Heading into its second-quarter earnings report and up 35% in the past twelve months, it's a great time to take a step back and think about what the value of Apple (AAPL -1.22%) stock really is. Sure, we know what shares are trading at today, but what's the intrinsic value of the stock? What should shares be trading at? Having a better idea of what Apple's business is actually worth on a per share basis can help investors face earnings on Tuesday more objectively and less emotionally.
Valuing Apple stock
The value of any business is ultimately determined by the discounted value of its future cash flows. But predicting a ballpark estimate for future cash flows, of course, isn't easy. In fact, for some businesses, it's downright impossible. This is the very reason investors should stay away from companies that don't have a strong underlying business that is somewhat predictable. If you can't imagine a likely future for a company, then it becomes difficult to know whether or not the company is even worth buying. How can you value an asset if you have no idea where it's headed?
Fortunately, Apple's history of loyal customers and pricing power, both which serve as the evidence it has competitive advantages over its peers, suggest Apple's historical cash flows could be somewhat indicative of future cash flows, making it possible to at least get an estimate of what the stock could actually be worth.
The first step in valuing Apple stock by discounting its future cash flows is estimating a likely outlook for the company's future free cash flow.
What could the growth for Apple's free cash flow look like in the future? During the past three years, Apple's free cash flow has grown at an annualized rate close to 20%. Given Apple's sheer size today, however, expecting this same sort of growth, going forward, is probably too optimistic. On the other hand, it would probably also be a mistake to expect Apple to no longer be able to grow its free cash flow just because it's already raking in a mind-boggling $64.3 billion in free cash flow a year. Apple has clearly demonstrated a consistent ability to retain its loyal customer base, attract new customers, and protect pricing power. With all this in mind, a reasonable projection of Apple's free cash flow growth in the coming years could look like this: 5% growth next year, followed by growth rates which decelerate by about 5% annually, reaching an annualized rate near 3% in year 10 -- about in line with the historical rate of inflation. Beyond year 10 and in perpetuity, it seems conservative to estimate Apple can keep its free cash flow levels up with the historical rate of inflation.
With a projection for Apple's future free cash flow, it's now possible to find a value for Apple stock by discounting these future cash flows on a per share basis.
Discounting these future cash flows at a rate of 10% suggests the present value of these future cash flows is $178 per share. Discounting these cash flows by a more conservative discount rate of 11% provides a value for Apple stock of $156.
Leaving room for error
But given the risk in any forward-looking analysis, investors should leave room for error in their assumptions. Famed investor Warren Buffett has referred to this idea as requiring a "margin of safety." To ensure there is a margin of safety, investors should only consider buying a stock when it is trading at a discount to what they believe the intrinsic value of the stock is.
Apple's share price at the time of this writing of $128.50, the stock is trading at a 28% margin of safety to the fair value of the stock when using a 10% discount rate for calculating the present value of future cash flows. Using the more conservative discount rate of 11%, the stock is trading with a still meaningful 18% margin of safety.
While a simple valuation like this should never be relied on as the sole answer of whether or not to buy, sell, or hold a stock, this exercise at least shows it's unlikely Apple stock is overvalued. So, despite the stock's run-up in the past few years, investors may want to think carefully before they consider selling the stock before or after earnings -- no matter what the stock does before or after the report.