Apple Stock Back at $500: Buy, Sell, or Hold?

Apple (NASDAQ: AAPL  ) stock is at $500... again. Though it's a nice 28% return for investors who bought at $390 in April, it's still down 28% from the stock's all-time high of $705 in 2012. Is there hope for Apple to recover to $700? Is the stock a buy at $500?

Headwinds
It's been an emotional ride for Apple's stock lately. The underlying business has also been fluctuating. The company's gross profit margin hit an all-time high and then proceeded on a downward trend. Even worse, revenue growth rates decelerated quickly and earnings-per-share comparisons have actually dipped into the negatives.

AAPL Gross Profit Margin Quarterly Chart

AAPL gross profit margin quarterly data by YCharts.

These developments have left investors concerned, and rightly so. But has Wall Street overreacted? The stock is trading at just 12.5 times earnings, suggesting investors expect very little (if any) growth in Apple's EPS over the long haul. Even more, with a generous share repurchase program in place to help boost EPS, a 12.5 price-to-earnings ratio for Apple stock is especially conservative.

10,000-foot view
At a 10,000-foot view, however, the underlying business still looks like a cash cow poised to reward long-term investors.

Sure, year-over-year EPS comparisons have dipped into negative territory in the past three quarters. But this isn't due to declining demand for Apple's products. Instead, it's based on insanely tough gross profit margin comparisons. And, more importantly, there's no indication that its gross margin will continue to contract.

Demand for Apple's products is actually still climbing. Apple's iPhone business (51% of revenue) looks as healthy as ever. Trailing-12-month iPhone revenue is up 20%. On average, analysts expect Apple's fiscal 2014 revenue to actually exceed its 2013 revenue by more than $11 billion.

And Apple's having no problem generating cash. It managed to convert $0.25 of every dollar of revenue in the trailing 12 months into free cash flow. Paying out just 27% of earnings in dividends, the company has plenty of room to boost its dividend going forward. I've even argued that Apple is one of the best dividend stocks available for income investors (though Apple was trading at just $450 when I made that argument).

At a 10,000-foot view, the underlying business looks healthy.

Valuation
Though Mr. Market sends shares all over the place in the short term, the value of every business is ultimately equal to the sum of its future cash flows discounted to present value over the long haul. So what's Apple worth?

From my perspective, Apple's business is still doing just fine, and it's reasonable to assume (with the help of the company's generous share repurchase program) that the company can grow EPS at a very slow rate going forward, say 3% -- in line with the historical rate of inflation. Assuming 3% annual growth over the long haul, a discounted cash flow valuation (based on a 10% discount rate and excluding the value of Apple's dividend cash flows) suggests the fair value of Apple's shares is $618.

A 19% margin of safety to a conservative fair value estimate isn't typically enough to get me excited. But in the valuation I didn't consider the company's dividend, which currently yields investors about a 2.5% return. Even more, Apple has already showed it is willing to increase this payout with a 15% boost on the dividend's anniversary. That said, a 19% margin of safety plus a 2.5% yield of bonus cash deposits into my brokerage account makes for a pretty convincing case for ownership in an industry leader.

I'd say Apple is still a buy at $500.

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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 October 19, 2013, at 9:27 AM, Nygel wrote:

    Good article. Nice to see some actual financial analysis instead of the hyperbole we often find regarding AAPL.

    One question though is on the use of a 10% discount rate.

    The market recently bot $17B of AAPL debt at just a few basis points above Treasury rates, implying that at that point, at least, AAPL's financial position was seen as being pretty close to the risk free rate.

    Obviously, few would use the current 10 year Treasury rate of 2.6% as the discount rate, but quadrupling it to 10% seems more than a bit high.

    So, just wondering why you used 10%, when shirley, a rate of 5% or 6% or 7% provides plenty of premium over the risk free rate for a company of AAPL's quality??

    That said, even using the overly conservative 10% rate, AAPL's numbers are still impressive.

    I am long both the stock and LEAPs.

    Thanks.

