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Alexander Valtsev

Number-Crunching Proves Apple To Be A Buy (Please Set Aside Your Prejudice)

There has been a lot of talk about how Apple (NASDAQ:AAPL) has ceased to be innovative and that the company grows basically by exploiting its loyal customers, who switch for newer versions of IPhones, IPads, or other products by Apple on an annual basis. Some of my friends have been pointing out how each new version of the IPhone is basically a minor tweak to the previous model. I consider myself an unbiased spectator because I do not own Apple's products right now (although I have used Apple's computers for a while). While I am not a tech expert and by no means an early adapter of Apple's products, I cannot stop to admire the company's market success. Even after the August's market slump, Apple still keeps its "head above water", outweighed only by Sony:

(Source: Bloomberg)

Note: the stock's price returns are compared to S&P 500 Index's performance and returns of Google Inc., Samsung Electronics Co Ltd., Microsoft Corporation., and Sony Corp. I chose these companies because they either operate in the same market and/or have similar market capitalizations. Some well-known companies were excluded as they are not in the same "weight category" as Apple.

A more appropriate comparison to NASDAQ's historical performance reveals that Apple has continually delivered above-market returns over the recent years (even during the recent market decline):

(Source: Bloomberg)
Despite the growing popularity of Apple's stock, one can state with confidence that the market success the company's shares have had over the years is well-justified. Apple has tripled its net income since 2010, while cash flows from operations more than quadrupled over the period. Over the last five years, Apple has maintained a free cash flow yield (the proportion of revenues that eventually becomes free cash) above 20%, even though revenues have grown almost 3.5 times over the same time (i.e. one would expect large working capital increases to fund such a rapid growth). What I find remarkable in Apple is that the more the company grows the less net working capital it needs to fund its growth (just take a look at the Unearned Revenue figures on the balance sheet). I have decided to value Apple in a three-scenario discounted cash flow model in order to see how these positive developments affect the company's intrinsic value per share under various circumstances.

DCF Valuation

Apple's DCF model has three scenarios built-in: a Base Scenario (~6% CAGR in revenues in the next five years, a constant 33% EBITDA margin, and a 10% discount rate), a Bull Case (10% CAGR in the top line, an increasing EBITDA margin to 35% in 2020, and a 10% discount rate), and a Stress Case (4% CAGR in revenues, a declining EBITDA margin to 31%, and a 10% discount rate). The model's Base Scenario's output is provided below (see the rest in the model):

(Source: Calculations by author)

Note: the percentages indicate a downside move in the share price from the Monday's close of $118.30 required for the stock to reach the fair value range.

I used a 10x EBITDA multiple in the model above. This may seem high in absolute terms, but before we jump to conclusions, let us see how the model's multiple is comparable to historical data:

(Source: Capital IQ)

The above illustration shows the dynamics of Apple's EV/EBITDA multiple over the last seven quarters (i.e. almost two years). Readers can see that the 10x multiple is actually a fairly conservative estimate of the company's terminal value. Besides, take a look how Apple compares to its peers in terms of profitability and key margins:

(Source: Capital IQ. Compiled by author)

Because the company is a strong performer, it deserves a premium valuation over its peers:

(Source: Capital IQ. Compiled by author)

The historical and the comparable companies' data show that the multiple chosen in the valuation model is fair and more or less conservative. Now that we know what the stock's fair value is, we can derive a reasonable price target range based on a desired rate of return (10%):

(Calculations by author)

According to the calculations above, there seems to be a decent upside opportunity in the next year.

Opinion

I issue a BUY recommendation on the shares of Apple Inc. with a target price range of $123 - $133 per share in the next twelve months. I admire the company's ability to generate high free cash flow yields and expect continuous increases in dividends and buybacks in the medium- and the long-run.

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