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. 

Apple Inc (AAPL): Are Investors Overlooking Cash Earnings?

Apple Inc (nasd:AAPL) $157.08: I believe investors have become overly fixated on Apple’s expected accounting income, while ignoring Apple’s impressive free cash flow generating ability. Free cash flow, not earnings reported in the accounting statements, determines the true value of a firm. AAPL’s high margins coupled with minimal capital investment needs, enables it to produce robust free cash flow. Another issue is the iPhone accounting treatment, which conceals the true magnitude of its cash generation. According to my estimations, the 3G model’s cash flow per unit is higher than its predecessor. In addition, Apple receives these cash flows much sooner compared to the old model. Not only will Apple sell many more 3G models, the per-unit impact on cash earnings will be much greater. Therefore, when shifting focus to cash earnings, as opposed to accounting earnings, AAPL looks attractive at current levels.

Earnings Expectations:
At the Q3 earnings call, Apple guided well below expectations for Q4, and gave a weak gross margin forecast for FY09. Shares took a hit and prompted Wall Street analysts to reduce their 4Q08 and FY09 estimates. Consensus estimates for FY08 & FY09 are $5.20 & $6.05, respectively. Early this year, the FY09 estimate was ~$6.50, then drifted lower to ~ $6.35 where it hovered for several months. Since Apple announced its margin guidance, the consensus FY09 EPS estimate has plunged to $6.05.

Apple shares currently trade @ 27x FY09 EPS, with expected annual growth of 16%. A 27x multiple for 16% growth isn’t exactly cheap. However, evaluating Apple on an EPS-multiple basis is misleading due to Apple’s iPhone accounting treatment. Considering Apple’s cash flow/share, the stock looks attractive.

Wall Street estimates are for accounting income- what Apple is expected to report, not what Apple will actually earn. Cash flow is the true metric that matters, not accounting earnings. Accounting earnings are a product of a firm’s finance department, and cash earnings are a product of customer behavior. Thus, one shouldn’t place too much emphasis on accounting income and quarterly estimates.

The amount of cash flow available for distribution to owners determines intrinsic value. Accounting income and cash flow are not the same, and often accounting income is a poor proxy for distributable income, hence intrinsic equity value.

Evolution of Market Expectations:
The 3G iPhone developments- new markets, new revenue model, lower price points, and new features, etc didn’t seem to affect AAPL shares much. However, concerns over Steve Jobs’s health and guidance have pressured shares. iPhone demand has been relentless since the launch as stores struggle to keep supplied. Analysts have raised their forecasts for unit sales, yet earnings estimates have only changed slightly (before CC).

Earlier this year, investors and analysts were questioning whether Apple would achieve its stated sales goal of 10 million units in CY08. Some began to think the iPhone was going to turn out to be a disappointment, and that expectations were certainly excessive. However, iPhone sales projections rose significantly with the June announcement. Many analysts raised estimates to more than 20 million for 2009. Yet, there was then the question of reduced profitability due to the reduced price points. Originally, the thinking was that volume could certainly expand but the effect on the bottom line would be subdued due to shrinking margins. Yet, it was soon agreed that margins won’t be significantly impacted due to the larger-that-originally expected subsidy payment. Instead of receiving a cut of monthly carrier payments over 24 months, Apple will receive an upfront lump-sum payment that is likely equivalent.

So, we have a massive increase for iPhone sales expectations with profitability remaining somewhat intact, yet AAPL shares react moderately and analysts only revise estimates slightly higher. Ostensibly, earnings estimates didn’t change significantly due to the iPhone accounting treatment that spreads revenue over 24 months. Thus, iPhone sales won’t really impact the income statement until a much higher run-rate persists for many quarters so that revenue recognition has had time to catch-up.

Shares reacted little to the June announcement, until somebody pointed out that Jobs looked unhealthy causing the stock to tank. Shares later recovered only to get slammed again after the Q3 earnings call when management refused to elaborate on Job’s health condition. Panic over Job’s health has abated, but concerns regarding Apple’s gross margin guidance and susceptibility to a weakened consumer still linger.

3G Produces More Cash Flow & Sooner:
The transition from shared payments from carriers to an upfront subsidy payment increases Apple’s intrinsic value.

Apple’s cash flow will increase from receiving an upfront, one-time payment opposed to recurring monthly payments. Originally, when an iPhone was sold, Apple only received cash associated with the handset sale, revenue which probably averaged around $430-$440. Apple then would receive $15/mo (guesstimate) for the next 24 months, $360 in total payments, or PV of $319 @ 12% discount rate. Present value of total CF is ~$750/unit, However, this isn’t a very realistic assumption to model. Actual revenue/unit is significantly less due to several reasons.

First, not all units receive full 24 months of payments due to iPhones being lost, stolen, broken, etc. Monthly payments are then attributed to the replacement unit and the original device no longer generates monthly revenue payments. AT&T shares revenue per iPhone customer (activated device), not for each device sold. Thus, Apple has sold two handsets yet only collects $15/mo, or theoretically $7.50 per device.