  • Report this Comment On October 19, 2013, at 12:30 PM, skyisfalling wrote:

    I amhappy that someone has raised the question of using a discount rate of 10% and I remember reading an write-up using a discount rate of 17% ( I might be wrong by some 1-2%). It should really be the cost of capital for the company and the forecast need a close relation with the like of Mr. Oppenheimer, see how the company think their Cost of Capital going forwards, say,4-5 years. The forecast would be a function of multiple variables including future needs to go outside for money. I have seen people taking the discount rate so casually, but it is much more serious thing.

  • Report this Comment On October 19, 2013, at 12:43 PM, TMFDanielSparks wrote:

    @Nygel,

    Thanks for your great question.

    I tried posting this comment once already. So forgive me if it posts twice :). Anyways, 10% is actually very reasonable for a company like Apple. The risk of Apple's notes are far lower than the risk of investing in the stock. Company's are required to pay off their debtholders in the case of liquidation before they pay off shareholders. Given this fact and the fact that Apple's $100 billion in cash and making $0.25 of free cash flow on every dollar of sales, the loan is virtually riskless.

    For investors, however, we take on far greater risk. There's no certainty that Apple can maintain current levels of earnings and gross profit margins, which lead the industry. If competition intensifies and Apple's margins continue to contract and revenue declines a bit, investors are at risk of the share price falling in the future.

    Personally, I do not vary discount rates from company to company. Instead, I adjust my margin of safety requirements to account for varying business specific risk. A risker company, for instance, would require a 50% margin of safety instead of a less risky one that would require a 25% margin of safety.

    For your reference, changing discount rates causes huge fluctuations in valuation and you could, in a way, "fudge the numbers."

    17% discount rate gives AAPL shares fair value of $309

    8%: $866

    5%: a crazy and unrealistic $2166.

    Personally, I require a 10% return to convince me to invest in stocks, period -- thus a 10% discount rate. The stock market is very volatile and there is far more risk than in bonds.

  • Report this Comment On October 19, 2013, at 3:47 PM, Nygel wrote:

    >> Given this fact and the fact that Apple's $100 billion in cash and making $0.25 of free cash flow on every dollar of sales, the loan is virtually riskless.<<

    I completely agree, and the effectively risk free interest rate AAPL has to pay reflects just that.

    And a company with a different balance sheet and cash flow metrics would, of course, pay a considerably higher interest rate for the risk premium.

    Which is to say, I think your consistent 10% cap rate has the benefit of having a quicker inclusion/exclusion outcome, but clearly there is a wide range of risk factors that can and should dramatically impact the cap rate as one looks closer at a prospective investment, no? A small cap with plenty of debt and lots of promise would obviously deserve a considerably higher risk premium in their cap rate compared with a large cap like AAPL, that has virtually no debt and enormous cash flow...

    I'm assuming you use the consistent 3% growth rate as well and there, again, it strikes me that different companies in different industries in different product cycles deserve some differentiation, as well. That said, however, using a consistent growth rate does make more sense than a consistent cap rate, since growth is always, and ever, subject to enormous speculation based on continuously changing assumptions and historical information.

    Ultimately, though, these pieces of the puzzle are subject to our own personal investment process and great topics for discussions that rightly, never reach a consensus.

    I must say though, that I doubt there are many companies that meet the 10% cap, 3% growth rate criteria for your investment threshold. Can you share a couple? High cash/very low p/e types, I'm guessing?

    I gotta say though, it was a pleasure to read your post and be able to think about and discuss the process rather than the usual "AAPL is Doomed" silliness. Thanks for taking the time.

  • Report this Comment On October 19, 2013, at 4:23 PM, TMFDanielSparks wrote:

    @Nygel

    The 10% discount rate is the only factor that I leave constant across valuations. Most analysts don't use the concept of margin of safety. They just find a "price target." But when you have the concept of margin of safety you have another way to account for business specific risk.

