Recently, as I watch my Apple shares sink to new lows, I decided to pull out a DCF spreadsheet to punch in some numbers to get myself closer to a conclusion to this question – Are Apple shares stupid cheap, cheap, or cheap-fairly priced?
I think Apple makes a good candidate for a DCF valuation method as their cash flows are not only plentiful, but somewhat steady and ‘predictable’.
Here’s the data for the historical Free Cash Flow (FCF) of Apple taken from Gurufocus.
- The first Iphone was released in 2007.
- Iphone 4 was released in mid 2010.
- Iphone 6 was released in late 2014.
I would ignore the results from 2007 – 2010 as periods of ‘abnormal’ growth. ( I would like to think that the introduction of the smartphones was taking the world by storm during those periods.)
I would also ignore the results from 2015 as the introduction of the iPhone 6 and iPhone 6 plus could have caused a spike in the cash flow. ( People love bigger screens – I am one of them.)
I want to come up with a CAGR that I am comfortable with and use it as a basis of comparison when I plug some numbers into the DCF spreadsheet.
CAGR from 2011 – 2014 = 18.38%
CAGR from 2012 – 2014 = 9.72%
A CAGR of about 9.72% would be more ‘normal’. It coincides with the period where the iphone 5 and iphone 5s was released as well. That phone didn’t carry with it any big drastic changes. Also, I am trying to force my thinking to a more conservative and pessimistic approach when doing my DCF valuation of AAPL.
Here’s a REVERSE DCF approach for Valuing Apple.
* A typical DCF approach works by inputting projections to derive an intrinsic value per share for your company
** a Reverse DCF works by inputting numbers until you derive the Current Share Price of your stock. Then you ask yourself how possible it is for your company to meet this growth projections. In this case, I take the share price to be about $92.
Wait…what’s a DCF valuation?
For those of you who understand the basics of a DCF valuation, you can skip this segment and continue reading the rest.
DCF = Discounted Cash Flow.
We usually use Free Cash Flow to value a company for a few reasons:
- Earnings can be easily manipulated. However, its harder to fake free cash flow. So we rather use Free Cash Flow numbers to get gauge of how well a company is doing. A company can have negative earnings and positive Free Cash Flow. A company can also have positive earnings and negative Free Cash Flow.
- Free Cash Flow is the excess cash generated by the company after it has expended all it’s money in activities related to maintenance or expansion.
A DCF approach basically calculates the value of a company by summing up all future cash flow projections to arrive at a present value estimate.
If that sounds confusing to you, ask yourself – which is more valuable, getting $1000 today, or getting $1000 after 10 years. Of course all of you will say getting $1000 today! Hence, just like getting $1000 in the next 10 years, the future cash flows of a company is not worth as much as the present cash flow. So in order to assign a value to that, we need to discount future cash flows to a Discount Rate that you are satisfied with.
Discount Rate – 11%
I have set the discount rate to 11%.
Based on the S&P return average, the annulised returns for rolling 30 year periods is about 10%. Hence, if I were to invest in a stock like Apple, I would probably want to earn higher than the market. So I decided to set it at 11%. That means, all the value of the future cash flows will be discounted by 11% to show the present day value of that future cash flows. (If you demand more from Apple, go ahead and set your discount rate to 12 or 13%.)
In short, although Apple is receiving $57B in the next 12 months, that cash flow is only worth $52B at the present day. And if Apple is receiving $60.8B at the next year, that value is only worth $49B in the present day. They are all ‘discounted’ to take into account the opportunity cost of simply dumping my money into an S&P500 index.
Growth Rate YR1 – YR15
This DCF spread sheet makes use of a 3 stage growth model. In simple words, I can input values to estimate the growth rate from YR1-YR5, then YR5-YR10, and finally YR10-YR15.
So to be really conservative… I am going to assume that the smartphone market is near saturation… and Apple’s cash flow can only grow at 5% from YR1-YR5. Then it will slow down to 2% growth from YR5-YR15.