Second, not all iPhones sold were activated with a participating carrier (unlocked), so a significant percentage of legacy iPhones (maybe 40%-50%) don’t receive carrier payments. Unlocking has actually been beneficial because is has allowed Apple to sell units that it would have never sold, and it has generated product exposure in foreign markets. Yet, for the sake of modeling, and for cash flow comparison between the former and current revenue models, we can’t assume that the average monthly payment is $15 across all units.

Third, many units will be replaced with 3G iPhones before the full 24 months elapses. 2.5G iPhone owners that upgrade to the subsidized 3G model contribute maybe 12 months (or less) worth of payments. Piper Jaffray’s survey on launch day found 38% of 3G buyers were current iPhone owners.
Just for the sake of illustration, assume 50% of iPhones are unlocked (or lost/broken), and one-half of the other 50% upgrade to the 3G model after 12 months. This leaves 25% with 24 months of revenue payments At $15/month shared carrier payment, the average unit revenue/month is $5.63, or $135 over 24 months. Assuming ASP of $430, total revenue/unit is $565 (not accounting for time value of money). Therefore, it’s unrealistic to assume that the legacy iPhone revenue model was bringing in $790/unit ($430 + $15 x 24m)

With the subsidy payment model, there isn’t any uncertainty as to what the actual realized revenue/unit will be, since all payments occur on the front-end. Sales thus far have been skewed towards the 16GB model, which AT&T is offering for $299 with a 24-month contract, or $699 for no commitment. Similar arrangements exist in foreign markets, and the pricing works out to be roughly equivalent on a currency translation basis. So, AAPL could be capturing over $600/unit, a more conservative figure would be $550 or $500. Thus, Apple is likely receiving revenue per unit commensurate to the 2.5G iPhone.

A major point that I feel is overlooked relates to the timing of cash flows. For example, consider the following illustrative assumptions. Apple receives $600 upfront on the 3G opposed to $450 upfront and $150 in total cash payments spread over 24 months for the 2.5G. The accounting will look the same for both models since total revenue/unit is equivalent, and in both cases is recognized over 24 months resulting in revenue of $75 per quarter. Even though both scenarios appear to be similar from an accounting standpoint, the cash flows are different. All cash flow from the 3G hits at the time of the sale, where as just a portion of 2.5G cash flow occurs on the front-end.

To summarize my points:
1) 3G iPhone realized revenue/unit is higher- not every 2.5G iPhone generates shared carrier revenue, and not all units that have attached payments will survive the full 24 months.
2) Time Value of Money- Apple receives 3G iPhone revenue upfront, whereas the previous model entailed deferred revenue payments. Not only is there the opportunity cost of forgone investment alternatives, the cash payments are uncertain.
3) 3G model’s production cost is estimated to be about $55 less that the original model.
4) Demand, demand, demand. More markets, more features, cheaper price. The first iPhone took more than two months to sell 1 million units, which the 3G iPhone surpassed its first weekend.

The new 3G iPhone and revenue model will dramatically boost Apple’s cash flow that should result in a higher valuation. Not only is demand substantially stronger for the 3G model, but the actual revenue/unit realized will be higher, and the cash flow will occur sooner.

iPhone Impact:
If Apple sells 20 million iPhones next year assuming: $500 ASP, 50% gross margin. 30% tax rate, it will generate incremental cash flow of $3.90/share. Assuming that Apple sells 5 million in each quarter, the accounting treatment would only recognize $1.23/share for 2009. Cash earnings are more than 3x higher than reported earnings. Using more aggressive assumptions: $600 ASP, $250 COGS, the iPhone would produce $5.50 CF/share. Subscription accounting would only report $1.72/share.

The assumptions I am modeling for FY09: 20 million units, $350 subsidy, 65% 16GB ($299) & 35% 8GB ($199) = $614 ASP, $233 production cost, 30% tax rate. This calculates out to 5.32B in after-tax cash flow, or $5.92/share.

Apple’s FCF/share (ttm) is roughly $6.84, a price multiple of 23x. In contrast, Apple trades 31x EPS (ttm). I estimate that $1.10 of the $6.84 CF/share is iPhone related, thus FCF/share associated with all other segments is $5.74. With a 25% growth rate, non-iPhone CF increases to $7.18/share in FY09, and adding $5.92 from iPhone, CF for FY09 totals $13.10/share. This figure equates to a price multiple of 12x, and as mentioned previously, Apple is trading 27x FY09 EPS estimate of $6.05.

This is more or less a “back of the envelope” exercise, but the purpose is to illustrate the vast difference between Apple’s cash flow and accounting EPS due to iPhone revenue recognition.

Apple’s Free Cash Flow-
Apple is an impressive free cash flow generator. The primary components of free cash flow are 1) NOPAT- net operating profit after-tax 2) Working-capital requirements 3) Investment in fixed assets (capex).

Apple’s has negative working-capital requirements due to rapid inventory turns. AAPL turns its inventory about every 7 days, or 50x a year. Apple’s collection period for outstanding receivables is slightly more than 20 days, yet it doesn’t pay its suppliers for roughly 90 days. Thus, Apple doesn’t need to sink additional cash into working capital as sales increase since it’s funded through trade credit. This would allow more cash to be distributed to shareholders since it doesn’t need to be retained to fund operations.

