Apple (AAPL -0.11%) stock is up about 35% in the past year. While it was fairly clear to many investors that it was a buy at $500 after selling off from an all-time high of $705, its recent run-up makes it a great time to return to valuation. Is Apple a buy at $600?
About valuing stocks
Valuing stocks is a tricky business. Even more, with so many uncertainties in investing, it is more of an art than a science. This means that there are a lot of gray areas. Fortunately, however, there's a pretty straight-forward method to valuing mature, large-cap cash cows: a discounted cash flow valuation.
Ultimately, the value of any asset is equal to the present value of future cash flows. For growth stocks that may not benefit from a robust bottom line in years, it can be tricky to make projections of future cash flows. But cash cows like Apple? They're the model companies use in a discounted cash flow analysis. Not only is Apple a mature, profitable company, but its proven customer retention and powerful ecosystem of software, hardware, and services gives the company the staying power needed to make reasonable projections into the future.
Valuing Apple
So what is Apple worth?
A discounted cash flow valuation begins with a growth rate. Based on Apple CEO Tim Cook's promised "new categories" and rapidly growing worldwide smartphone and tablet markets, Apple's second-quarter earnings per share growth of 15% seems quite indicative of its short-term growth opportunities. Even better, this EPS growth takes into consideration the benefits of Apple's aggressive share repurchase program enabled by its healthy cash flow. So, let's assume Apple can grow EPS by 15% in the first year of our projections.
But 15% EPS growth for the world's most valuable publicly traded company probably isn't sustainable over the long haul. Competitors will vie for a share of Apple's profits and large numbers will continue to challenge the company's growth prospects. With that said, let's project its EPS growth to decline by 20% every year until the rate comes in line with the historical rate of inflation. With these assumptions, the year-over-year growth of Apple's EPS over the next 10 years may look something like this.
|
Year |
EPS Growth Rate (YOY) |
|---|---|
|
1 |
15% |
|
2 |
12% |
|
3 |
9.6% |
|
4 |
7.7% |
|
5 |
6.1% |
|
6 |
4.9% |
|
7 |
3.9% |
|
8 |
3.1% |
|
9 |
3% |
|
10 |
3% |
Of course, the present value of these future cash flows is worth far less than the actual projection of these cash flows. That's why we need a discount rate. To account for the time value of money and the risk of investing in large-cap stocks, I'll use a discount rate of 10%.
In perpetuity, we'll assume Apple's cash flows and share repurchases will help the company achieve an annualized growth rate in line with inflation of 3%.
A quick aside: Obviously, making projections this far into the future is extremely difficult. Fortunately, however, it's the early years that matter the most in a discounted cash flow valuation; the discount rate comes to our aid in diminishing the importance of cash flows in later years.
So what's Apple worth using these inputs? $890 per share. Of course, investors wouldn't want to buy Apple at fair value; to further account for the risk of error in cash flow projections, investors should require a margin of safety, or a discount to fair value. The more uncomfortable investors are with the stock, the larger margin of safety they should require. Personally, I think a margin of safety of 20% is acceptable for Apple. This would mean the stock is a buy at any price below $665.
iPhone 5s.
But there are drawbacks to this valuation approach. The simplicity of a discounted cash flow valuation renders it more of a tool for double-checking assumptions rather than a direct reason to buy or sell. Even more, the output is only as good as the inputs. These particular inputs are based on my personal research background knowledge of Apple's situation, but opinions about the company's potential will certainly vary widely from one investor to another.
Still, the margin for error is significant. Even at $600, Apple is trading at a whopping 33% discount to this fair value estimate. Even after a run-up, I still think Apple is among the few stocks that are still a buy in this pricey market.
