per share is real close to the analysts' 16% expected rate.
Hmm. Given the above expectations, Microsoft or Google might be better spots for your money, today. Of course, further due diligence is required.
Is Apple fairly valued at today's price? I'd have to say, probably yes. At least the growth rates currently baked into the price aren't either ridiculously low or extremely high. If Apple does manage to grow faster, more power to it. But I would like to see a lower share price before investing in it again.
Microsoft is a Motley Fool Inside Value pick. Google is a Rule Breakers recommendation. Apple is a Stock Advisor pick. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Legg Mason.
Fool editor Jim Mueller used to own shares of Apple, but doesn't any more. He does own shares of Legg Mason and is a beneficial owner of Microsoft shares, but has no financial interest in any other company mentioned. The Fool's disclosure policy has a crush on Michael Mauboussin.