Apple’s capital investment needs are quite modest. FY07 capex was $735 million and $893 million for the last 4 quarters. This equates to roughly 3% of revenues, and when depreciation is taken out, net investment is approximately 1.7% of total sales. A sizable portion of Apple’s capital investment relates to retail store growth. Apple’s stores produce extremely high revenue per square foot, as well as attracting consumers unfamiliar with the Apple brand. Retail stores perform a marking function for Apple due their appeal that generates substantial foot traffic. The stores are also ideal for cross-selling Macs to consumers who have come to purchase an iPhone or iPod. Thus, Apple’s retail store strategy has proven to be a very worthwhile investment.

Much of Apple’s assets are intangible, thus not reported on the balance sheet. Intellectual capital and brand equity are just two examples. Relatively speaking, Apple doesn’t have to spend heavily on developing these assets. Apple’s marking spend is 2% of revenue as it enjoys doses of free advertising from the media and word-of-mouth from satisfied users. Apple’s research and development expense is just slightly more that 3% of sales. In comparison, R&D for Yahoo ~16%, Google ~13%, and Amazon ~ 6%.

Conclusion:
In summary, EPS (ttm) is $5.11 or 15% net margin, and free cash flow as a percentage of revenue is 20%. As iPhone sales increase, these two metrics will diverge further, yet the focus should be on cash flow. It’s widely accepted that the iPhone has a much higher gross margin than the overall Apple business, yet due to subscription accounting, the iPhone’s impact on overall gross margin is very minimal. Thus, panic over the gross margin forecasts is misguided because on a cash basis, gross margins would be much higher. Investors should then place less weight on Wall Street earnings estimates. Therefore, when evaluating Apple on its prospective cash flows, shares look attractive under $160.

Disclosure: None

Comparing Valuations: Yahoo vs Google

Comparing price-earnings multiples and expected growth rates of Yahoo and Google several items become apparent. Yahoo is extremely overvalued as an independent company with its current share price reflecting the likelihood of a buy-out. Google is the better value of the two, but Google alone is fairly valued.

First, let’s run through the numbers I gleaned from Yahoo Finance and Nasdaq.com

Yahoo Valuation:
Yahoo shares currently trade 57.7x FY07 EPS of 47 cents. Looking forward, Yahoo trades 59x FY08 EPS estimate of 46 cents and 48.5x FY09 estimate of 56 cents. These EPS estimates translate into Yr/Yr growth of -2.1% (FY08) and 21.7% (FY09). Yahoo’s annual growth rate has averaged 23.3% the last 5 years.

Taking a slightly different perspective, Yahoo’s combined EPS for the last 4 quarters is 48 cents, and consensus estimates for the next 4 quarters total 52 cents. This represents 7.3% growth. The P/E multiple using EPS for the next 4 quarters is 52.7x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Yahoo has a PEG of 7.23.

Google Valuation:
Google shares currently trade 37x reported FY07 EPS of $15.59. Looking forward, Google trades 28.6x FY08 EPS estimate of $20.14, and 23.3x FY09 estimate of $24.74 . These EPS estimates translate into Yr/Yr growth of 29.2% (FY08) and 22.8% (FY09). Google’s annual growth rate has averaged 75.4% the last 5 years.

Taking a perspective of last 4 quarters versus upcoming 4 quarters, Google’s combined EPS in the trailing 4 quarters is $16.74, and consensus estimates for the next 4 quarters total $21.23. This represents 26.8% growth. The P/E multiple using EPS forecasts in the next 4 quarters is 27.2x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Google has a PEG of 1.01.


The difference in the two’s valuation is stark and quite apparent. Google’s forecasted growth is higher than Yahoo’s, yet it trades at lower multiples. That suggests Yahoo is overvalued relative to Google. But, does that mean Google is undervalued and should be bought? And that Yahoo is overvalued and should be sold?

Yahoo Analysis:
In my opinion, Yahoo is certainly overvalued as the company exists today. Its current valuation hinges on a business combination, most likely with Microsoft. Of course, this is the reason that Yahoo shares are trading at such high levels. It’s not a surprise why Ballmer balked at Yahoo’s $37 asking price since colossal synergies would have to be extracted from a combination to justify that high valuation.

Even at $33, $31, or Yahoo’s current share price, a suitor would really have to leverage Yahoo’s assets to unlock value. Now, common thinking concedes the value in Yahoo’s assets already exists, yet management and its strategy have been poor- leading to weak performance. Hence, strategic synergies and proper management may quickly boost Yahoo’s cash flow to a level that would justify such valuations.

The fact that Yahoo shareholders are irate that the board was holding out for $37 shows that they believe that valuation to be unreasonable. $31-33 is better than $27. If it weren’t for the possibility of a deal, the share price would be much lower, perhaps a teenager. However, Carl Icahn reportedly will launch a proxy battle to replace Yahoo’s current board. Such attempts are generally difficult to execute since ownership is fragmented and diffuse, however shareholders are angered and Icahn has established a track record.

