Why Apple Stock Could Be Worth $120

With Apple's (NASDAQ: AAPL  ) second-quarter behind it, it's a good time to return to valuation. Also, with the stock nearing its all-time high, it's worth returning to some important questions:

  • What is the company actually worth?
  • Are investors who buy shares today getting a good deal?
  • Can investors who own the stock today expect to get a decent return on their investment over the long haul?
  • What exactly is the intrinsic value of Apple stock?

Let's find out.

Apple store in China. Source: Apple.

Searching for a moat
Before attempting to value any company, it's important to first decide if its business looks sustainable in the first place. Without durability, buy-and-hold investing is rendered useless. So, does Apple have a sustainable competitive advantage?

Warren Buffett refers to sustainable competitive advantages as economic moats.

"In business, I look for economic castles protected by unbreachable moats," Buffett has said. 

The harder it is for competitors to grab a piece of a company's profits, the wider and deeper a company's moat. Common sources of moats include switching costs, network effects, intangible assets, cost advantages, and scale.

iTunes works seamlessly across Apple's products. Source: Apple.

In an environment of rapid change, economic moats are even more important when looking at technology stocks. But tech stocks with predictable staying power are few and far between. Fortunately, Apple is one of them, with a number of powerful sources for its moat. Here are some of the most prominent sources for Apple's moat:

  • Intangible assets: Apple's brand is incredibly powerful, evidenced by the premium prices consumers have paid for its products for decades.
  • Switching costs: With an incredibly robust ecosystem of competent products that work together seamlessly, the purchase of one Apple product often leads to another. This makes Apple's ecosystem of products "sticky," which makes it difficult to move away to another platform.
  • Scale: It's difficult for manufacturers to match the quality of Apple products. With basically more money than it needs for research and development and for locking in third-party supplier contracts, Apple can use its scale as an operational competitive advantage.

With a powerful brand, a "sticky" ecosystem of products and services, and operational scale, Apple looks poised to sustain high levels of profitability for years. This makes the stock a prime candidate for valuation.

Apple stock valuation
With top- and bottom-line growth rates having slowed in recent years, a discounted cash flow valuation model is a good fit for Apple stock. After all, the value of every asset is ultimately equal to the present value of discounted cash flows -- and Apple's free cash flow has enough history for us to make reasonable assumptions about the future.

It's fairly easy to create a bullish case for the stock using a discounted cash flow model. If Apple's free cash flow increased by only 3% per year in perpetuity, or at the historical annual rate of inflation, and future cash flow was discounted at a rate of 10%, the fair value of Apple stock is $120.

If you doubt that Apple can grow its future cash flow at 3% annually over the long haul, keep in mind that a discounted cash flow valuation puts for more weight on the free cash flow in the years in the near-term than it does in the years further out. So, if Apple is able to grow its free cash flow in the next five years at more meaningful rates than 3%, yet rates fall below 3% over the longer term -- a similar case could be made.

iWatch concept design by SET Solution. If Apple's rumored iWatch proves to be both a meaningful driver to earnings and wholly accretive to Apple's business, these inputs for Apple's free cash flow growth may prove to be too conservative. Image used with permission. Watch a video of this concept here.

Further, not all cash flow is created equal. Fortunately, Apple investors know that its free cash flow is prone to create value. Management and the board of directors have historically proven their fiduciary responsibility to shareholders. In recent years, for instance, Apple initiated a dividend and, more importantly, ramped up its repurchases when shares were trading at post-split levels around $60 to $80 -- far below today's levels close to $100.

The company has also been very conservative in the prices it pays to acquire companies, with its acquisition of Beats Electronics for $3 billion as its largest ever. This figure pales in comparison to some of the billion dollar deals made by Apple's smaller peers. And, looking further back, there's no doubt Apple's investments in new products have panned out nicely. So, compared to many other companies, Apple is likely to outperform its peers when it comes to the use of free cash flow.

In a discounted cash flow analysis, conservatism is key. Counting on just 3% annualized growth of free cash flow per year over the long haul, this scenario purposefully underplays the continued potential of Apple's iPhone line and other new products we could see in the coming years. Yet these conservative inputs still yield a fair value estimate of $120 per share for the stock -- or a margin of safety of about 21%.

With such a meaningful margin of safety to a conservative estimate of Apple's fair value, this market leader looks like it will be a rewarding investment for those willing to hold over the long haul. Perhaps Apple's 15.4 price-to-earnings multiple and its 11.9 price-to-free cash flow ratio really are as cheap as they look.

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[Editor's note -- Added additional commentary to Apple's Beats acquisition]


Read/Post Comments (9) | Recommend This Article (29)

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 10, 2014, at 7:53 AM, Eushtna wrote:

    Great article on Apple! What folks need to realize is that this company is at the verge of introducing new products &services. It's huge reach into the iTunes membership sets it light years ahead of its competition. As Apple finally introduces a payment option on their new phones. I see this stock going to 160 before end of the year.

