Apple Inc (AAPL): Current Valuation Still Reasonable

Apple Inc. (nasd:AAPL) $162.83- Despite Apple shares rising more than 100% from its 2009 low of $78, the stock still appears to be attractively valued especially as a long-term holding. Using cash-flow and non-GAAP earnings, AAPL trades at less than 15x on a trailing 12-month basis. Since sales and cash flows were likely significantly depressed over that time period due to the sharp economic contraction, demand should improve considerably in the quarters ahead. Thus, forward multiples would be even lower given the anticipated rebound in sales and earnings growth.

The modest price multiple at which AAPL currently trades leads me to conclude that investors are: 1) Attributing the slowdown in Mac and iPod segments to a permanent secular decline, rather than temporary weakness consistent with economic contractions. 2) Ignoring/underappreciating the growth potential of the iPhone and products yet to be introduced.

Non-GAAP Earnings & Cash Flow:

Apple has reported $5.72 GAAP EPS for the past 4 quarters combined (ttm). However, over the same period, Apple has earned $9.23 in non-GAAP EPS (ttm). The non-GAAP figures are a better representation of Apple's earnings power since iPhone revenues are recognized in the period sold and not deferred over a 24 month time frame as is the case with GAAP EPS. The GAAP EPS numbers grossly understate Apple's profitability and cash-flow generation.

Looking at the difference between GAAP revenue and non-GAAP revenue for the past 4 quarters, GAAP revenue would be $7.7B higher, or 22.3% if Apple were not required to account for iPhone sales using the subscription method. Reported EPS (ttm) would have been $3.51, or 61.4% higher as well. The most noticeable difference is the effect iPhone sales have on profit margins. Since the iPhone carries the highest margin for Apple hardware, there is a dramatic impact on gross and net margins when subscription accounting is reversed. Gross margin rises from 35.5% to 39.6%, and net margin increases from 15.0% to 19.7%.

GAAP Revenue (ttm) has increased 12.2% compared to the prior trailing 4 quarters, yet non-GAAP sales increased 29.7%, more than double the rate of GAAP revenue growth. GAAP earnings growth (ttm) versus the prior 4 quarters was 11.7% ($5.72 vs. $5.12). However, non-GAAP EPS (ttm) increased 66.3% ($9.23 vs $5.55) compared to the same period for the prior year.

From June 2008 to June 2009, Apple's cash holdings increased $10.35B, from $20.77B to $31.12B. On a per share basis, cash/share increased $11.38, or 50% from $22.85/share (June 2008) to $34.24/share (June 2009). Apple generated $10.26B in free cash flow over the last 4 quarters, or $11.28/share.

It is clearly evident that the reported GAAP figures widely understates Apple's true performance. Therefore, investors should focus on the non-GAAP numbers and cash flow when evaluating Apple.

Valuation Metrics:

Even though stock values reflect future cash flows, we can examine Apple's performance over the last 4 quarters (ttm) to use as a conservative proxy since the recessionary backdrop has most likely depressed revenue and earnings. Apple's GAAP EPS (ttm) of $5.72 translates into a historical P/E (ttm) of 28.5x. That would appear to be quire a rich valuation, especially given the multiple compression that has occurred in the overall equity market. Or, at least, imply significant future growth.

However, investors should know that evaluating AAPL based on GAAP accounting is completely flawed. To compare apples to apples, investors must gauge Apple using its non-GAAP figures relative to peers/market. Apple uses subscription accounting methods to account for iPhone sales which spreads handset revenues over 24 months by accruing unrecognized revenue in a deferred revenue account that is stated on its balance sheet. Apple's non-GAAP EPS (ttm) is $9.23 which equates to a trailing P/E of 17.6x. That is a stark difference than the misleading GAAP P/E of 28.5x.