In summary, under Yahoo’s current strategies, analysts don’t foresee much growth. Yahoo’s lackluster performance the past several years is not expected to change going forward, pursing the same course. Yet, shareholders and Carl Icahn believe Yahoo’s potential value is much greater than what historical performance and earnings projections would suggest- value contingent on business combination or management change.

If no deal (of some sort) ever comes to fruition, then YHOO shares would likely be cut in half. Ostensibly, there is inherent value not recognized in Yahoo’s performance, but if Icahn is not successful in removing a stubborn board, then it’s unlikely anyone else would be either.

Independent Yahoo- nearly all of Yahoo’s revenue comes from search and display advertising. Yahoo has been losing share in search; Google’s superior algorithms boosted its share into the mid sixties. In the English lexicon, Google has become a verb “Google xyz,” meaning to perform an internet search. Yahoo is still the second most popular search engine, but I believe most yahoo searches are secondary events. Yahoo’s content attracts users, who in the course of their visit, become compelled to search for a particular item and do so on yahoo, instead of navigating to Google. Conversely, users not on Yahoo’s portal choose to navigate to Google opposed to Yahoo to perform a search query. Hence, some of Yahoo’s search traffic is a matter of circumstance, and not necessarily one’s usually first search engine choice. Hence, the content from the portal aids in generating search traffic, but without a superior search engine, search depends heavily on traffic the portal attracts.

53% of Yahoo’s revenues come from advertising on its own properties, and segment revenues increases 18% in Q1. Yahoo attracts traffic through its news, finance, sports, and mail content/services. There isn’t anything proprietary about the content Yahoo provides, thus can be duplicated. In addition, Yahoo is buggy. Yahoo Mail doesn’t work right (search & spam filter), sometimes pages don’t render correctly and tables fail to populate. Groups and message boards are filled with spammers.

In my opinion, there are many things that have gone down hill on Yahoo’s site. Social networking sites and blogs are gaining traffic, traffic that could be going to Yahoo. Much of what Yahoo has now, could be duplicated, perhaps by Google. Google provides similar content and services, such as mail, messenger, maps, etc. and in my opinion, is better. In sum, Yahoo is dependent creating content and services that will attract visitors to its website.

Yahoo also provides advertising to third parties or affiliate sites, but segment revenue (33%) and margins have been declining. In Q1, segment sales fell 7%, after accounting for the drop in margin (shares more with partner), net revenues declined 13%. Yahoo’s total net revenue increased 9% for Q1. Google’s revenue growth was 42%.

Google Analysis:
At $576 / share, Google is fair-valued. In mid-March, I was bullish on Google when it was trading around $440. In my Google valuation analysis, I pegged Google’s fair value at $540 / share. I think, given the take-over turmoil engulfing Yahoo, and the ensuing distraction and departures, has boosted Google’s lead further. Thus, a $600 share price for Google is reasonable, but not attractive.

I am reluctant to place a valuation higher than $600 on Google due to its spending. GOOG has very high profit margins, but absent from the income statement is capital spending. Capex as a percentage of total revenue has been in the mid-teens for the past several years. R&D as percentage of sales has increased as well, from 10% (FY05) to 13% (FY07). Headcount has also significantly expanding leading to declining sales/employee & income/employee ratios. The significance- On the margin, each incremental dollar of revenue growth is accompanied by higher costs and investment. Hence, Google’s prospective growth generates less incremental corporate value compared to its past growth. Nothing new here, just the law of diminishing returns taking hold.

Conclusion:
Owning Yahoo at these levels is purely a bet on an acquisition. There is some upside to $31 or perhaps $33, but there is some downside risk as well. Owning shares of the acquirer (whoever that may be) is a bet that synergies will enhance value and that the purchase price was not excessive. Owning Google is a pretty safe bet with the upside potential balanced with downside risk.

EPS Revisions for S&P 500 Companies

Here is a brief summary of data I collected from Yahoo Finance for companies in the S&P 500 Index.

EPS Estimates for the current fiscal year compared to estimates 90 days ago:
UP: 166 (33%)
DN: 306 (62%)
UNCH: 24 (5%)

In aggregate, current year estimates were revised down 4.7%.
The average upward revision was 4.2%
The average downward revision was 9.9%

Not much of a surprise as to which type of companies received the largest revisions: Energy & commodities-Up and Financials & consumer goods-Down.

Out of the 496 companies I could find estimates for (current & 90 days ago), 479 have positive EPS estimates and 17 negative, up from 11 negative estimates 90 days ago.

I eliminated the negative EPS companies when calculating the revisions to consensus estimates since percentage changes for negative values do not make sense. Therefore, the 9.9% figure for average down revision is slightly understated.

Back in February, when the market was trading at 13.7x estimates I theorized that investors were thinking estimates were too high and would be revised down, opposed to the market being relatively cheap. (see low multiples mean market cheap?) Currently, the S&P 500 is trading slightly higher than it was in February when I made those comments, yet according the data from the WSJ, the estimated P/E has risen to about 14.5x. It appears logical, the multiple has risen close to 6% and estimates have fallen close to 5%, and the market price level has increased a touch as well.