  • Report this Comment On August 10, 2014, at 10:49 AM, GaryGoulding wrote:

    I completely agree that this stock is worth holding for until they reveal their new products and services. The stock is primed to keep going higher and higher.

  • Report this Comment On August 10, 2014, at 11:57 PM, ConstableOdo wrote:

    Definitely worth holding but I don't think shareholders should get up their hopes too high. Apple stays in a stiff headwind from the dour analysts, news media and critics wearing tin-foil hats. For every positive thing Apple tries to do, the iHating, nay-saying cockroaches come crawling out of the woodwork or are summoned up by the trolls of CNBC. Basically, I think Apple's share price will be sat on by many elephants with an axe to grind. If Apple were Google or Netflix or even Microsoft, the share price would be flying but it's not going to happen with Apple. If Apple gets to $105 by the end of the year we should consider ourselves very lucky. The market was up 185 points on Friday and I think Apple went up 25 cents. Booyah!

    Apple investors are like freaking penny-pinchers. Apple has to invent some new amazing product every year or has to double its revenue just to move the share price a tiny bit. If some analyst even suspects Netflix might get a million more subscribers, the share price immediately goes up $50. However, Apple could bring 600,000,000 credit card accounts to the table for some new service and Wall Street simply yawns. This is a bias against all things Apple that is totally uncalled for. No free share price boosts for Apple and shareholders. Wake me up when Apple gets to $101 because I'm sure I'll be sleeping like the dead by then.

  • Report this Comment On August 13, 2014, at 8:37 AM, CraigWPowell wrote:

    May be this will help to reach $120 target:

    Apple’s suppliers are manufacturing new iPads

    http://apple-stock-news.com/2014/08/apple-stocks-news-apples...

  • Report this Comment On August 13, 2014, at 8:54 AM, Dro1992 wrote:

    Good article, but why do you not address the saturation of the hardware market and Apple's dependence on practically 1 product. Before you throw numbers at me about iPhone sales, yes they broke a record this year in quarter 1. However, the question to ask is if they can diversify their product line? The iPhone accounts for roughly 48% of the companies income so any kink in sales. If anyone responds to this comment, please don't be the incompetent average Joe and state that the iWatch will help their revenue structure. The Mac and iPad are roughly 13 and 11% respectively. They gets deals through educational institutions and have a plethora of uses. The iWatch will most likely generate as much revenue as the iPod, which is under 1%.

    My point is you spoke about a competitive moat, but didn't address Apple's dependence on one sole product which is something you should consider, particularly when promoting a company. Forget everything else that comes out this year, the market performance of the new iPhone, with arguably the biggest change since the creation of the iPhone, is the most important variable in regards to Apple's future revenue.

  • Report this Comment On August 14, 2014, at 2:18 PM, XXF wrote:

    So a stock price of $120 would value the company at $718.6 billion dollars, given that, if we consider 10% a reasonable rate of return, AAPL would have to be returning, give or take $72 billion per year to investors in perpetuity. Their current operating cash flow less capex (52 weeks ending 9/28/13) is about $44.6 billion. Would anyone care to explain to me how AAPL plans on growing free cash flow by 60% in the next year, as I would love to apply that particular strategy at a couple other businesses.

  • Report this Comment On August 15, 2014, at 9:58 AM, TMFDanielSparks wrote:

    @Dro1992

    to address the risk of the iPhone line, there was significant conservatism baked into the valuation.

    The iPhone has some clear catalysts around the corner and I feel these were not fully represented in this valuation

    http://www.fool.com/investing/general/2014/05/27/does-the-up...

    Further, risk is also taken into account by requiring a margin of safety. A 20% margin of safety to a conservative valuation that predicts a 10% annualized return seems to make enough room for risk, in my opinion.

    @XXF,

    I'm not really following your analysis. Maybe you could expand a bit? This scenario only predicts Apple to grow FCF at 3% per year, not 60% next year.

  • Report this Comment On August 15, 2014, at 10:02 AM, wallscreet wrote:

    Why didn't you give me this news when it was $50 and all the analysts hated it?

  • Report this Comment On August 15, 2014, at 10:21 AM, TMFDanielSparks wrote:

    @wallscreet,

    I'm assuming you are referring to the time when Apple pulled back from all-time highs in 2013? The stock reached levels around $60, but never quite pulled back to a post-split $50.

    There were a handful of authors at The Motley Fool, including myself, that were extremely bullish on Apple Stock during that time.

    Here are a few of my own.

    At $64: A Dividend Investor's Dream Stock http://www.fool.com/investing/general/2013/05/31/apple-a-div...

    At $61: Why Apple is An Undervalued Cash Cow http://www.fool.com/investing/general/2013/04/07/apple-an-un...

    A few more during this time:

    The Short and Sweet Bull Case for Apple Stock

    http://www.fool.com/investing/general/2013/05/30/a-short-and...

    Don't Choose Between Apple and Google -- Buy Both Stocks

    http://www.fool.com/investing/general/2013/05/30/dont-choose...

    Also, The Motley Fool's paid services were recommending the stock during those times.

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