Saturday, February 20, 2010

Is Apple Really the Fourth Most Valuable Company in the United States?

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Upon glancing at the top holdings in the SPDR S&P 500 ETF (SPY), I must admit I was very surprised to see that Apple Inc. (AAPL) was the fourth most heavily held company in the index. Smack between Proctor and Gamble (PG) and Johnson and Johnson (JNJ), as I looked at the list I started to wonder whether the assumptions behind AAPL's valuation might be a little rosy.

To do this analysis, I used the financial information from Apple's most recent 10-K to build a discounted cash flow valuation model. My goal was to see whether the assumptions built in to AAPL's stock price were realistic. After really digging in to the numbers I feel confident that Apple, especially with a one year target price from analyst estimates of $248.33, is in a bubble.

Looking At the Numbers

From a price to earnings perspective, Apple (at 19.64) is somewhat overvalued. Exxon Mobil (XOM) trades at a P/E of 16.56, Microsoft (MSFT) at 15.85 and Proctor and Gamble (PG) at 15.11 (these are the only other companies in the S&P 500 more highly valued than AAPL). If one were to take an average of these three, and infer from this Apple's stock price, one would get a price of $162.68, $38.99 less than what it closed at on Friday.

But price to earnings ratio comparison would be a ridiculous way to value Apple, since obviously its shareholders believe there is still some growth to be had for the company. To see what these growth assumptions are, I projected out through 2015 a balance sheet and income statement for Apple and then did sensitivity analysis with a discounted cash flow to see how operating profit margins and sales growth rates impacted the company's valuation.

>To schedule out the balance sheet, I looked at Apple's ratio of either the various line items to sales or the line items to cost of sales from 2008 and 2009. I then used the average of these two ratios to infer the future values for the line items. While this is a relatively simplistic way of doing this and will no doubt not occur as projected in reality, I wanted to see how Apple would perform if they ran the company much like they have been doing in the recent past.

Looking at Apple's income statement, I tied R&D as a ratio to sales based on recent historical levels and cost of sales based on an operating profit margin. Looking at Apple's recent history, it becomes quite apparent that this company has been immensely profitable and successful based on its extremely high operating margins (40% in 2009) and robust sales growth, with 34% in 2008 and 13% in 2009.

For my DCF valuation, I just did a simple 10% discount rate. Looking at the sensitivity analysis, it becomes quite evident that Apple's future valuation is pricing in consistently strong sales growth and operating margins:

Based on Apple's current market valuation, it appears as though the market is presuming that Apple is going to maintain operating profit margins of 40% in perpetuity and that sales growth would be 14-15% next year tapering off to a terminal growth rate of 4% in 2015.

Since I thought that 40% operating margins in perpetuity was a little much, I looked at what would happen if it tapered off to a terminal level. In my opinion, I feel like it'd be very difficult to constantly stay ahead of the curve and provide products that were just so downright amazing so as to justify a 40% operating profit margin for the life of the company. To find this terminal rate, I took Dell's operating margin from their most recent 10-K and added 5% for good measure:

The valuations under these assumptions are no where near that of the market, which leads me to believe that this stock might be in a bubble.


Of course some of the assumptions I used in this model were a bit simplistic and if I had a little more time I could go in to more detail, but from my simple analysis I feel comfortable saying that the market has absurd expectations for Apple. Does this mean that I don't think Apple is a great company? Of course not. But I do feel like it's overvalued right now, and the analyst estimates seem downright ridiculous, putting it at a market capitalization of $225 billion one year from now.

When the very best case scenario is what seems to be driving the stock price I think it's time to look for greener pastures.

You can download my model below and play with the numbers if you like.

AAPL DCF Valuation


  1. like you, it seems like most these days are bearish.

  2. Why do you use a 10% discount rate? Rates are extremely low right now with 10yr TSY yielding 3.79%. I think 5% is good, 7% extremely conservative. That discount rate should cause AAPL's numbers to look more reasonable.

  3. @the dog: You're right that rates are really low right now, but looking out in to the horizon, the yield curve gets much, much steeper.

    While typically you'd take the risk free rate for the term of the investment and then add in the equity premium multiplied times the beta of the stock, the proper premium to use is highly debatable. Because of this I just used a simple 10% discount rate.

    I did leave my model so that you can go in and plug in any rate that you want as the discount rate, so if you want to you can download it and play around with it.

    Thanks for the comments!