The question remains: “Are earnings estimates still too high?”

The S&P is still trading at low multiple considering that the 10-year currently yields 3.48%, and that multiples have generally been in the high teens for the past couple decades. So, does suggest more downward revisions? Well, if the investors were to think the economic slowdown will be brief and shallow, it would stand to reason that the S&P would be trading at a much higher multiple- reflecting the expectations of a strong rebound and higher future earnings.

Many do believe that the economy will strengthen considerably in the second half of this year and that earnings will return to double-digit growth rates. However, the S&P’s P/E multiple doesn’t convincingly confirm that sentiment. Perhaps another explanation exists.

A point I touched on in my February commentary was the increase to the equity risk premium, or ERP. Investors require a premium to hold risky equities over holding risk-free assets, such as Treasury Bills. The ERP over history has been 5.5-6.5%, but in recent times it has fallen to 2-4%, depending on which method used and which expert one asks.

In the last several months to almost a year, that risk premium has definitely increased. Using the price level of the S&P 500 index and expected earnings growth to calculate the ERP, the current implied ERP is somewhere around 5.5%. A higher ERP translates into lower price multiples. On the margin, when investors perceive increased risk to holding equities, they will pay less for $1 of EPS, hence a lower P/E multiple.

Investors have been less willing to pay up for equities. There has been an explosion of market volatility. Volatility is another way of saying uncertainty, which could be described as risk, actually it's the definition of risk.

Current conditions make the future impossible to predict. Times such as - when today was like yesterday, which was like the day before that, and so on, with static market and economic conditions, then it’s easier to assume that the future will be similar to the present. Volatility in the market is absent; investors perceive there to be less risk, hence P/E multiples are higher.

Currently, today is rarely anything like yesterday, and tomorrow is anyone’s guess. Will there be another big bank write-down? Which market will seize up next? We’ve had mortgages, auction-rate, muni’s, Libor, etc. Bear Sterns saw something like more than 10 billion in liquidity evaporate in the span of a day. It’s been an extremely uncertain and volatile period.

Getting back to the earnings estimates question- Does the market think estimates are not too high? That there will not be a rash of revisions? It’s hard to say. What isn’t hard to say is that even if investors think earnings forecasts are reasonable, they have a low degree of confidence (or certainty) that those estimates will prove accurate. Whether estimates are too high or not, or if a recession will be shallow or deep- actually may not be the question. Either way, investors are not willing to take that bet, instead they are paying low multiples for equities and buying low risk assets yielding negative returns (after factoring in inflation).

I have included tables for the 25 largest (pct) revisions- Up and Down

TOP 25 UPWARD REVISIONS (90 Days)


TOP 25 DOWNWARD REVISIONS (90 Days)

Google's Valuation Finally Reasonable

Google Inc (nasd:GOOG) $439.16- Google shares have dropped about 40% from its high around $750 due to concerns of slowing growth. Considering the long-term picture, coupled with GOOG shares historically being overvalued, Google’s current valuation is attractive. Google a the dominant player on the internet with a strong competitive position that will provide sustained growth and high margins for many years. In the internet space, Google is a must-own, and finally its valuation is reasonable.

Online Advertising Market Growth:
The internet is still growing in terms of users and usage- More people are spending more time online. Devices such as the iPhone, are contributing to this trend. Online advertising only accounts for 10% of total ad spending. As advertising on the web continues to grow, Google stands to capture a significant amount of expenditures.

TV advertising is facing major battles. Popularity of DVR devices is leading to declines in live viewer-ship as more people are recording content to watch later. It’s very likely that a significant number are skipping through commercials while viewing their recordings. According to an IBM study, 25% of US households own a DVR device, and 53% claim the majority of their TV viewing are recordings.

In addition, the proliferation of available television channels and content has dispersed the audience around the dial. This implies that on any given channel, there are less viewers. Audience dispersion encumbers advertisers seeking a mass audience in a single place (network TV). Declines in TV advertinsing will result in increases in web advertising.

User-generated content, such as videos found on YouTube are boosting web usage. The explosion of blogs, as well as more free content from the media and press are also catalysts. Print readership, newspapers and magazines, is declining, yet readership online is growing. Advertising spending will follow audiences online, and Google is well-positioned to benefit.

Market Share Growth:
Google’s share of online search is more than 65%, while Yahoo, the closest competitor, is only around 20%. Google’s share has been rising, while Yahoo’s has been falling. Google’s search engine is far superior to the alternatives, so much that “Google it” has become part of the English lexicon. As the web continues to expand, search is critical for navigation, thus Google will always be relevant.

Google dominates the paid-search category, which generated high ROI for advertisers. Yahoo has been stumbling for the past few years which has allowed Google to build a sizable lead. The fact that Microsoft is making a bid for Yahoo, is an admission that it can’t compete with Google. I don’t know that buying a company that can’t compete with Google either, will help Microsoft. I believe that the merger discussions are a distraction for both, and are giving Google the opportunity to further increase its lead.