Considering that Apple has $34.24/share in cash & securities that could theoretically distributed to shareholders, Apple trades at even a lower multiple based on non-GAAP EPS ex cash. If we strip out $34.24 cash/share from AAPL's $162.83 share price, we are left with $128.59/share which essentially reflects the value of Apple's operating assets. In addition, interest income must be stripped out of earnings before calculating a P/E multiple due to the assumption that the cash stockpile would be distributed, hence no longer contributing interest income to EPS. For the trailing 4 quarters, Apple earned 33 cents per share (after-tax) in interest income. Apple is trading 14.4x ex-cash (ttm) based non-GAAP EPS ex-interest income of $8.90.

When there is a large disparity between interest yield (interest income/cash) and earnings yield (EPS/Price or 1/PE), the large cash balances can skew the value of the (non-cash) operating assets. When short-term rates were over 5% (pre-tax) and Apple traded at 20+ multiple, the earnings yield was roughly equivalent to the cash yield. Therefore, there was little or no difference between the standard P/E and P/E ex-cash & interest. Now that current short-term rates are near zero, Apple's cash holdings contribute very little income to total company earnings.

If Apple used its $31.1B for a stock buyback, it could reduce share count by 191M to 718M. Non-GAAP EPS (adjusted for interest income) would rise to $11.21 translating into a P/E (ttm) of 14.5x.

In the past year, Apple's cash position has increased by $10.35B or $11.38/share giving a P/CF (ttm) of 14.3x. Trailing free cash flow was slightly less at $10.26B giving a P/FCF (ttm) multiple of 14.4x. Removing the value of cash and interest income (from share price & FCF), the P/FCF multiple drops to 11.7x.

Recall that this valuation exercise has been based on historical earnings, not expected future earnings which is more appropriate since investors only care about future cash flows. However, I used trailing earnings since those figures are known while future earnings are not. I am confident that Apple's next 4 quarters will be better than its previous four. The economy has been in a deep recession for the past year, but has begun to improve. Apple has managed to withstand the downtown reasonably well; and with the success of the iPhone/App Store along with the possibility of new products, Apples growth should accelerate moving forward. Thus, I am reasonably confident that Apple's valuation multiples are even lower on a prospective basis.

Price Implied Expectations:

Trading for less 15x trailing earnings and ~12x expected earnings, AAPL on the surface appears cheap. Historically AAPL has traded at much higher valuations, yet expected growth was much higher too. In addition, investors are demanding a higher required rate of return on equities by paying lower price multiples. The increase in equity risk premium inherent in all stocks has led to the decline in P/E ratios. Investors perceive greater risks and are less sanguine about the long-run prospects of equity returns. This accounts for a portion of Apple's low valuation relative to its historical premium.

The primary reason why the investors are assigning a paltry price multiple is due to expected declines in Apple's growth rate. In my opinion, the current share price reflects the expectation of Mac growth commensurate with the industry average, declining iPod growth, and iPhone growth that will peak and rapidly decline to the industry average in a couple years. In short, Apple is priced as if its growth is quickly maturing, such as MSFT or DELL who both saw their margins compress as growth stalled. All firms eventually fall victim to the industry/firm life cycle. However, is this expectation likely for Apple's future? That is the key question.

I don't believe that overly optimistic or unrealistic expectations are priced-in AAPL shares. I believe the current outlook implied by the share price is conservative, but not entirely unlikely. The future of Apple's growth hinges on innovation and new products/services, as it does for most firms. Many firms are unsuccessful at being able to continue to innovate, staying relevant and avoiding being commoditized. In short, Apple's share price doesn't give much value to its ability to innovate and reignite growth. In my opinion, it's the belief whether or not Apple can continue to introduce products that wow consumers that determines if AAPL is over/under valued.

Apple's Record of Successful Innovation and Execution:

1) iPod's Dominant Market Share-

Apple's unit market share has exceeded 70% in the U.S. for years as it has successfully continued to ward off competition leaving carcasses by the wayside. Many powerful companies such as Dell, Sony, and Microsoft have attempted dethrone the iPod only to fall short or outright fail. Apple has been able to keep iPod prices relatively high as its revenue share of the U.S. PMP market is higher than 90%.

