It has been a week of financial market turmoil. The Dow is closed at 8,451 on Friday – over 40% below the 52-week high of 14,279 and down 18% for last week alone. There are a lot of very smart people concerned that the markets and broader global economy are headed for a long-term slump. Within this turmoil there is a lot of discussion about valuation. Here at Valuecruncher we wanted to explain our take on valuation and the analysis we provide.

Here at Valuecruncher we believe that in the long-run markets are broadly efficient – market prices properly reflect the intrinsic value of assets. By intrinsic value we mean a ‘true’ underlying value. However, in the short-term there can be and are inefficiencies. At Valuecruncher, valuation is an attempt to estimate what this intrinsic value is and how it relates to current market prices. At Valuecruncher we do that by calculating a discounted cash flow (DCF) valuation. As we noted, in the longer-term we believe that markets will price assets at this intrinsic value. In the shorter term market prices may differ (either up or down). Our approach is a longer term approach. If someone is looking for a valuation of where a stock will be this week – a DCF isn’t the way to go. However, if you want to understand the underlying value of a stock relative the market price and have a longer-term view – that is where a DCF adds value.

For example: Apple ($AAPL). On 4 June 2008 with the $AAPL share price at US$186.10 our estimate of the $AAPL intrinsic value was US$146.70. By 23 September 2008 with the $AAPL share price at US$131.05 our estimate of the $AAPL intrinsic value was US$163.98. $AAPL closed on Friday at US$96.80. In just over four months the market price of $AAPL has dropped 48% – dramatic times indeed. Our estimate of intrinsic value has changed based on changing assumptions of the underlying business. But what we are trying to estimate is the intrinsic value – and we have argued it is both below and above the prevailing share price of $AAPL over the last four months.

At Valuecruncher we will continue to put out our take on the intrinsic value of companies like $AAPL and how this relates to the current share price. Our on-line interactive valuation models allow anyone to change our assumptions and calculate their own intrinsic value. In our own analysis we are going to try and avoid rhetoric like “buy”, “sell”, “cheap” and “expensive”. Ours is a longer-term analysis. We still believe that in the long-run that market prices and intrinsic value will eventually converge.

Understanding intrinsic value helps us to understand corporate transactions like share buy-backs. It can illuminate mergers and acquisitions activity. It can even expose opportunities to invest (and dispose) of stocks.

After a wild week we expect there are still some brave souls out there trying at assess value.

The on-going turmoil in the markets and analysts lowering estimates across the technology sector has had a big impact on Apple’s (AAPL) share price.  AAPL finished at US$131.05 on the 22 September 2008 – 35% below the 52 week high of US$202.96.  We decided to look at the underlying numbers for AAPL using the Valuecruncher on-line valuation model to see where we place the current share price.

Valuecruncher valuation model of AAPL with interactive assumptions

Valuecruncher produces a valuation of US$163.98 for AAPL.  This is a current valuation not a target price.  This valuation is 25% above the current share price of US$131.05 (note our model picks up an earlier price of US$140.91 because we completed the valuation earlier).

Assumptions

Our assumptions are revenues of US$32.5 billion in 2008 growing to US$50.0 billion in 2010. We have used an EBITDA margin of 20.5% in 2008 dropping to 19.5% in 2010. We used a terminal growth rate of 5.75%. We used a terminal capital expenditure number of US$1.25 billion. We have used a WACC (discount rate) of 10.0%.  All of these assumptions can be amended in the Valuecruncher on-line valuation model to adjust the valuation.

Our analysis incorporates the cash on the Apple balance sheet – Valuecruncher calculates a net debt number.

Based on our analysis the current share price looks cheap.  Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

With the release of Apple’s (AAPL) latest quarterly results the share price headed to the US$150 a share range in after-hours trading. Valuecruncher did a valuation for Apple in early June that put a base case valuation on AAPL of US$146.70 – 21% below the then share price of US$186.10. With AAPL moving into the range of our previous valuation – we decided to review our valuation using the Valuecruncher on-line valuation tool.

Apple (AAPL) Valuation Assumptions

Our assumptions are revenues of US$32.8 billion in 2008 growing to US$50.0 billion in 2010. We have used a flat EBITDA margin of 21% from 2008. We used a terminal growth rate of 5.75%. We used a terminal capital expenditure number of US$1.0 billion. We have used a WACC (discount rate) of 11.0%.

Valuecruncher valuation model of Apple (AAPL) with interactive assumptions

Our valuation comes out at US$149.75 per share. This is in-line with the current share price.

Our analysis incorporates the cash on the Apple balance sheet – Valuecruncher calculates a net debt number.

Apple is a great company with incredibly innovative products that consumers all around the world want desperately. That is a position that must be envied by all their competitors in the technology space and beyond.