Google’s growth potential is just not limited to paid search. Implementing ads in YouTube videos presents another avenue for growth. The acquisition of DoubleClick will boost display advertising revenues. In addition, Google has been experimenting with online applications for software as a service (SaaS) possibilities.

Valuation:
According to Yahoo Estimates, Google is expected to earn $19.98/share for FY08 and $24.91/share for FY09. Google trades at 22x and 17.6x FY08 and FY09 EPS, respectively. A 22x multiple is attractive considering the growth potential and its duration. Google is highly profitable, with operating margins over 30% and a net margin around 25%.

In comparison, Amazon’s multiple is 46 and Yahoo is trading at a 60 multiple. Google is more profitable, and I believe has better growth prospects than the two.

My discounted cash flow model returns a fair value of $537. Sales are assumed to grow 25% per annum for the next five years, then for years 6-12 growth steadily decreases to 3%. Operating margin assumption is 30% for the next five years then decline to 18% in the next 7 years. I believe these are conservative assumptions and suggest that Google is undervalued by almost $100.

One caveat, is that current earnings estimates may be too high, thus Google’s actual multiples are higher. While this might make Google less attractive, I think the focus should be on Google’s industry position, industry growth and duration.

Risks:
A significant risk is that Google will squander shareholder value by making poor investments. Google is actively exploring multiple new forms of growth, which can be both positive and negative. Firms must take risks to create value; however, taking the wrong types of risks can be detrimental.

Summary:
Google’s strong brand and dominant position in search guarantees strong growth and profitability for many years. Online advertising will continue to increase, and Google is well positioned to capture those ad dollars. Google’s valuation is attractive, 22x this years estimated EPS given 28% growth. Even if Google’s growth turns out to be less than expected, the length of time that growth will be above average, will be longer than expected. This is primary point that the market is missing.

Do Low Multiples Mean the Market is Undervalued?

S&P 500 is trading at low price multiple to expected earnings, 13.7 according to WSJ. The historical forward P/E has been in the range of 14-16, depending on how far you look back. With interest rates incredibly low, 3.88% on the 10-year, should make the fair-value multiple even higher.

According to my calculations, the S&P 500’s mean P/E = 14.2 and median = 13.2. Thirteen companies were excluded due to negative earnings. The highest P/E was 90, and only ten firms had multiples greater than 30. The chart shows the frequency distribution of the individual firm’s P/Es constituting the index.

So is the market cheap? The low price multiples suggest that it is.




The Consensus estimates point to a strong recovery. According to Thompson, Analysts predict earnings to jump 15.3 percent this year.

In my opinion, that magnitude of growth is wildly optimistic. The Market isn’t buying it either. It’s not that the market is cheap, it’s that investors believe consensus estimates are too high. Why do I think that? Because if the market had full confidence in the forecasted numbers, I doubt the market would trade at these multiples. Hence, investors are pricing in lower earnings than the consensus forecasts thus making multiples higher.

The most probable outcome will be downward revisions to the earnings estimates. It’s possible that some of the consensus numbers are stale, meaning analysts have been slow to update them. This seems plausible given the current environment of uncertainty, and the inherent lack of visibility, may delay updates to estimates. In some cases, analysts may be waiting for a clearer picture going forward, or updated guidance from firms before making revisions to this and next years’ full year estimates.

Another possibly is that the required rate of return investors demand from equities rose, the “Equity Risk Premium.” This implies that the Market perceives increased risk inherent in the equity markets. This seems plausible since volatility has increased relative to years past. Higher perceived risk leads to higher demanded returns which compresses price-earnings multiples.

In my opinion, stocks are not as cheap as forward multiples suggest. Earnings estimates are too high and are likely to come down. In addition, the ERP has increased pinching multiples. However, if the economic slowdown begins to appear less severe as the Market is expecting, then stocks would be rather cheap. That would mean that analysts are not overestimating future earnings. However, given the turmoil in the housing market and the relationship to consumer spending, it’s likely the coming quarters will be weak.

Starbuck's Valuation: A Few Thoughts

Starbuck’s Coffee (nasd: SBUX)- Discounted Cash Flow Valuation: $23

Starbuck’s stock has been getting a beat-down for more than a year already, down more than 50% from the $ 40 high reached Nov ’06. In the past few months, SBUX fell from the $ 26-28 range where it was treading water all summer into the fall. Now, trading around $18, SBUX is still not cheap. Applying a discounted cash flow model gives a fair value estimate of $23. 

Even though fair value exceeds current price by a decent amount, the margin of safety is too small given Starbuck’s negative momentum and expected near-term weakness. However, for a long-term investment horizon (10yr+), I believe SBUX can be bought here. However, Starbuck’s may have rough time in the near-term.

Last August, I placed a value on SBUX of $35 /share. SBUX announced it is scaling back store additions for the coming year, thus I slashed my sales growth forecast resulting in the steep drop in valuation. Projected 5 year growth rate assumption decreased from 18% (aug) to 14%. The other input assumptions really didn’t change, just the revenue growth projection. Read SBUX: Long-term Hold

The last 5 years, SBUX sales growth averaged 23.5% fueled primarily by new store additions. Starbucks cut its previous forecast for 2008 new stores from 1,600 to 1,175 (US), plus mentioned closing 100 or so underperforming locations. The company is forecasting ’09 US store additions of less than 1000. Slower/less growth in Starbuck’s store count translates into less revenue in future periods.

