Apple (AAPL) Valuation

As you probably know Apple is a leader in consumer electronics. If you’ve never heard of the iPod, it’s time to crawl out of the cave you’ve been living in.

Now the tech industry is a fast paced, constantly changing environment where companies have to be the first one to release an innovative product in order to get ahead. Just following the crowd won’t cut it in this sector. This is a reason why Warren Buffet and Charlie Munger do not invest in tech companies. They prefer stable, boring companies with steady growth rather than the wham-bam-thank you-maam nature of tech.

Apple as a Market Leader and Innovator

Apple are doing a lot of things right and it oohs and ahhs the crowd each time Steve Jobs releases a new gizmo at Macworld. The new Macbook Air is pure porn for the techies and nerds. However, Apple was only able to get back to being the darling on Wall Street with its iPod phenomenon. As it can be seen, nothing can currently penetrate the hold Apple has on the mp3 player market. Competitors like Creative, Samsung, Sandisk have all been trying but nothing seems to be working. Consumers just crave the small, sleek, clean design of the ipod. Who can’t resist?

The iPhone was launched in mid 2007 with huge success, selling over 1 million iPhones in its first 3 months. The iPhone catapulted Apple into the handset arena with its innovative and breathtaking features and usability. They also have many other products which I won’t go into here.

Making Sense of Historical Data

First off, Buffett tells us that we should be looking at at least 4-5 year histories. Makes sense, since figures from a single year does not say much. I tend to look at 10 year histories in order to get a sense of the company and how it has fared.

So What Do The Numbers Say?

Looking at the cash flow statement for the past 10 years we see that from 1998-2004 there was no real growth in Free Cash Flow (Buffett calls it Owner Earnings). The company burnt through $47 mil and $85 mil in 2001 & 2002 before turning a profit in 2003. This was probably due to the aggressive iPod campaign finally paying off. From 2003 on, FCF growth has been huge. Realistically, can this keep up?

Apple’s Future Growth

Since Apple has had a turnaround from the time Steve Jobs made a comeback, I will consider 5 years worth of historical data. Free Cash Flow grew at an average of 44.3% over the 5 years and CROIC at 14.3%. (For a full detailed explanation on CROIC go to http://www.fwallstreet.com/blog/23.htm). Now a company grows at the rate its cash grows since cash is what drives business and earnings. However, I prefer to think that the business will only grow as fast as its Cash Return On Invested Capital (CROIC). Here we see that for every $1 Apple invested from its FCF, it was able to generate an additional $0.143 in cash.

Apple’s Future Cash Value

At the end of fiscal year 2007, Apple had $4,735 mil in FCF. If the future cash of the business is to grow at a rate of 14.3% for the first 3 years, slowed down 10% for the next 4 years, and slowed down by a further 10% for the next 3 years, till it slowly grows at a rate of 5% for the next 10 years, the sum of the future cash for 20 years comes out to be $262,041 mil.

Apple’s Current Value

We’ve just calculated the sum of cash over 20 years. Apple will have $262,041 mil in cash. But we are not just buying the future $262,041 mil cash. We are buying the networth of the company as well. At the end of 2007, Apple’s shareholder equity was $14,532 mil.

But there is a problem, I don’t have $262,041 mil to buy the company’s networth of $14,532 mil + future cash of $262,041 mil today. And why would I want to pay $262,041 mil today just to receive $262,041 mil over 20 years resulting in a 0% return?

Discount it Back

By definition, the current value of the company is the sum of its future cash value discounted back to today. This means that you should discount $262,041 mil by a certain percentage in order to find how much $262,041 mil is worth today. Remember the time value of money concept? You want to receive something like yearly interest each year for the money you are investing today so that you can get a piece of the networth and $262,041 mil.

What Discount Rate Do I Use?

We use a discount rate of 9% since Apple is 1) a well known brand 2) I expect it to still be around in 20 years and 3) it has a moat.

The Intrinsic Value is…

Thanks to Microsoft Excel, discounting $262,041 mil by 9% and adding the 2007 networth results in a present value of $115,301 mil. This means I should pay only $115,301 mil today for the $262,041 mil + $14,532 mil.

Divide $115,301 mil by the current number of shares outstanding gives a per share intrinsic value of $129.70

But Wait, There’s More

Up until now, we have been projecting the future cash based on assumptions of CROIC growth rate. I have no ability in predicting the future and I know 100% that my calculations are not spot on. So what do I do? The core principle Benjamin Graham told us is to use a LARGE Margin of Safety (MOS). A 50% MOS shows that my calculations has the potential to be off by 50%. Therefore, I would have to purchase Apple at 50% of $129.70, i.e. $64.85. Closing price of AAPL on Jan 25th was $130.01. Pretty close to the calculated intrinsic value.

