So What's a Fair Value for Apple?

Well, we've been writing about Apple (Nasdaq: AAPL  ) all week, covering topics like:

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.

For comparison's sake, looking at competitors Google (Nasdaq: GOOG  ) and Microsoft (Nasdaq: MSFT  ) , I get the following:

  • 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.


Read/Post Comments (7) | Recommend This Article (12)

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 June 18, 2010, at 1:42 PM, Fool wrote:

    A great article, Jim, and thank you for putting this together. But I must add my two cents and say that I think that your estimate (along with the analysts') is still being too conservative and that AAPL still hasn't reached its valuation.

    The expectation is 16% growth. But asking AAPL to get 16% growth is like asking the LA Lakers to beat a team of high schoolers. The company has grown Net Income at a 58% annualized pace over the past 3 years and 71% annually over the past 5. This can be attributed to consumers' infatuation with the iPod and iPhone -- which is exactly the same response we're seeing right now with the iPad and iPhone "4". I think Mr. Jobs has still got a strong pipeline of new toys for the world to play with.

    I bought AAPL back at $87, and have been tempted to cash in lately. But I think AAPL's not quite done yet, and estimate (from my own model) that it's worth at least $350.

  • Report this Comment On June 18, 2010, at 3:09 PM, TheDumbMoney wrote:

    For my 2 cents, I tend to agree with Jim! There is also what I what I like to call "What if Steve Jobs' Liver Goes Kaput? Risk" in Apple. It wasn't a pretty sight the last time he went away. Apple may need its personal diety. At the very least, when he eventually leaves, there will be nobody capable of excercising the same (inspired) leadership. May happen twenty years from now, or may happen two years from now. At $87 I would take those odds, but not at $270 -- along with all the other stuff Jim said, not if I'm planning to hold for a long time anyway.

  • Report this Comment On June 18, 2010, at 5:35 PM, daveshouston wrote:

    This discounted cash flow methodology falls into the category of "cutesy". This sort of mathematical BS doesn't give us any truly viable answers.

    Apple's success is product driven. How can you apply simple arithmetic to a company like this that regularly introduces game changing products?

    Today the iPad and iPhone version 4. Tomorrow the iTV. After that only Apple insiders know.

    What is apparent is that they've struck gold with their iTunes ecosystem. It's a fair guess to predict that they'll be introducing more products that can run their iOS operating system and tune in to iTunes.

    Apple stock should be selling at $350 today. I think it would be if not for the recent market correction. Analysts keep upping their estimates. Long time arch rival Microsoft has gone into hibernation.

  • Report this Comment On June 18, 2010, at 6:47 PM, lutece7 wrote:

    The Fool never tells you to buy Apple when it IS a a great, or even good price. And when its price skyrockets, they say it is too late. Well where was the Fool when it was at 200 or 150, or 100???

    Every time I sell Apple stock in order to diversify and follow the Million Dollar Portfolio or Hidden Gems recommendations, I end up regretting it. I sold a lot of Apple at 168 just to be able to follow those two Fool memberships. Since then, my Million Dollar portfolio has gone up 2.6%. They should have added Apple. Why didn't they? I can't think of why Fool hasn't been recommending Apple. I think it must be something personal.

    As far as Steve Jobs succumbing to cancer and the stock going down... Don't you think that Warren Buffet's departure from this world would have much more effect on Berskshire Hathaway... a stock in the Million Dollar Portfolio (BRK-B)? Besides I don't remember Apple doing poorly when Jobs was sick. It will be a sad day when we lose Steve Jobs. He is an incredible innovator, visionary and leader. I am betting that what Apple already has in place will be enough to sustain it for years after he leaves. Maybe I am wrong. But we all KNOW that the Fool braintrust has been wrong to avoid recommending Apple for a very long time. Sure am glad I am still so substantially invested in Apple.

  • Report this Comment On June 18, 2010, at 7:33 PM, SimonJester753 wrote:

    Apple has never disappointed me. It's the only stock that I've never lost money on.

    They should not break it up. The synergy between the products is a creative engine. The iPhone runs a modified Mac OS. If they were separate companies, the iPhone would be a Droid. iPhone buyers would not migrate from Windows to the Mac, as many are doing.

    Losing Jobs would be tragic, but I hope at this point the board has someone waiting in the wings who is not another Gil Amellio.

    Jobs can pile up the spare cash and hold orgies on it for all I care, (though I wouldn't send back a dividend).

    I'd like him to buy Adobe with it, instead of fighting with them. I'm a loyal MacUser and the major programs I earn a living with are Adobe. I want Flash in my iPhone and on the iPad.

  • Report this Comment On June 18, 2010, at 7:53 PM, TheDumbMoney wrote:

    "Don't you think that Warren Buffet's departure from this world would have much more effect on Berskshire Hathaway... a stock in the Million Dollar Portfolio (BRK-B)? Besides I don't remember Apple doing poorly when Jobs was sick."

    lutece7

    1) I'm just a random commenter, you analysis of BRK.B, which I happen to agree with, somewhat (though I still own the stock), is totally irrelevant to my analysis of Apple.

    2) My friend, do try to think back a BIT farther than that when Jobs was recently sick, when he was still very much a driver. I'm talking about when Jobs left-left, before he returned in the early aughts for a $1/year salary and brought about the iMac revolution (funny, it seems forgotten how big a deal that was, so much has Apple broadened our conception of it) and then of course the iPod revolution, etc.

  • Report this Comment On June 21, 2010, at 6:23 PM, lutece7 wrote:

    dumberthanfool, the difference I see is that when Jobs was forced out in 1985, he didn't get to pick his successor. But the next time he leaves, he WILL have picked his successors. Looks like it is Cook and Ives and the rest of his faithful inner circle.

    See the difference???

    BRK losing Buffet and Apple losing Jobs, that was the relevance to my comparison. Nothing more.

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