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:

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.