But here are some things to take note:
- As mentioned in earlier – CAGR from 2012 – 2014 = 9.72%
- So my assumption of 5% growth is probably very pessimistic.
- According to Morningstar, the average growth rate for the US economy is about 3%.
- Assuming a 2% growth rate for YR5 – YR15 is also being very pessimistic
I add up the Present Value (PV) of cash flows from YR1-YR15 to get $504B.
But what about the YR16 onwards?
Terminal Growth Rate, Terminal Year, Terminal Value
I decide to set the terminal growth rate at 1% (less than the average growth rate of the US economy 3%). Again a very pessimistic estimate. What this means is that I am projecting that Apple will only grow its cash flow by 1% each year from YR16 till perpetuity.
The cash flow of the terminal year, YR 16 is about $86B.
From there onwards… I simply apply the Gordon Growth Formula with calculates the Terminal Value. This basically assumes that Apple will continue increasing its cash flow by 1% forever.
Intrinsic Value and Margin of Safety
Finally, by adding together the PV cash flows from YR1-YR15 and cash flows all the way till perpetuity (terminal value), and after deducting Apple’s Net Debt, I get the Present Value of Apple today – which is $685B.
I divide the number by the number of shares outstanding to get $115.05 a share.
But what if all my pessimistic assumptions and values that I’ve input into the DCF are still way off the mark?
I shall then factor in a Margin of Safety.
This is similar to what engineers call a safety factor when making calculations for their designs. Just in case their calculations are wrong, or due to unforeseen external circumstances, the margin of safety will work to safeguard against any potentially destructive accidents.
In the case of Margin of Safety (MOS) applied to investing, it helps an investor discount for any mistakes made in his assumption of a company’s value.
Some individuals may ask for an MOS of 50% because Apple is a tech company. Some individuals may say that given Apple’s size and track record of consistent cash flow generation, an MOS of 10% would do. I am just going to be in the middle of these 2 polarising opposites, (slightly slanted to the latter) and apply a margin of safety of 20%. ( If you want to apply an MOS of 50% please go ahead.)
So finally I arrive at the value that Apple is worth $92 per share.
Looking at the numbers plugged into the DCF spreadsheet to get the current value of Apple, it doesn’t seem like Apple needs to clear a high hurdle to meet the expectations of the market, at the current share price of $92 at this time of writing. I am able to derive the share price by keying in what I feel are very conservative and pessimistic values into the spreadsheet. If my assumptions are right, then Apple shares are looking very cheap now.
Do take note that
- Apple is still buying back shares ( shares outstanding dropped from 6.5B in 2013 to 5.48B as of April 2016. That’s about a 15.7% overall reduction in shares outstanding.)
- Apple is increasing the dividend payout every year. I am not gonna calculate the percentage of increase… you can view it here >>> Apple dividend history.
And on the flip side, do also take note that
- Apple is not expanding as fast in China as analysts would like them to. (Apple just paid $626M to a patent troll!)
- There is speculation that the smartphone market is near saturation.
“Beware of geeks bearing formulas.” – Warren Buffet
If investing was all about calculating cash flows and applying formulas, then mathematicians would be rich. There is so much more to it than that. The strength of a company’s management, the investor’s psychology and his or her temperament, the ability to stomach huge paper losses, going against the crowd…
One must also be aware that when using a DCF approach to valuing companies, tiny tweaks in values can lead to huge changes. Rubbish in, rubbish out.
A too conservative approach with valuation will stop you from investing in a lot of companies. Thus, limiting the number of hands you play, and hopefully your losses.
A too optimistic approach with valuation may allow you to invest in lots of companies – but be prepared to make lots of mistakes along the way. On the flip side, you get to play more hands and maybe get more chances to strike it big.
At the end of the day, no company, no valuation method, no investing thesis is perfect – and even if it is, it is subjected to constant changes in the business environment everyday. The right investment today could easily turn into an embarrassing folly within a few weeks. We as investors can only make calculated, rational and diversified bets… and simply wait.
Wanna Play Around with this DCF Spreadsheet?
You can get it here! Simply click the image below to download!