2) Apple's iTunes store is largest music retailer-

Tunes surpassed Best Buy and Wal-Mart to take the top spot is sales volume. Apple should increase its lead as bricks and mortar stores cutback on music selection due to high inventory cost and required floor space. Demand for physical music continues to decline as consumers shift to buying digital music online. Competitors have followed with online music download stores, yet they have made little dent in iTunes market share.

3) Retail stores generate highest revenue/sq.ft. and foot traffic-

It's quite indisputable that any retail strategy has been as successful as Apple's retail stores. Apple leads in performance metrics such as revenue/sq.ft. and visitors/store etc, but its retail strategy also has been extremely successful in promoting its brand and introducing customers to its products. Other computer makers' retail efforts have failed, such as Gateway and Dell. Many third-party computer and electronics resellers have also disappeared, such as CompUSA and Circuit City. It's quite evident that it's a very challenging environment to navigate. Apple continues to open new stores and is expanding considerably abroad.

4) Turn-around of Mac business and domination of premium segment:

Mac unit sales increased 38% in FY08 and 40% in FY07, which was more than 3x the PC industry as a whole outpacing the industry in 18 of the last 19 quarters. Even though Mac unit growth has slowed to single-digits, its share of the premium price segment has exploded. According to NPD, Macs made up 91% of sales for PCs priced $1000 and above for June 2009, up from 88% in May. This compares to 66% share Mac had in Early 2008. I believe Apple had about 40% share of the premium market in 2007. It is quite evident that Apple is the only PC manufacturer than can command a premium for its products.

5) Large and increasing share of smartphone market-

Even with the experience and industry footing incumbent mobile handset makers possessed, Apple was able to enter the market and quickly gain share. According to several surveys, the iPhone has the highest satisfaction rates by a considerable margin. Industry competition is very intense, yet Apple is the one to catch in the smartphone segment.

6) iTunes App Store-

One year after launching, the iTunes App Store offers 65K applications and has seen over 1.5B downloads. Other firms have followed with their own mobile app stores, yet haven't been able to duplicate nearly as much developer and consumer interest. Nintendo mentioned last quarter that Apple's App Store is impacting its handheld gaming business.

These remarkable achievements illustrate a common theme. Apple has been able to enter new product markets and become the leader that others must chase. Even though many competitors have attempted to duplicate Apple's strategy, most have had hardly much success, at least in terms of stealing business from Apple. A popular concern among Apple investors is that increasing competition from the number of firms following in Apple's footsteps. They believe that others will eventually catch Apple (iPhone, App Store, iTunes Music),hence its lead is only temporary. However, this has been a concern for ages and yet to come to fruition. That is not to say it won't happen as there is a real possibility that it will eventually. But given Apple's proven track record of disrupting, dominating, and defending its new endeavors, it's likely Apple will remain the innovative leader for sometime.

Apple's share price may reflect declining iPod growth and decelerating Mac growth, but it doesn't reflect potential new products which are a certainty. The success of those new products are less certain, but Apple makes products/services that complementary to its others, rather natural extensions. Basically, Apple products help drive sales of other products as well as increasing switching costs creating customer "lock-in."

Apple's products elicit the some of the highest customer satisfaction scores for their respective categories which has created immense loyalty and a powerful brand.

Conclusion:

On a non-GAAP basis ex-cash, Apple is trading at less than 15x trailing EPS. Considering the economy has been going through the worst economic downtown since the Great Depression, Apple's trailing earnings are depressed. As the economy turns up, earnings will normalize at a higher level. In addition, iPhone sales should continue to exhibit strong growth and drive free cash flow. Therefore, investors should be highly confident that future earnings will be considerably higher. On a forward earnings basis, AAPL's price multiple is 10-12x, a valuation representative of maturing growth. However, Apple has a long track record of innovation and using products to promote and attract consumers to its other offerings. Looking at the many remarkable achievements by Apple any the many stumbles by competitors, it can be argued that AAPL deserves a premium multiple, not a multiple reflective of ordinary growth.

