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Getting Real About Apple

Timothy 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) is almost certainly the most written about company on the planet. As the stock ascended to $700 per share last year, making Apple the most valuable company in the world, predictions of a run to $1,000 and beyond seemed to be published every day. The party soon ended, with the stock price crashing over the past few months down to around $450 a share. This, of course, has been accompanied by claims that Apple is a has-been, that innovation is dead and that Apple is doomed.

Apple's iPhone and iPad are losing global market share to Google's (NASDAQ: GOOG) Android devices, with Microsoft's (NASDAQ: MSFT) Windows-based devices becoming a serious competitor as well. There are two things to remember, though. First, Apple makes its own hardware. Google gives away Android for free, meaning that they make nothing directly from their increased market share. This also allows Android phones to be made extremely cheaply, with Apple having no low-cost alternative. It's no wonder, then, that Android is gaining market share. But these low-cost phones most likely come with low margins -- not exactly Apple's forte.

Second, the markets for smart phones and tablets are growing extremely quickly. The smart phone market grew by 39.5% in 2012, with Apple having a 18.8% market share compared to Android's 68.3%. Because the market is growing so fast, Apple could actually lose market share over time and still sell more phones than it does today.

I doubt that Apple will ever make a truly cheap phone, and their market share is most likely capped by this fact. But they make a lot more money per phone than Google does. The smartphone market will end up looking like the PC market, with Apple having a small market share but a very profitable product.

IDC predicts that Apple will actually increase their overall market share by 2016, with Windows Phone gaining share and Android losing share.

<img src="/media/images/user_13886/aapl-share_large.png" />

If this prediction turns out to be true then the total volume of phones Apple sells will be significantly higher than today. Of course, any prediction like this should be taken with a grain of salt.

How Much Is Apple Really Worth?

I'm not going to try to predict iPhone sales in 2016, or gross margins in Q4 of this year. These types of guesses are full of uncertainty. Instead, I'll lay out three different scenarios and determine how much Apple is worth in each one. As you'll see, the market is extremely pessimistic regarding Apple.

So Much Cash

At the end of 2012 Apple had $137 billion in cash and investments and no debt. On a per share basis this comes out to about $144 of cash per share. Almost a third of Apple's market capitalization is derived from this cash. With a market cap of about $440 billion the market is thus valuing all of Apple's future earnings at roughly $296 billion.

So Much Profit

Apple has seen free cash flow grow dramatically over the past few years. In 2008 Apple recorded FCF of $8.4 billion, a number that grew to $41.5 billion in 2012. The TTM free cash flow, which includes the most recent quarter, is $46.3 billion. This equates to about $48.90 per share of FCF.

The adjusted P/FCF, obtained by subtracting the net cash from the market capitalization, is about 6.4. The most profitable company to have ever existed is trading at 6.4 times its free cash flow.

Valuation

I'll use a discounted cash flow calculation to value Apple in each of my three scenarios. For my discount rate I'll use both 12% and 15% to define a fair value range.

  • Slow-Growth Scenario - Apple grows its free cash flow at a rate of 6% annually over the next 10 years and 3% annually after that.

  • No-Growth Scenario - Apple maintains its current free cash flow indefinitely.

  • Death Spiral - Apple's free cash flow declines by 3% annually for the rest of time.

The fair value range for all three scenarios are shown below.

<table> <thead> <tr><th>Scenario</th><th>Low-End</th><th>High-End</th></tr> </thead> <tbody> <tr> <td>Slow-Growth</td> <td>$650</td> <td>$832</td> </tr> <tr> <td>No-Growth</td> <td>$470</td> <td>$551</td> </tr> <tr> <td>Death Spiral</td> <td>$407</td> <td>$460</td> </tr> </tbody> </table>

The same market that only a few months ago was predicting Apple stock would continue to $1,000 and beyond is now pricing Apple at a level that assumes that the company will whittle away into nothingness. Apple's valuation is now similar to that of Microsoft, which I've written about here. Both companies have huge amounts of cash and are valued in the mid-single-digits times free cash flow. Apparently the expectation is that both companies have unsustainable profits. This seems unlikely.

The Bottom Line

Apple, much like Microsoft, is currently priced at a completely irrational level. The pace at which overwhelming optimism has turned to overwhelming pessimism is astounding. In the short term I have no idea what Apple stock will do. But the stock is almost certainly worth far more than the current market price.


TheBargainBin owns shares of Microsoft. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple, Google, and Microsoft. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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