Apple Stock (NASDAQ:AAPL)
I am a fervent supporter of Apple Inc. (NASDAQ:AAPL) and have been for a while. The Cupertino corporation is among the most amazing in the IT and consumer industries, in my opinion. In my opinion, its brand value is unmatched. High margins and excellent cash flow generation are very well supported by the capital-light company strategy. The management team’s track record is also about as strong as one can find in Silicon Valley or elsewhere; it may even be comparable to Microsoft Corporation’s (NASDAQ:MSFT), but there aren’t many others.
I am nonetheless better able to comprehend one of the main tenets of the bear case the more I examine my value computations. Today, I use the discounted cash flow model, or DCF, a flawed but nonetheless helpful method, to explain how Apple appears to be priced for perfection.
Apple and the Most Negative Trends
A quick search of the internet reveals a few issues that most Apple bears have in common.
Given supply chain issues that are gradually abating and the impending slowdown in consumer spending and economic activity, some claim that the iPhone cycle is in danger. With the high expectations for 20%+ growth, which, while routinely delivered in quarters previous to mid-2022, look difficult to repeat in the near future, some people perceive problems with the services sector. Apple is said to be overly dependent on China on both the supply and demand sides, which is another reason to exercise caution.
These seem like solid contenders to be included on my list of “major threats to the bullish argument.” Nonetheless, I think it’s a little speculative to use these potential obstacles as the foundation for a bearish argument. In the past, Apple has done a great job of avoiding problems like these while still finding demand for its goods and services and maintaining pricing power.
Rich values are the bearish justification that I find to be more quantitative and less reliant on anyone’s ability to forecast Apple’s future P&L. The problem might not be as clearly illustrated by Apple’s current-year P/E of 26.6x, which is in line with the average of the previous 18 months (see below). Yet, a DCF model analysis performs a superior job.
Apple’s DCF Appears Tacky
A DCF model works to determine a company’s enterprise or equity value by discounting future cash flows to the present using a specific discount rate, for the benefit of individuals who are unfamiliar with the technique.
The WACC, or weighted average cost of capital, is the rate to be used in enterprise value calculations. For Apple, it mostly depends on the risk-free rate, which is typically the yield on ten-year Treasury notes, the beta, which varies from stock to stock, and the equity risk premium, which is now 5.5%. The higher the discount rate, which is influenced by any one of these three elements, the lower the enterprise value will be.
I included future cash flow generation that is probably beyond the present consensus in my DCF calculation. I did this by projecting Apple’s revenues and earnings for the next five years with a high level of optimism. For instance, I predict that long-term EPS growth will average 11.2% annually, which is around 1% more than the 10.3% now reflected in consensus predictions.
I made the assumption that working capital would continue to be the same because it is an essential part of free cash flow. In other words, Apple is already highly skilled at managing with a rather low working capital foundation. Although it is difficult to imagine the company making considerable progress in this area, I do not anticipate working capital to increase much any time soon.
I turned to the WACC after establishing future cash flow predictions at what I consider to be above-consensus levels. The following facts are undisputed: (1) the ten-year Treasury rate is currently 3.6%; (2) Apple’s beta is 1.24; and (3) the aforementioned equity risk premium of 5.5%. Given that Apple has approximately $50 billion in net cash and a 4.1% cost of debt, the WACC is therefore 10.6%.
I made a 2.5% annual growth assumption for a cash flow increase in perpetuity. This is roughly in line with (if not a few bps higher than) what I consider to be the long-term global GDP growth rate.
I arrived at a fair value of $106 for Apple shares after plugging the figures using the assumptions above, which I feel to be reasonable if not a little overly optimistic. In this scenario, the potential loss from current levels is a staggering 34%, which would leave Apple bulls perplexed.
I had to go out of my way to “push” my DCF to produce at least Apple’s current share price. I decided to concentrate instead on the discount rate and the growth in perpetuity because my cash flow predictions already appeared to be a little bit exaggerated in comparison to the consensus.
I modified my beta to 0.8 for the earlier. Using a beta value below 1.0 may appear irrational on the surface, but it may be forward-looking and consistent with the notion that Apple will be better able to withstand macroeconomic headwinds in 2023 than the rest of the market. This has been the situation at least thus far this year.
I raised the growth in perpetuity for the latter by 50 basis points to 3%. Playing with this number is risky, in my opinion, as no business should be expected to continuously grow cash flows faster than the world economy. This supposition’s percentage change alters my estimate of Apple’s fair value by $12 per share.
The Reason I Remain a Bull
The main lesson to be learned from this exercise is that many investors, especially value investors, may find Apple Inc.’s valuation to be too high. However, a DCF model by itself won’t make me change my bullish outlook on Apple stock.
There are various issues with discounted cash flow. As an illustration, I believe it is irrational to assign a value to a corporation based solely on my (presumably inaccurate) predictions of the amount of cash it will generate in 2027, 2037, or 2057. In as little as three or five years, the launch of new items or even entire product categories, such as metaverse-related equipment and autonomous vehicles, could profoundly alter the structure of Apple’s P&L, for better or worse. Thus, why bother gazing so far into the future?
Furthermore, I do not accept the notion that Apple’s discount rate should be any greater than 10%, regardless of how theoretically sound this may be. The market undoubtedly perceives Apple shares as having a low risk due to the company’s capital-light business strategy, valuable brand, rich (and still improving) margins, robust balance sheet, and spotless management track record. In this instance, a WACC of 7% to 8% might actually be the most suitable.
Having said that, I always think it’s necessary to take the opposing viewpoint and view the market from a bear’s perspective. I can definitely understand the bearish argument made by high valuations in the case of Apple stock.
Featured Image: Unsplash @ tracminhvu