Disclosure: Long AAPL

Understanding Valuation Multiples with Respect to Cash

A common mistake I see people make refers to how a firm’s cash stockpile is treated in the valuation process. Specifically, Investors err when they subtract cash from market value before calculating an earnings multiple that includes interest income. P/E multiples are calculated using EPS, or net income per share. This figure includes interest income that is generated from a firm’s cash investments. It’s incorrect to make assertions regarding P/E ratios based on cash/share values. For instance, $100 share price & $5 EPS, and has $20 cash/share, the firm’s P/E is 20x. End of story. No adjustments are to be made, nor should the $20 cash/share have any bearing/relevancy in that scenario. It’s true and only P/E multiple is 20x. The common mistake is to adjust the share price by the cash/share and then divide earnings. Hence: 100-20= 80/5 = 16x. If the $20 cash/share earns 5%, then it contributes $1 to EPS. If cash were eliminated from the calculation, it needs to be done on both sides. EPS would then be $4 not $5, and $80/$4 is 20x. Multiple doesn’t change because the value of the cash was captured in the share price as well as the EPS. Therefore, cash/share doesn’t have any effect on P/E multiples and shouldn’t be part of P/E analysis.

EQUITY VALUE MULTIPLES:

Let’s take Apple (nasd:AAPL) for example: Price =  $172.55, Cash/Share = $23.45, FY09 EPS Estimate = $6.06. The forward P/E is 28.5x. The  incorrect computation is to subtract cash from the share price before dividing by expected EPS: $172.55 - $23.45= $149.10 / $6.06 = 24.6x. The rationale people give for making this mistake is that one share of Apple represents $23.45 of cash and a business that generates $6.06 in EPS, thus an investor can purchase the earnings stream for $149.10.

Here’s the issue- the cash balance contributes to earnings in the way of interest income. Without the cash stockpile, EPS would be lower. One must not assume that Apple’s FY09 EPS will be $6.06 without interest income, thus a higher multiple should not be assigned on the basis of its high cash/share. In FY07, Apple earned $647 million in interest from its cash holdings, which totaled $15.4 billion at year-end. In per-share terms, interest income contributed roughly 51 cents to Apple’s reported FY07 EPS of $3.93. Apple’s P/E multiple based on FY07 EPS is 43.9x. Without interest income, EPS falls from $3.93 to $3.42, and subtracting cash from share price, Apple’s historical P/E is 43.6x. That’s roughly the same as the multiple calculated with cash included in both price and EPS. The common mistake is not subtracting out interest income from EPS while taking cash out of the share price. Therefore, it’s incorrect to subtract cash from one figure without taking it out from the other figure as well.

Since P/E ratios represent income that includes interest income, the conversation of cash/share is inappropriate, as it has no bearing on value, nor multiples in that regard. It’s incorrect to assert that a firm’s P/E multiple is actually lower because it has a relatively high cash/share, and that one should consider cash/share in tandem with P/E ratio. The cash/share is accounted for in the P/E ratio because it’s a part of the “E” or earnings, which includes interest income. The cash balance is the present value of future interest income, thus the two are the same.

ENTERPRISE VALUE MULTIPLES:

In instances where EBIT or EBITDA figure (Earnings before Interest, Taxes, Depreciation, Amortization) is used in a price multiple, then cash holdings should be considered since interest income (expense) is not captured. Thus, a P/EBITDA multiple makes an incorrect comparison since cash & debt aren’t included in the value of the denominator but are in the share price, or market value of the equity. To properly compare EBITDA, one should use enterprise value, or EV, in place of share price, or P. EV is the market value of the equity plus value of debt minus cash. Therefore, the multiple becomes EV/EBITDA. Cash holdings are excluded from the value figure, numerator, as well as excluded from earnings stream, EBITDA, in the denominator. 

