Why Dell Isn't as Cheap as You Think

Dell (Nasdaq: DELL  ) is cheap, but not as cheap as Apple (Nasdaq: AAPL  ) .

Please don't take that as a slight, Dell investors. Looking at the numbers tells me that those of you who are buying now, after a quarter in which the PC maker soundly beat Wall Street's expectations, are getting a good deal.

How good is it?
Mr. Market prices Dell as if it's on track to grow free cash flow by just 3% a year, forever. Here are all the numbers, as I entered them into the DCF calculator we offer to Motley Fool Hidden Gems subscribers:

Metric

Value

Discount rate

12%

Free cash flow

$2.1 billion

Assumed FCF growth for next 5 years

3%

Assumed FCF growth for years 6-10

3%

Assumed FCF growth after 10 years

3%

Shares outstanding

1.96 billion

Excess cash and equivalents

$11.7 billion

All debt

$3.4 billion

Debt equivalent value of operating leases

$928 million

Estimated value of outstanding stock options

$508 million

FAIR VALUE OF DELL SHARES

$15.89 per share

Source: Capital IQ, SEC filings, and author's estimates.

Notice how I used the same format for valuing Dell as I used to value Apple last week. For simplicity's sake, we'll review the thinking behind the two major data points in the same style as before.

Discount rate
My colleagues over at Motley Fool Inside Value might call 12% too high a required rate of return for Dell. Advisor Philip Durell used a 10% discount rate when estimating the intrinsic value of the company's shares in his February 2006 recommendation.

But 10% seems too low to me. CEO Michael Dell has been forced to cut operations and capital investments to the bone. Margins are recovering as a result, yes, but there's no way to tell whether long-term growth will return. And don't say "smartphones." Dell's distribution deal with China Mobile (NYSE: CHL  ) is nice, but it's one of many such deals the top Chinese telco has made. Plus, Apple's arrangement with AT&T (NYSE: T  ) is far richer.

Free cash flow
For comparison's sake, I'm keeping with the classic formula. That works to Dell's detriment in a head-to-head clash with Apple. See, there are varying ways to measure FCF. Here, we're using the classic definition of free cash flow where we subtract capital expenditures from cash flow from operations. However, free cash flow to the firm (FCFF) -- a more complicated measure -- might be more appropriate, given Dell's dependence on borrowing.

Using FCFF would change Dell's base free cash flow number from $2.1 billion to $1.3 billion -- not insignificant. Interestingly, were we to run Apple through the same exercise, free cash flow would drop to $7.5 billion, from the $10.3 billion I estimated here.

FCFF is lower here in part because Apple carries a lower effective tax rate -- 30% -- than the normalized 37.5% that Capital IQ calls for. We're also stripping away interest benefits from the FCF equation, which add up to $653 million over the trailing 12 months.

That's the beauty of Apple, whose cash flows include subscription revenue -- similar to what salesforce.com (NYSE: CRM  ) , SuccessFactors (Nasdaq: SFSF  ) , and NetSuite (NYSE: N  ) earn when they sell access to their cloud-computing platforms. All that money has to be accounted for in valuing the shares. The best way to do so is via straight-up free cash flow.

Foolish final thoughts
Last week I covered the vagaries of accounting for operating leases and unrecognized stock compensation expense, so I won't do so again here. Instead, let's focus on why Dell is cheap. Mostly, it's because the company is a lot like Apple. To review:

  • Dell produces billions in free cash flow.
  • Dell has a pristine balance sheet.

Yet the shares are priced for just 3% growth, unfair by any standard. So what is fair? I'm going with 9%, equal to the consensus estimate for Dell's five-year annual earnings growth. Maintaining a 3% terminal growth rate from 2014 onward values the shares at just more than $19 apiece -- an 18% margin of safety.

Apple does better using the same standard. Setting the growth target to 17% -- also equal to analysts' consensus five-year earnings growth estimate -- and then 3% perpetually values Apple at $252 a share, a 33% margin of safety going by Friday's close.

That's why I say Apple is cheaper than Dell. Many of our Inside Value subscribers would likely disagree. Which side are you on? Let us know by taking a moment to vote in the poll below and then leave a comment explaining your rationale.

Apple is a Stock Advisor selection. Dell is an Inside Value pick. Salesforce.com is a Rule Breakers recommendation. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers had stock and options positions in Apple at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. The Fool's disclosure policy hopes Dell doesn't swell too much too soon. Fall is an awful time for a lancing.


Read/Post Comments (2) | Recommend This Article (5)

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 31, 2009, at 4:40 PM, ozzfan1317 wrote:

    MSFT is even cheaper than Dell why just pay for a PC maker when you can own a piece of a company that controls all PC software? Apple is the best buy of the three however.

  • Report this Comment On September 10, 2009, at 5:00 PM, papamaui wrote:

    As I look back on my PC days ... the first word that comes to mind is "FRUSTRATION"! DOS wasn't so bad ... but Windows invokes no happy memories whatsoever!

    As I look back on my Mac days (which started with the introduction of OSX and the "all-in-one computer ... and later on, the "lampshade model" and finally, the purchase of a 24" iMac) The first words that come to mind are TOTAL SATISFACTION and the iMac is SO QUIET!

    Yes, the early versions of OSX were slow but I saw its potential and in my opinion, it has matured into an awesome OS!

    If I HAD TO RETURN to a PC for whatever reason, I'd give it a fair trial and hope for the best!!! ... but my heart would still with my trusty Macs!!

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