The One Number That Explains Why Apple Is Still Cheap

There's so much debate among my colleagues over whether Apple (Nasdaq: AAPL) is still cheap now that it's trading for more than $500 a share. Eric Bleeker points to existing product growth, new initiatives, and international growth in making the bull case. A more nervous Brian Richards refers to history in worrying about the bullish consensus for Apple shares on Wall Street.

Count me with Eric, and not just because the iPhone is winning converts around the world. I'm comfortable keeping open a sizeable real money position and outperform CAPS call on the basis of just one -- yes, that's right one -- number. Follow along in the charts below and see if you agree.

The Law of Really Large Numbers
Most bulls point to Apple's extraordinary growth rates as cause for staying in or buying now. To be sure, there's plenty to crow about:

• Revenue is up more than 50% in each of the last two fiscal years, and three of the last five.
• Profit growth has accelerated each year since 2009. Earnings doubled in calendar 2011.
• Gross margin has improved 9% since 2007.
• And most importantly of all, free cash flow is up 61% annually over the past five years.

Cash is the story when it comes to Apple. The Mac maker is creating so much that it's approaching what expert investor Seth Klarman identified as "rare air" in his introduction to the sixth edition of Graham and Dodd's value investing handbook, Security Analysis.

In discussing relative versus absolute value, Klarman offers investors guides for what makes a bargain: "[One possible] standard is to invest when a security offers an acceptably attractive return to a long-term holder, such as a low-risk bond priced to yield 10% or more, or a stock with an 8% to 10% or higher free cash flow yield at a time when 'risk-free' U.S. government bonds deliver 4% to 5% nominal and 2% to 3% real returns." [Emphasis added.]

There are two main things to consider here:

1. Klarman's argument is for buying businesses whose free cash flow yield is at least three points greater than the available risk-free rate (8% versus 5%), though it appears he would prefer a six-point gap (10% versus 4%).
2. Applying this same math to present circumstances finds the 10-year Treasury yielding 2%. That's a good proxy for the risk-free rate if our intent is, as Klarman says, to be a "long-term holder."

Now do the math. Stocks yielding at least 5% and ideally 8% are "cheap" by Klarman's standards. How does Apple measure up? A lot depends on how you measure the yield, but all three of tech's titans do well by the most traditional definition, which is to divide calculated FCF by market cap:

Sources: S&P Capital IQ, Yahoo! Finance, TMF estimates. TTM = Trailing 12 Months. * Numbers in millions.

Value hounds should love that table. Cheapskate poster boy Microsoft (Nasdaq: MSFT) yields a very generous 7.2% in free cash flow as compared to market cap. But it gets even better. Mr. Softy improves even more than Google (Nasdaq: GOOG) when using enterprise value as the denominator, which factors in most but not all of the strengths of each company's balance sheet:

Sources: S&P Capital IQ, Yahoo! Finance, TMF estimates. TTM = Trailing 12 Months. * Numbers in millions.

As great as those ratios are -- all three are officially "cheap" on the basis of FCF yield -- they still understate the impact of held but illiquid investments. I think that's wrong, especially so in Apple's case.

CEO Tim Cook has said twice now that he and the board are giving careful consideration to whether Apple should pay a dividend. If they do, at least some of the proceeds are likely to flow from the $67 billion noted below. Here's what happens when you factor those assets into its Apple's FCF yield:

Sources: S&P Capital IQ, Yahoo! Finance, TMF estimates. TTM = Trailing 12 Months. * Numbers in millions.

Not surprisingly, Microsoft still looks like a screaming buy. And while you wouldn't know it from its CAPS rating or the headlines, so does Apple. We've focused so much on growth that we've forgotten that, in at least one way, this stock is also a ridiculously good value. Perhaps it's time we thought differently.

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