Apple, Inc. Stock Valuation: Are Shares Worth $164?

Apple (AAPL -1.22%) stock reached another new high this week, hitting $133.60 per share. Adjusted for Apple's 7-to-1 stock split, this is equal to $935.20; Apple is getting closer and closer to reaching the pre-split $1,000 price target many analysts had for the stock when it was soaring toward $700 in 2012. Just a few bucks off this new all-time high, Apple's value is nothing short of astounding. The company's market capitalization of $769 billion is more than twice the value of the second most valuable company in the world, ExxonMobil.

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As the tech giant's stock continues to hit new highs, it's worth considering whether or not the stock is finally getting close to fairly valued, or perhaps even overvalued. One way to get a ballpark estimate of what the stock could be worth today is with a discounted cash flow, or DCF, valuation.

The model
A DCF valuation is simple. A business is ultimately worth the present value of its future cash flows, so a DCF valuation takes estimates of future cash flow and discounts it to present value to find the value of an asset.

Apple is an excellent company for the DCF model. With a consistently high gross profit margin providing evidence of the company's enduring competitive advantage in the premium segment of its respective markets, and consistent hefty free cash flow, Apple's future cash flows are somewhat predictable -- something that couldn't be said of many publicly traded businesses. Of course, even "somewhat" in the realm of forward-looking predictions doesn't imply much accuracy; but that's why you work a margin of safety into your valuation (more on that later).

Of course, this sort of valuation is far easier in theory than in practice. Bad inputs will result in poor outputs. Or, as they say: Trash in, trash out. It's the inputs, and not the model, therefore, that make or break a DCF valuation. So, it is important to get a good picture of the factors driving and affecting a company's revenue and free cash flow to be able to come even close to predicting future levels of free cash flow.

The inputs
To understand Apple's potential for growth going forward, consider its recent growth trends, Apple's current competitive position, and the health of the tech giant's key markets.

A look back at Apple's recent revenue and free cash flow growth clearly shows that Apple doesn't appear to have hit a point at which business growth is leveling out. In Apple's most recent quarter, its $51.2 billion in revenue was up 30% from the year-ago quarter. During the same period, iPhone unit sales, which account for 69% of total sales, soared 46% higher than the year-ago quarter. Free cash flow jumped a whopping 48%. While this quarter is somewhat of an anomaly in comparison with other recent quarters, this big growth highlights just how healthy Apple's business is.

iPhone 6. Image source: Apple.

Taking Apple's monstrous first fiscal 2015 quarter out of the picture, and zooming out a bit to an annual look at growth, Apple's fiscal 2014 free cash flow of $49.9 billion was up 12% from the year-ago quarter.

When it comes to Apple's competitive position, its pricing power is an excellent representation of just how strong the company's current position among competitors and with its customers is. In Apple's most recent quarter, it achieved a new all-time high for iPhone average selling price, or ASP of $687, up from $637 in the year-ago quarter. The new high for the iPhones ASP comes as Apple tested customers with the launch of the iPhone 6 Plus by introducing a more expensive iPhone and higher-priced storage tiers. Apple's incredible display of pricing power is happening just as the overall market for smartphones struggles with pricing and battles it out at the low-end. Android-powered devices are literally trending in the opposite direction, with average selling prices falling by more than $100 in 2014. Clearly, Apple is still on its "A" game when it comes to combatting a proliferation of cheap competition.

Then there's the smartphone market's growth in general. As the most important market to Apple, given that iPhone contribute the lion's share of the company's free cash flow, investors should keep the overall market growth in mind as they evaluate Apple's potential. In 2014, global smartphone sales were up 27.7% from 2013, according to IDC. Going forward, IDC predicts smartphone sales growth will achieve an average compound annual growth rate of 9.8% between 2014 and 2018. IDC predicts Apple smartphone shipments, specifically, will average a compound annual growth rate of 7.8% during this same period.

The value of Apple stock
With all of this taken into consideration, it's now possible to come up with a reasonable growth trajectory forecast for Apple's free cash flow. Taking into account the continued upside in Apple's smartphone business and watching Apple absolutely crush it in its holiday quarter, I believe Apple could reasonably grow free cash flow at a trajectory that resembles the one that follows, which starts at 5% growth in 2015 and decelerates by 5% each year.

If this forecast were to pan out, what would Apple stock be worth today? Given these inputs for growth rates over the next 10 years and assuming 3% free cash flow growth in perpetuity beyond year 10, the value of Apple's future cash flow discounted at a rate of 10% would be $164 per share.

Of course, this doesn't mean investors should automatically buy the stock if it trades below $164. Given just how uncertain any forward-looking outcome is, investors should give themselves some room for error in their projections, or some margin of safety. I prefer to adjust my required margin of safety to account for varying confidence levels in my projections. And I usually base my confidence level on the strength of a company's perceived moat, or durable competitive advantage. Apple, I believe, has a very strong moat, evidenced by its pricing power.

The crux of my argument for Apple's moat goes like this: As the company continues to use its design and manufacturing prowess, combined with its intense focus on only making a few, great products, Apple's premium-priced products and services will continue to attract both new customers and its existing loyal customer base. With this said, I feel fairly confident about the trajectory I've laid out for free cash flow and would require only a 15% margin of safety before I thought shares were a buy. In other words, I believe Apple stock is worth buying at $139 or lower --15% off of $164.

A simple DCF valuation, of course, is only one of many tools investors can use in deciding whether or not a stock is a buy. And investors certainly shouldn't rely entirely on someone else's DCF model given the model's sensitivity to inputs. But the exercise does clearly show that the discounted value of a reasonable estimate of Apple's future cash flow can make a compelling case for owning the stock.