Warren Buffett’s famous quote is “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. At around US$150 a share – in our view Apple fits that criteria. Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

With the WWDC set for June 9-13and the current AAPL share price of $186.10 - we are being asked about whether we see a $200 share price for AAPL in the near term. Now the AAPL share price may reach $200 in the near future – there are a lot of Apple fans out there. Our concern is what business fundamentals would be required to make this $200 appear a reasonable price?

At Valuecruncher we decided to have a look at the underlying financial performance of AAPL required to get to a $200 share price using our models. We have used the Valuecruncher interactive tool for analysing the company. That means that anyone can follow the links below and amend our valuations. We started by creating a base case valuation of AAPL – using assumptions we believe are reasonable.

AAPL Base Case

Our assumptions are revenues of US$32.8 billion in 2008 growing to US$48.0 billion in 2010. We have used a flat EBITDA margin of 21% from 2008. We have used a terminal growth rate of 5.75%. We calculated that using a present value calculation with the growth rate dropping from 17.5% in 2011 to 3.5% in 2015 (the current projected growth from 2009 to 2010 is 18-20%). We used a terminal capital expenditure number of US$900 million. We have used a WACC (discount rate) of 11.0%.

Valuecruncher Base Case Valuation AAPL

Our analysis gives a share price of $146.70 which is approximately 21% below the current share price of $186.10.

AAPL At $200

To move the valuation we looked at three key levers:

1. The discount rate (or weighted average cost of capital – WACC). This is a measure of the variability (both up and down) of the cash flows generated by AAPL. The more variable the cash flows the higher the discount rate. Because we are trying to get the valuation to $200 we looked at lowering the discount rate from our base case 11.0%. If we lower the base case discount rate to 10.0% (keeping all the other assumptions constant) we increase our valuation to $175.53 (a 20% increase – but still below the current share price).

2. The terminal growth (the rate of growth into the future beyond our three-year forecast period). At Valuecruncher we use a present value calculation to determine this growth rate (the present value of five years of cash flows beyond our three years of forecasts and an economy wide terminal rate – 3.5%). In our base case the 2009 to 2010 growth rate is expected to be 18-20% - based on analyst estimates. We used a 17.5% growth rate in 2011 dropping to a terminal rate of 3.5% from 2015. In this case we used a 25% growth rate in 2011 (this is above current 2009/10 forecasts of 18-20%) dropping to a terminal rate of 3.5% in 2015 – this gives a terminal growth rate of 6.25% compared to 5.75% in the base case. If we increase the terminal growth rate to 6.25% (keeping all the other assumptions constant) we increase our valuation to $159.11 (an 8% increase).

3. The terminal capital expenditure (CAPEX). This is the investment in plant, equipment and technology needed to maintain and grow the cash produced by the business expressed in revenues and profits. In our base case we used a US$900 million terminal CAPEX number. If we reduce this by US$100 million we increase our valuation to $148.49 (a 1% increase).

However if we adjust all three of these levers at the same time – discount rate to 10%, terminal growth to 6.25% and terminal CAPEX to US$800 million (while keeping all the other base case assumptions constant) – we do get close to $200 a share. The combination of those adjustments to our base case valuation is shown in the link below to a new valuation created using the Valuecruncher valuation tool. The result is a valuation of $197.63 – this is 35% above our base case valuation and 6% above the current share price.

Valuecruncher Adjusted Valuation AAPL

Our view is that this adjusted valuation appears optimistic. Play with our assumptions - what does your analysis say?

Valuecruncher has placed a mid-point estimate for Apple at $77.98 per share with a range between $63.15 and $94.00.The current share price is $85.94.

Key Assumptions

Revenue Growth

Apple has experienced rapid revenue growth in the last three years, growing by 33.38%, 68.27% and 38.65% in the last three financial periods. The underlying factor behind the growth of Apple is their continuing innovation, with products such as the iPod, iPhone and OS X. With Apple continuing to develop innovative technologies it is likely that revenues will continue to grow. We have forecasted revenues to grow by 35%, 30% and 25% for the next three periods.

EBIT Margins

Apple’s EBIT margins have also been on the rise from a low of 1.48% in 2004 to a high of 14.59% in 2006. We have forecasted margins to be 17% for 2007 (due, in part, to the release of the iPhone, which has gross margins of around 50%). Apple’s long term EBIT margin is assumed to be 15%. It is not surprising that Apple has higher margins than its comparators (Dell and HP: EBIT margins around 8.5%) as they are moving into small consumer electronics as well as remaining in the lower margin personal computer sector.

Terminal Growth

The terminal growth rate used in this analysis is 4%.

Discount Rate (WACC)

The discount rate applied is 11%.

Apple Inc. Valuation