    If I accounted for business specific risk in the discount rate AND by adjusting my margin of safety, then I would leave far too much room to "fudge the numbers." So I have opted to use the discount rate to account for the time value of money and the risk of investing in the stock market, a factor that remains constant between every security... It's with my margin of safety that I account for business specific risk. So, for a company like Apple or Google, I may only require the stock to trade at a 20% discount to fair value (20% margin of safety) in order to merit a buy, since they're fairly low-risk stocks.

    But if I was valuing, as you said, a small cap with plenty of debt, I would require an enormous margin of safety (in reality, I wouldn't even consider such an investment because I wouldn't likely even be able to reasonably project its cash flows) -- maybe 60%.

    As far as growth rates go, that always changes between stock to stock. Every company is a completely different story. Google, for instance, I would probably project cash flows to grow at about 15% annually initially and then I would decay that rate by about 5% per year or so over the next 10 years. And for years beyond 10, I'd probably use higher than usual perpetuity rate of about 4% because online advertising will likely be a growing business for many years to come. So, every stock is a case in and of itself and requires deep knowledge to decide growth rates, decay rates, perpetuity rates, and required margin of safety. It's a highly customized process.

    I could focus on the discount rate to account for business specific risk by varying it too, but then it would be very difficult to gauge the type of margin of safety I would require because I would be accounting for business specific risk in two different ways.

    Does that make sense? There's plenty of right ways to do DCF analysis ... but this is the way that works best for me.

    Love your comments!

  • Report this Comment On October 20, 2013, at 10:07 AM, Nygel wrote:

    Not often is there an opportunity to have a respectful cyber-conversation and actually have to think about investing concepts. Appreciate you taking the time to share your approach.

    That said, I actually look at this process in almost exactly the opposite way -- and your comments have given me pause and caused me to think about my approach. That is, I keep my margin of safety number and my expected growth number fairly consistent and I spend more time laboring over a rough cap rate.

    I think the reasons are as follows:

    Earnings growth rate is the easiest. CEO's are paid very, very well to speak about earnings and earnings growth using every possible happy word in their vocabulary. And are punished when they speak otherwise. (not a problem for most CEO's to "filter" their comments since several recent studies suggest that the job of CEO attracts psychpaths<g>). I use a 0% growth rate with the idea being no growth is actually the mid point between growth and contraction. If a company makes sense at zero growth my risk is immediately reduced and I can judge the CEO on results rather than promises.

    I keep margin of safety pretty constant as well. Most of the great investors have observed that truly outstanding investing opportunities come along rarely and I believe it is because their margin of safety is very high. They also generally take outsized positions when they do invest, which is also likely influenced by their comfort level with the large, non-negotiable margin of safety.

    Cap rate is where I spend most of my initial time and consideration. What I want to know is not what value I place on the equity, but what a reasonably sophisticated buyer/seller would conclude and how they would conclude it using standard DCF methodology.

    No risk Treasuries are easy.... weekly and monthly auctions tell us risk free almost continuously. Every incremental measure of risk on any investment above "risk free" requires not just an additional payment, but also an additional explanation. Your minimum return requirement is 10%, so on a risk spectrum you are willing to accept some measure of risk for the roughly 7.5% in incremental return over the risk free return. A willing seller would insist on knowing why.

    Which is to say, if we all have access to the same historical earnings and balance sheet numbers and to roughly the same growth numbers (we certainly have no clear advantage over the bevy of analysts that get paid to publish they guesses, ad nauseum), then assigning risk to those numbers is our only job -- especially if we have already established a minimum margin of safety.

    In additon, in AAPL's case we already have knowledgeable ratings agencies and the market itself telling us the cash flow stream and balance sheet are as near risk free as a non-Traeausy can get, suggesting a much more modest risk premium of the equity is required.The debt balance itself is very low. The beta is low. And so on, just using AAPL as an example.

    Anyway, my cap rate for AAPL is roughly 6.5%, which I still consider to be quite conservative, but still provides my 25% margin of safety -- again, using zero growth. (FWIW, my model using your 10% and 3% numbers comes within $10 of your results).

    At the end of the say, I suppose it's whatever method is reproducible and works for us individually, with the real benefit being the time and attention paid to seriously considering and weighing the inputs.

    Thanks again for the conversation.

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