Click the image below to see the cash projection.

Here we see the historical price of AAPL over 5 years compared to the intrinsic value and target price. Note how price follows value. Pretty scary huh?

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12 responses to “Apple (AAPL) Valuation”

  1. Jae Jun says:

    Let me go through your questions;
    Jae, is this post meant to be a joke?
    Why are you applying the historical 14.3% CROIC on to project FCF going forward? Are you simply stating that whatever happened to FCF (and also what makes up the FCF e.g. sales, costs) in the 5 years from which you’ve taken the average from is being repeated?
    Over the long run, a business will grow at the rate of its CROIC. The company will grow at the rate it can turn invested dollars into excess cash and then reinvest those dollars into excess cash. Although FCF is a good growth indicator I do believe that the returns a company is able to generate from it is much more important.
    Also, I’m sure you know that history is just a guidance and the future is uncertain. Wall Streets estimate for the industry growth over the next 5 years comes out to be 14.98% which isnt far off from my 14.3%. However, I am not saying AAPL will perform par. It is just a conservative estimate that AAPL may perform relative to the industry.
    Business growth varies year to year. There are ups and downs. From 2002-2004 the CROIC rate was 2.8% and from 2005-2007 the CROIC rate was 28.2%. How can you know which to choose? We just dont know. Looking at only one 5 yr period, we dont know whether that is normal for the business. That is why by looking at multiple timeframes we can see the normal, high, low rates for the company. Taking the median, not average, is getting that dead middle number without any skews to either end.
    Actually, as I think more about this, CROIC is a performance measure and not a growth rate. Since CROIC is reset to 0 each year and is not based on the prior years to calculate, the better growth rate to use would be FCF growth. This I will have to to change. But aside from that, the argument is the same even if I used a FCF growth rate of 14.3%
    What is your basis for assuming 5% perpetual free cash flow growth?
    I like to keep things simple. Can you tell me the future growth of AAPL?
    No company in the world, not even apple can grow at a rapid rate forever. Berkshire is one of the best companies around but even with Warren at the helm, growth as slowed down considerably compared to its early days. If Apple was to continue converting about 15% of revenue to owner earnings, Apple would have to bring over $160 billion in revenue 10 years from now. Law of large numbers doesnt help it either.
    What is your basis for assuming 9% discount rate aka WACC? You can’t just say I picked 9% because it’s “a well known brand” and that “you expect it to still be around in 20 years” and that “it has a moat”.
    When Buffett bought Coca Cola in 1988, he used the 10 year treasury as the discount rate which was above 8% and even close to 14% between the 1970’s-1980’s. Buffett’s goal was to beat the risk free treasury rate. That’s why he probably took a high discount rate.
    Now Buffett also says that “Intrinsic value can be defined simply: it is the discounted value of the cash that can be taken out of a business during its remaining life.” This concept of using discount rate is much different to the WACC formula.
    I dont refer to discount rate as WACC. I use the discount rate because I want to discount the future cash back to today’s present value. Meaning I want at least 9% return on my investment.
    Why are you adjusting discounted FCF’s by shareholder’s equity? (I’m guessing this is the book equity?) You’re right in that we’re buying the net worth of the company, you should be adjusting discounted FCF’s i.e. aggregate/enterprise value, by net debt, not shareholder’s equity.
    Like Buffett says above, the value of the business is the value of the cash that can be taken out of the business during its remaining life.
    During the life of the business, management will use its cash in a way we cant control. That may be paying back dividends or reinvesting and generating more cash. The company could pay off $100 of debt and we now own an additional $100 of assets (since shareholder equity increases). They could also acquire an additional $100 of assets or spend it in other ways to generate cash.
    Whatever happens, that $100 now belongs to the shareholders.
    If we are buying the net worth of a company, shouldnt we be entitled to shareholders equity?
    As an example (which Joe Ponzio gave) look at a lemonade stand. Kids buy the table for $50 and make $30 selling lemonade, then shut down. What is that business worth? If we were investors, we would invest for a piece of that $30 and a pieve of the table when they shut down and sell the asset. If AAPL ever shuts down, I want a piece of the table, phone, chairs, real estate and any other assets that converts to cash when liquidated.
    I know that a lot of people don’t like and agree with what I am saying. Why? because the calculations are too simple. Human nature has a perverse tendency to make the simple complicated and people just dont like how things can remain simple. I dont consider a galaxy of variables when valuating. I just need to be confident of the few variables that I do use in my calculations. As long as my margin of safety is big and not 100% off the mark, the gamblers will help me buy a great company at a very attractive price. Investing is not rocket science where you have to correct to 10 decimal places. If I am off by a couple of dollars that is fine with me.
    There are soooo many other ways to value and they could result close or far off to my value. However, the point I am trying to make is not whether I am a”joke” or you are wrong, but as long as the value comes out similar and we have a margin of safety, we will all trounce the market in the long run.
    Thanks for the comment and helping me to re-look at a few things as well as brush up on some knowledge.

