We think the company’s stock is overvalued, but at the same time, we suggest we trust the market. We tell you how much Apple is worth and how interesting its securities are to invest in.
Fair share price
There are various ways to assess the company’s investment potential. One of the working and certainly useful options is fundamental analysis and multiples. Using Apple as an example, let us try to apply some basic approaches and see if our estimates coincide with the market.
In our opinion, Apple stock is now overvalued and we do not invest in it for this reason. But that, as they say, is solely our problem. The market itself does an excellent job of valuing companies based on the current consensus forecast for future cash flows.
Assuming we have a DCF model compiled jointly by all financial analysts, we get a fair price for the company at the current market value.
The DCF model is a discounted cash flow model. It helps to determine the fair share price benchmark, the return on investment. In other words, to know the value of the asset, taking into account the discount rate. Discounting is the reduction of future payments to an equivalent amount in the present.
If you’ve done your analysis and see very expensive valued stocks, there’s likely a good reason for it, and your understanding of “expensive” in the context of those stocks doesn’t match reality.
True, on rare occasions, the market is wrong. To understand who is closer to the truth (our estimate or the market’s estimate), let’s try to justify the current value of Apple shares and at the same time see how they are valued by analysts from major investment banks.
There are three fundamentally different ways to determine the fair value of Apple stock (or any other company):
- DCF or multiples;
- valuation by parts (SOTP);
- Apple’s valuation as a service company.
DCF or multiples.
Since we do not disagree about the future growth rate of Apple’s business (about 7% in the long term), the DCF-model is not useful for us. We can limit ourselves to multiples.
Apple by multiples looks frankly expensive: at the same level as Amazon and higher than Microsoft, Alphabet, and Facebook, despite the most modest growth rates in this group. If we take the EV/EBITDA multiple, the level of 16 looks fair. Apple, on the other hand, is valued at 20x next year’s EBITDA, which means it is overvalued by 20%.
Sum-of-the-parts (SOTP) is the process of valuing a company by figuring out how much its divisions, businesses, would be worth if they were spun off and bought by another company.
Apple has two fundamentally different businesses: products and services. Apple will make about $250 billion next year on product sales, or just under $100 billion in gross profit. Technology equipment manufacturers with growth rates on par with Apple’s product segment are now worth about 9x gross profit, so this segment can be roughly valued at $900 billion.
It turns out that about two trillion of Apple’s current estimate (1.9 trillion) comes from services. How fair is this? Next year, services will bring Apple about $60 billion, and the long-term growth rate is about 15%. This segment is easy to compare with companies of the caliber of Microsoft, Adobe, Salesforce, and ServiceNow: they have a comparable growth profile and level of profitability.
These companies are valued at an average of 13 EV/Sales, and Apple’s service segment, it turns out, is valued at almost 17x Sales. That’s not a huge premium, especially since for the entire company, the revaluation turns out to be around $200 billion, or just over 10%.
Apple as a service company
Apple has a very high level of user loyalty. The renewal period of iPhones should stabilize in the long term at four years (now it is slightly above this mark, but probably will go lower again due to the emergence of 5G). This gives us grounds to consider all of Apple’s revenues as service revenues, and to consider the purchase of a new iPhone as a kind of subscription.
Let’s take Netflix, the most famous company that sells its services by subscription, as a benchmark. The standard for its valuation is $1,000 per user, based on the projected number of subscribers in 2025 (that is, at the point when the growth rate of subscribers will drop to 5%). Even with the gradual increase in subscription costs, Netflix users will be paying the company about $150 a year.
Apple, on the other hand, earns an average of $300 a year per user, of which it has a billion, which means it can expect a valuation of $2,000 per user (we assume that Apple, unlike Netflix, has already achieved a user growth rate of around 5% per year), or two trillion dollars for the entire company, which is almost identical to the current valuation.
Estimating a stock’s fair value should include an element of creativity. Optimally, when all three methods of analysis produce similar results. It’s not good when you’ve valued the stock two ways and ended up with, for example, $100 and $200.
Now let’s look at how Apple stock is valued by sell-side analysts. To begin with, even though the consensus for Apple is generally positive, it is not as optimistic as for other technology stocks: 60% recommendations to buy, 30% – neutral, and 10% – sell.
The main method of evaluation is the target P/E value. At the same time, those analysts who give a neutral or negative recommendation estimate the fair P/E at the same level as the market (for example, Goldman Sachs and Barclays).
However, most analysts give Apple a P/E premium to the market of 10-20%. Among them are Credit Suisse, Citi, Deutsche Bank, JPMorgan. That said, the basis for the premium seems a bit of a stretch:
- start of a new renewal cycle (acceptable);
- stable financial position (doubtful: it is no more stable than that of other tech giants);
- increase in the share of services in the revenue structure (doubtful: the service component in software companies is present in an even greater proportion).
Here it is interesting to remember that before 2019, Apple was valued at a discount to multiples, justifying this by the cyclical nature of the business.
Some analysts value Apple by the sum of its parts, as in our example above. They are Morgan Stanley and Wedbush (authors of the highest Apple targeting). We like the SOTP valuation better than other ways, so the experts at these financial firms have taken a step forward, although you could say about the analysts at Morgan Stanley that they made up for it by taking two steps backward.
- First, they chose completely irrelevant groups to compare Apple’s product and service businesses. For Product, they used multiples such as HP (0.5 EV/Sales, 18% Gross Margin, 0% