Guest Post – Andrew Smith on Apple (AAPL)
2011 has been an eventful year for Apple, to say the least.
Perhaps the most significant occurrence of the year, and certainly the unhappiest, was the October 5th passing of Apple’s co-founder and visionary Steve Jobs. Jobs cr
a company, and led it, through turbulent some turbulent times to become today one of the world’s most distinguishable brands, whose design-focused products have developed a cult-like following. Jobs’ legacy lives on, and the company continues to astound.
It was perhaps a tribute to Steve that, before his passing, he witnessed in early August Apple pip oil group ExxonMobil to become (for a while) the world’s largest company by market value, at the time reaching a market capitalisation of US$337 billion. While this was due in part to Exxon’s poor fortune amid turbulent times on the stock market and depressed oil prices, having announced its best quarterly performance ever helped Apple’s share price to hit US$365.25, causing its market capitalisation to temporarily leapfrog that of Exxon.
In the week of the 17 October 2011 Apple’s share price hit US$426.70. Today that price is US$366.99, implying a market cap of US$341.08 billion. What is driving investors to value the technology company so highly?
Firstly, let’s look at the consensus estimates for Apple’s revenues and profit levels.
Analysts predict revenues to continue to grow strongly, but at a slower rate than the previous five years, achieving a compound annual growth rate (CAGR) over the next five years of 8.9%. Profit (as measured by EBITDA) grows as well, at a five year CAGR of 9.8%. The implied profitability levels are forecast to stay relatively constant around 33%.
How do these forecasts compare to Apple’s historical performance?
The first observation is that revenue grows 52% from 2009 to 2010, and a massive 66% from 2010 to 2011, with the growth rate falling in the forecast period. Second, profitability has grown from 19.2% to 32.9% in the five years to 2011, and is forecast to stay relatively constant over the forecast period.
These are impressive growth rates. But do they justify the current share price?
Discounted Cash Flow (DCF) Valuation
First, we carried out a DCF valuation based on consensus estimates for future revenue and profitability, CAPEX and depreciation, and Valuecruncher estimates for parameters including the discount rate and the long term growth rate.
Using a DCF valuation, we value the share price of Apple at US$323.76 – 11.8% lower than the November 23 closing price of US$366.99. For this valuation we used a discount rate of 11.5% and a long term growth rate of 2.5%.
To get to a valuation of US$366.99, assuming the consensus estimates and estimated discount rate are accurate, implies a necessary long term growth rate of 4.6%. This means investors buying in at US$366.99 expect revenues to grow at least 4.6% per annum forever (while maintaining the current profitability ratios) to justify the price.
Note: The value of equity is calculated as enterprise value less net debt. Equity value is then divided by the total number of shares to get a price per share. In our valuation, we used cash and equivalents plus short term investments plus long term investments to calculate net debt. Apple has zero debt and a total of US$81.74 billion of cash and equivalents, short term investments and long term investments. Thus, because net debt is negative, Apple’s equity value is US$81.74 billion greater than its enterprise value.
It is obvious then that the treatment of cash in the net debt calculation directly affects the share price. If we were to use only cash and equivalents and short term investments to calculate net debt, the share price falls to US$263.92. If we reduce the cash calculation further by only including cash and short term equivalents, the share price drops again to US$246.38.
We then completed a comparison analysis, looking at how the market was valuing a range of Apple’s peer companies. The companies used in the comparison were:
Using the Valuecruncher interactive analysis report, these comparators can be substituted for others as you wish. Other potential comparators include:
- Research in Motion
- Hewlett Packard
The metric of choice for this valuation was EV/EBITDA, that is, the enterprise value of the company divided by its EBITDA. This metric essentially allows us to compare how investors value one dollar of Apple’s earnings relative to its competitors – a high metric shows that investors value one dollar of a company’s earnings more highly than one dollar of a company’s earnings that has a low a metric.
To complete the comparison analysis, the average EBITDA multiple from the four peer companies is calculated and then applied to Apple’s EBITDA, to give an implied enterprise value for Apple based on how similar companies are being valued. Net debt is then subtracted from the enterprise value to give the value of equity in the business, which is then divided by the number of shares to give a share price.
The market cap weighted average EV/EBITDA multiple for the chosen peer group was 9.06x. Applying this to Apple’s EBITDA from the last financial year of US$35.582 billion implies an enterprise value of US$322.37 billion. The negative net debt means that to calculate the value of equity, Apple’s cash and total investments balance of US$81.74 billion is added to the enterprise value, to give an equity value of US$404.11 billion, and a resulting share price of US$434.81.
Thus, based on how the market is valuing Apple’s peers, Apple appears to be undervalued by 15.6%.
The two valuation methodologies shown above elicit very different results. We place more weighting on the DCF analysis, which looks at the fundamental aspects of the business, rather than how the market is currently valuing Apple’s peer group.
The difference in the valuation produced by the two methodologies used above suggests there is a disconnect between the fundamental analysis (DCF) and how the market is currently valuing Apple and its peers.
Results of the market analysis suggest Apple is undervalued by 15.6%. In other words, the market currently values one dollar of Apple’s earnings lower than one dollar of their competitors (included in the comparison analysis).
Thus, we suggest that the market is currently overvaluing the technology industry (as represented by the companies included in this analysis), but undervaluing Apple, relative to its peers.
Note: Andrew Smith is an analyst at investment bank Woodward Partners