  2. Adam Gulledge says:

    The biggest problem I have with your analysis is your discount rate. I literally cringed when I read your explain of it. I also read your response to first comment regarding your discount rates and still I cringed.
    You cant pull a discount rate out of thin air like that based on qualitative factors alone, you have to have some time of quantitative explanation as well. The discount rate is probably the most important part of a Cash Flow Analysis.
    I also read your article regarding discount rates and you gave companies like Wal-Mart and Johnson & Johnson a discount rate of 9%, which is also the discount rate you used for Apple. To me, companies like Wal-Mart, Johnson & Johnson, and Coca Cola are completely different then Apple. For starters, Apple has a lot more growth opportunities and this us because like you said “they are innovators. JNJ, WMT, and KO, may at one time been a huge innovator, but I don’t see either company revolutionizing an industry anytime soon like Apple did with the iPhone. Secondly, on a macro level, the technology industry and those companies are completely different then those in the consumer staples and healthcare sector. Third, JNJ, WMT, KO are not only in defensive sector of the stock market, but they are also very mature companies. Really comparing Apple to Johnson & Johnson, Wal-Mart, Coca Cola, is like comparing apples to oranges. (Pun intented) This takes me to my next point
    You can not have the same required rate of return for all investments “ unless you assume that all those investments have the same level of risk. You said that you, have a minimum return rate [of] 15%. And therefore that is your discount rate. You cant do that! You are not looking at a firms individual level of risk, JNJ is a lot less risky than AAPL and because of that I have a lower required rate of return. There is less chance of me losing my money with JNJ then with AAPL. You really need to have a way to calculate the unsystematic risk of firms individually, regardless of your personal required rate of return. Now on to the Capital Asset Pricing Model (CAPM) and as someone else mentioned Weighted Average Cost of Capital (WACC)
    I will be the first to admit, I hate both models. The reason I hate WACC is because I hate CAPM because it puts a discount rate on the equity of the company and most companies are financed mostly, with equity. I hate CAPM for that reason because it relies so much on Beta, and I absolutely hate Beta. So really my hatred for WACC and CAPM stems from Beta because so much of WACC is based on Beta. Beta explains at best 30% of the unsystematic risk (usually between 10 to 20% in my experience so far).
    Now, as much as I hate these models, I admit, I still use them. Why? Because unfortunately those are currently the best models we have for Cash Flow Analysis, as bad as they are, they’re the best we got right now.
    And no offense, as much as I hate these models, I would have to say they are better then your qu

  3. Jae Jun says:

    Well, I get the impression that you are not a Buffett follower or practitioner.
    By looking through his books and shareholder letters, Buffett clearly describes his ideas on discount rate and they do not refer to the two models you have mentioned.
    Let me first ask you a few questions.
    1) Do you own AAPL?
    2) Do you believe a value can be put on AAPL?
    3) What do you think the potential of AAPL is?
    I am by no means compensating risk with a discount rate. Discount rates are not about risk, it is about valuing the business. As Buffett puts it, value of a business is “the sum of the future cash, discounted back to the present value”. He does not mention anything about WACC of CAPM. Buffet chose a discount rate of around 9% when he purchased KO. So your argument is stating that Buffett just picked 9% out of thin air which resulted in his best purchase ever?
    KO, WMT, JNJ may be huge industries now, but think back to when they were revolutionizing their industries. KO revolutionized the beverage industry. WMT revolutionized the retail industry. JNJ revolutionized the health care industry. Does that mean that during these revolutionizing stages, these companies couldnt be properly valued or were supposed to be exponential?
    Maybe AAPL is different, but AAPL is still another business which can be valued.
    You mentioned that AAPL should have a higher growth rate. I did another analysis with a growth rate of 22%… AAPL part 2
    You are of course entitled to your opinion.
    My opinion is that the discount method I use, which I learnt from following Buffett’s teachings, is not regarded highly by efficient market people, finance professionals or business school folks. Efficient market people call Buffett and other great value investors lucky..yup he was lucky for 50 years..
    If a concept can be explained simply and disgusts you, Im sorry that you feel that way, but I am also including a margin of safety, which is just as important. Had I only used a discount rate of 15% with no safety margin, I would rightly be a fool because I am trying to compensate risk with a discount rate as you say. But I am not.
    Basically to sum up, discount rates allows me to find the intrinsic value of the company. Margin of safety is the amount of risk I am willing to take.
    Like Ive said before, this method rules out probably 98% of the investment ideas out there. I dont mind. Im not after those. I want the sure wins from the remaining 2%.
    Thanks for taking the time to question my ideas.