CONCLUSION:

To calculate multiples correctly, one shouldn’t include components in the numerator without also including in the denominator. If one is computing P/E multiple, then cash/debt needs to be ignored because those values are captured in the EPS. If one is computing EBITDA based multiples, then EV instead of P, is the correct input for the numerator. Since EBITDA doesn’t account for interest income/expense, then it would be much higher for a debt-laden firm. If share price, P, were used instead of EV, then the numerator would be too low resulting in too low of a multiple. Adding debt to arrive at EV, increases the numerator to coincide with the exclusion of interest expense increasing the denominator as well. 

Using Excel to Import Financial Data from the Web

There truly is no better program when it comes to crunching financial data than MS Excel. It is very simple to build valuation and analysis models by creating spreadsheet formulas to perform calculations on a firm’s financial data. Getting the data into Excel can be a problem especially if it has to be manually keyed-in. That can become very time consuming and transcribing figures manually is very error prone. With the use of VBA macros, Excel can import specified data automatically from the web. This is an extremely powerful tool for researching investments. Randy Harmelink developed an Excel Add-in that imports a whole myriad of stock data. The best part is that anyone can download and use.

Professionals on Wall Street have had this type of automated analysis for years through such services as Bloomberg. Yet, for the individual investor not willing to shell out $2k a month, he/she resorted to a legal pad and financial calculator. Every investor needs to do their own math so that they get a grasp to the larger story that the numbers tell.

Mr. Harmelink’s Excel Stock Market Function Add-in is located in the files section on this website: http://finance.groups.yahoo.com/group/smf_addin/

It’s a yahoo group where members discuss ideas and share spreadsheets.
Additionally, Models I have created that use this add-in are posted in the files section at this yahoo group:
http://groups.yahoo.com/group/stock_analysis_group/

I recommend visiting these sites and downloading/installing the add-in and then look at the spreadsheets already created by group members.

When I conduct my analysis of a given stock, I usually apply three valuation methodologies

1) 5yr Forecasted EPS / Exit Multiple
2) 3-Stage Discounted Cash Flow Valuation
3) Relative Price-Multiple Valuation

For this post, I will discuss the first model and will discuss the others in subsequent posts.

The EPS / PE model doesn’t require much data to calculate.
Inputs:
-Historical EPS
-Historical DPS
-EPS estimates (current yr and next yr)
-Projected 5yr EPS growth rate
-Stock’s Beta

First, I analyze historical EPS growth to see if it’s accelerating, decelerating, or constant. I compare this to the analyst’s forecasts and make any adjustments to arrive at what I think is a reasonable growth rate.
Then I take last year’s EPS and project it out 5 years- (EPS * (1+g)). If Consensus estimates are available for this year and next year I will use those figures for year 1 & 2 EPS, and the apply my forecasted growth rate for years 3-5. At the end of year 5, I multiple EPS by a P/E ratio that is reasonable- Industry average etc. That will give the projected stock price in year 5. To calculate today’s value we must discount Year 5’s price back to the present using the required rate of return on equity. If the stock pay’s dividends, those too must be discounted back to the present and added to the PV of the stock price.

Using the Excel Stock Market Add-in all the required inputs can be downloaded automatically in excel. I have created a spreadsheet called Cash Flow Model that includes the above calculation that can be found at the locations mentioned above.

The primary drivers are the projected growth rate and exit multiple so it is crucial that these assumptions represent the most accurate predictions as possible. A useful strategy is to “invert” the model, meaning finding the input assumptions that equate model value to market value. For example, using the consensus growth rate and then finding the exit multiple value that returns the current price. Alternatively, the user could input a desired multiple then find the growth rate implied by the Market price.

The usefulness of valuation techniques is not to arrive at a single valuation as calculated by the model, yet to formulate a range of values for various assumptions. For instance, the assumptions that are implied by the price and valuations for pessimistic / optimistic scenarios. This provides the practitioner with an understanding of what must occur to support a given valuation.

I will discuss methods for estimating growth rates and exit multiple in upcoming posts.