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Apple's Sell-Off Presents A Buying Opportunity

Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Apple (NASDAQ: AAPL) stock is down 21.5% from its September high of $700, losing over $130 billion in market value.

After Apple's recent sell-off, it's time to return to the fundamentals and value the stock. To no surprise, $543 for Apple's stock offers a great opportunity for investors to purchase a stake in the iBehemoth.

Discounted cash flow valuation: A brief background

The value of any business is ultimately the present value of future cash flows discounted by the time value of money. A simple discounted cash flow (DCF) valuation model can serve to calculate intrinsic value in this manner. A business should meet several requirements in order make a good match for the model.

  • Economic moat, or a durable competitive advantage
  • A historical trend of at least five years of consistently positive free cash flow
  • A clear and understandable business model that makes forecasting a reasonable endeavor
In my opinion, Apple meets all three of these requirements. Furthermore, Apple's recent tumble in market value makes it a great time to revisit a valuation.
 
In a good DCF valuation, there are four input rates:
  1. Growth rate
  2. Discount rate
  3. Decay rate
  4. Perpetuity rate

Apple DCF valuation inputs

Some analysts use earnings in DCF analysis, but we'll use free cash flow (FCF).

Apple's TTM FCF amounts to $41.45 billion. Year-over-year FCF increased by 38%. Based on the past five years of strong free cash flow growth and a clear trend of improving performance and profitability ratios, forecasting 20% FCF growth in 2013 seems to be reasonable. Apple's new line-up of iPhones, iPads, Macbook Pros, iPods, and iMacs, combined with the upcoming holiday season, should easily help Apple reach 20% growth in fiscal 2013.

As far as a discount rate, I'll use 10%, meaning that I require a minimum of a 10% return in order to take on the risk of investing in stocks and to compensate myself for the time value of money.

The decay rate is the rate at which the growth rate declines each year over the next ten years. Apple is pressed with competition from every side. Its current growth rates are simply not sustainable. So I'll use a high decay rate of 30%. In other words, I estimate Apple's free cash flow growth to decrease by 30% each year. The resulting projected growth rates for the next ten years are presented below:

Companies are an ongoing concern. In other words, Apple will not cease to exist in ten years. A perpetuity rate, therefore, is required. The perpetuity rate calculates the value of all future cash flow beyond ten years. We'll use 3%, assuming Apple will keep up with inflation.

Apple DCF valuation results

I plug these inputs into my DCF valuation spreadsheet, and voila! Apple appears to be trading at a significant discount to fair value with a 39% margin of safety.

Double-checking

Just like any human being, I don't like losing money. So to double check my valuation I'll ensure that the company is also fundamentally cheap enough to merit a decent FCF yield and maybe even a nice dividend yield.

The FCF yield shows you what percentage of a company's share price is represented by the cold, hard cash it's churning out. The higher this percentage, the better. Apple's FCF yield is 8%--very solid for a company that analysts are predicting to grow at rates between 10 - 20% per year over the next five years.

Let's see how Apple measures up with other wide-moat, mega-cap stocks.

Company FCF Yield Dividend Yield
Apple 8.1% 2%
Google (NASDAQ: GOOG) 5.9%  - 
Wal-Mart (NYSE: WMT) 5.1% 2.2%
McDonalds (NYSE: MCD) 4.5% 3.6%
Procter & Gamble (NYSE: PG) 5.4% 3.3%

Apple is significantly cheaper than Google, Wal-Mart, McDonalds, and Procter & Gamble when measured by FCF yield. This is quite the conundrum considering Apple's recent growth, huge growth prospects in China, and a full line-up of new products headed into the holiday season.

The bottom line

Performing a simple discounted cash flow analysis reveals that Apple is significantly undervalued. The recent sell-off provides investors with a great opportunity to jump in for the first time or double-down on their stake.


DanielSparks owns shares of Apple. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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