  4. five_whys says:

    Well the fair value calculation seems fair!! But the issue is that Apple is famous for coming up with products that create markets.. and effect of these things are tough to calculate.. this is why its hard for value guys to play tech companies that are not in mature or cycle driven markets (like memory, PC or processors).
    In my opinion, buying a stock like Apple, specially with iPhone potential ahead, at “conservatively calculated fair valuation” is like having “built-in margin of safety”.
    Choose the best tools

  5. mike says:

    aapl does not lend itself to a discounted cash flow analysis. the technology changes too fast. aapl had periods in it’s past that it was barely making money. that could happen again. the best kind of companies to do DCF on are food, beverage, utility, tobacco, water, spirites, etc. The other issue is are you modeling “distributable” cash, that is dividends? Otherwise you are double counting the effects of reinvestment. Finally 5% forever is way way too aggressive. I would use 3%.

  6. Jae Jun says:

    Hi Mike,

    Yes DCF works best for companies that have a consistent history but this doesn’t mean that it cant be used for “tech companies”. Go outside the world of Wall Street, and you’ll realise that mergers and other business transactions involve DCF, not just food and consumer product companies.

    I am looking at FCF i.e cash from operations – capex.
    This means I only worry about the cash the company is able to generate. If they have leftovers, they can give it out or buy shares or whatever, but the important thing is to find the growth of the cash from operations not “distributable cash”.

    You can see my explanation of DCF and how it applies here.

    5% may be aggressive, but my calculations show that a terminal rate of 5% or 3% doesn’t yield much difference.

  7. mike says:

    jae, yes I know that it’s used all the time. But I don’t worry about that. I worry about if it is valuable for Me to use it. And I submit that it’s the wrong tool to use for aapl. Remember Buffett’s definition of IV. Cash that you can TAKE out of the business. If that cash that aapl generates needs to be used to grow the business then it is not cash that can taken out and thus overvalues the company. It’s a subtle distinction but will mean big variances in value. I would never buy aapl stock based on the value I got out of your dcf calc, unless it was using very very conservative inputs, and I don’t see that. thanks for the exercise and I enjoy your site, especially your hunt for value in the Forbes list.


  8. Jim says:

    Adam Gulledge,

    I use WACC in many instances for my discount rate but I guarantee you that in most cases using a 15% discount rate is going to produce a much more conservative valuation than WACC. The goal to valuating a business isn’t to be as accurate as you can it is to be as conservative as you can and if you can generate a large margin of safety using the most conservative estimates as possible the probability of you obtaining that intrinsic valuation based on conservative efforts is much more to your advantage. The important thing here to remember is the goal which is to be as conservative as possible, not accurate.

  9. Jim says:

    Furthermore, If the goal were to be accurate, we’d all know today what the exact price of tea in China will be tomorrow.

  10. Jae Jun says:

    Thanks for the input Mike.
    I understand what you are saying, but I feel that by trying to use the cash that can actually be taken out of a company, that means you are eliminating everything from your radar except the mature cash cows that make up the Dow. But you are right that DCF cant be applied to every company.

    I still believe the value of AAPL to be in the 160-180 range, and I do believe my calculation at the time was conservative and inline with a neutral market rather than a bear that we have now.

    Again, thanks for the input. I’m working on 70-130 at the moment.

  11. Mark says:

    Hi Jae Jun,

    I’ve been looking for a DCF excel spreadsheet and I’ve run into your excellent site. I’ve seen you offer visitor a free DCF excel tool so I signed in and confirmed my sign through the e-mail I received from you; so now, how can I obtain the above mentioned excel spreadsheet?

    Please, let me know.



  12. Jae Jun says:

    Hi Mark,

    I need to fix the free version and post it up again.

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