Fear of slowing growth is the main culprit to Starbuck’s stock price slide. Concerns that a slowing economy will materially affect SBUX might be discounted in the share price, but SBUX is well insulated and recessions are short-lived events. Stocks are valued over a long-time horizon, at least 50 years. Worries about McDonalds giving SBUX a run for its money are laughable. Yes, MCD may negatively impact Starbuck’s growth, but only slightly, if at all. I believe that new store expansion has been too aggressive, causing cannibalization of store traffic. Aware and addressing this issue, Starbuck’s is scaling back store openings. Read SBUX Face-off

Foot traffic at comparable stores declined (or was flat) for the past several quarters, leading me to suspect sales cannibalization. Some geographies likely became over-saturated, thus a new store takes traffic from an existing, causing weak SSS comparisons. Surely, some customers who constituted the sales at new locations had visited a SBUX in the previous year. Take a person who had 20 store visits last year. This year that customer returned 10 times to that location, but also went to newly opened store on other ten occasions. That’s where the foot traffic is going, to the 1,800 stores opened this year. Read SBUX Cannibalization

Last fall, management maintained saturation played no part in declining foot traffic as concerns rose. The Reduction to planned store openings is an admission that cannibalization is becoming an issue. On the last call, the CEO said they were slowing down store additions to avert sales cannibalization of existing locations. So, it is problem, the primary problem, not the MCD noise or economy fears.

I think SBUX still has significant growth potential, albeit at a slower pace. SBUX still has some room to grow domestically and plenty of room internationally. Management needs to be more deliberate about expansion, instead of shooting from the hip putting stores any & every where.

Starbuck’s generates high returns on capital and equity. Usually competition and market forces drive returns down to a more normal rate, yet Starbuck’s possesses a very strong competitive position that will keep returns above normal for a considerable time. These factors underlie premium multiple that investor’s have placed on SBUX.

Examining Starbuck’s market valuation from price/earnings vantage point also suggests that shares are fairly-valued. Maybe slightly undervalued, maybe. Certainly not undervalued or cheap by any means.

SBUX is trading at 19x Sep FY earnings and 16x next year’s estimate. Using ValueLine and Nasdaq.com for estimates years farther out, I calculated my 5-year growth rate projection of 15%, not 19% analyst consensus estimate. 13-15% growth may not warrant a 19 multiple, but given ROI and the persistence of growth and competitive advantages, SBUX trades at a reasonable multiple. Interest are very low too, making a case for higher P/Es.

One area of concern is the downward trend in revisions to EPS estimates, which may portend even more downward revisions.

Earnings Estimates and Revisions:


Starbuck's Historical Data:


SBUX Valuation: Discounted Cash Flow Model

Valuation Analysis: Apple vs Amazon

In performing a valuation study on Amazon.com and Apple Inc. it is evident that both stocks are priced with high expectations for growth and profitability. Both trade at high P/E multiples; that doesn’t automatically signify that the two are overvalued as long as solid justifications for the high multiple can be ascertained. Decomposing the value assumptions (expectations) which are implied by the current share price, an understanding of future performance required to support the share price can be obtained.

I evaluated Amazon and Apple and made some comparisons with respect to P/E multiples and DCF model valuation. I concluded that Apple’s current valuation is reasonable based on input assumptions I believe are sensible given historical performance and growth momentum. Amazon, on the other hand, I determined it’s overvalued primarily due to my operating margin assumptions.

The key underlying factor implied in Apple’s market valuation is the continuation of rapid growth and stout margins for many future years. This attainable, in my mind, given Apple has already demonstrated the capability to create new products and attract customers. Amazon’s market value hinges in the expectation that margins will expand. Amazon has yet to prove that it can boost margins consistently for years now. Until Amazon exhibits consistent improvement in its margins, I will use historical op margins of 4% in my valuation assumptions. Without rising profit margins of at least 6%, AMZN is overvalued.

Relative Valuation- Price/Earnings Multiple
APPLE:
Apple ($185) currently trades around 37x 2008 consensus EPS estimate of $4.97. On the surface, it’s a pretty rich multiple, yet in reality, Apple’s multiple is lower when taking account of a couple issues.

First, Apple always provides very conservative guidance. This is no secret; Wall Street adjusts its earnings estimates in response to management’s low-balling, yet Apple still manages to mightily exceed the consensus earnings number. Hence, history suggests that one should assume that future estimates are too low. AAPL has averaged 32% earnings surprise for the last four quarters, and for the last 2 years, earnings came in approximately 25% higher than estimates on average. Those figures don’t account for the revisions during the months leading up to an earnings announcement. In the past 2 months, Apple’s 2008 full year estimated earnings were revised upward about 13%, and we still have almost a whole year until 2008 earnings are released. Actual 2008 earnings might possibly be 10-30% higher than the current consensus estimate.

Second, EPS is an accounting measure based on accruals not actual cash received by the firm. Apple’s special accounting treatment for its iPhone spreads revenues over a 24 month period even Apple receives cash for the device sale up-front. Thus, the cash pouring into Apple pockets is recorded as deferred revenue on the balance sheet. When taking into account “cash earnings” opposed to accounting earnings, EPS would be somewhat higher depending on the level of iPhone sales / deferred revenue accruals.

In sum, investors pay a multiple based on their earnings expectations, not necessarily on the publicized consensus estimate- a whisper pro-forma estimate that adjusts for accounting issues and conservative guidance, Hence, for relative purposes, there’s a strong case for saying AAPL trades at lower P/E, possibly in the low 30’s.

Apple’s growth has been extraordinary the past couple years. Assuming that this will continue, a 30ish price multiple is likely justified. On average, analyst project 23% earnings growth annually for the next 5 years which produces a PEG ratio less than 1.5 (using a 33 multiple). Apple’s earnings have grown 150% the past 5 years according to Yahoo.

AMAZON:
Amazon ($90) trades 56x its $1.61 FY08 estimate. Historically, AMZN reported EPS has been in a close range of the Street’s estimates, except for a couple of blow-out quarters. Thus, no clear, consistent earnings pattern exists to assume that estimates are too high/low. Amazon’s sales figures have been fairly consistent, but its profit margins are volatile. Amazon’s multiple 56x multiple is likely realistic.

The 5 year projected growth rate for AMZN is about 23% making the PEG greater than 2. That’s expensive but if you believe that margins will expand significantly then growth will be much greater and consequently AMZN shares less overvalued.

Discounted Cash Flow Valuation: FCFF
APPLE:
According to my DCF model the fair value of AAPL shares is $175 versus recent market price of $185. The input assumptions are fairly aggressive: expectations for sales growth and operating margins to maintain their strong momentum for many years going forward. The model uses 22% annual revenue growth for next 5 years, and for years 6-12 annual growth transitions from 15% to 5%.

Sustaining high annual growth rates becomes increasingly difficult due to the law of large numbers. Revenues only have to increase by about $5 billion to equate to 22% growth rate next year, yet in year five, a $11 billion annual sales increase is required to attain 22% growth. Apple will need to attract new customers in larger and larger increments to generate the level of expected sales implied by the share price.

Key Point: To justify Apple’s current share price, margins and sales growth must remain strong for a considerable period of time. Apple has significant momentum in its favor: massive brand power, innovative product design, and a strong portfolio that leverages individual products to boost demand of other products (“Halo Effect”). Apple products receive very high customer satisfaction, almost seeming every new user of Apple products end up loving them. However, there is a possibility that much of the low hanging fruit has been picked, and attracting new customers will be more difficult if they are not pre-disposed to adopting Apple’s products.

Conclusion: I am more confident than not, Apple will/can match these expectations. Yet, I am not completely confident Apple will meet or exceed the price-implied growth/profitability expectations. In my opinion, expectations are neither too high/low to assert comfortably that shares are over/under-valued. In essence, AAPL is fully-valued and to assume otherwise would entail prophetic guessing, in my opinion.

AMAZON:
Amazon’s intrinsic share value is $60 based on the DCF model compared to $90 market price. 5-year expected annual sales growth is 24%, then transitions (7yr) from 21% to 5.5% starting in year 6. Input assumptions for operating margins hold steady @ 4% during the 12-year horizon. I believe achieving high sales growth levels will not be a problem for AMZN. Amazon Margins are the primary factor behind the discrepancy between market and model values.

Key Point: Amazon shares are priced on expectations for margin expansion in future years. Amazon’s operating margins have shown significant volatility in past periods, and the firm has yet to demonstrate it can attain above 4% consistently.

Amazon must offer discounted prices to generate revenue. Since many retailers sell the same products, competition is based on price. Competitors with the lowest cost structures can offer the lowest prices, thus business strategy revolves around attaining economies scale and cost efficiencies. Amazon sales have increased 100-fold in ten years but the operating leverage and cost advantages have not been so robust, as one would naturally expect.

In order to avoid price competition, Amazon must differentiate its offering. Amazon has been working to accomplish this, yet the increases in R&D spending shaves margins. The hope is that the high R&D expenditures will materialize in fatter profit margins as AMZN diversifies its revenue streams.

Conclusion: We have yet to observe solid evidence than Amazon will be able to boost margins above levels for the average retailer. Investors have been expecting that to happen, and management says that it will, but until then I am skeptical.

Summary:
Both firms have lofty expectations to live up to, but Apple has the hot hand as of now. That’s not a secret, hence the reason AAPL is trading at a high multiple. Amazon is very rich at its current share price, but historically investors have been patient, and I don’t foresee a major drop in the share price in the near-term. If higher profitability doesn’t eventually come to fruition at Amazon shares will definitely come under pressure.

I don’t expect stock returns to be above normal for both Amazon and Apple in the coming quarters due to all the good news and the high expectations currently reflected in their share prices. But, both are terrific companies and If I owned them I wouldn’t want to sell them. In the long-run both should do well.

I do not have a position in any of the stocks mentioned.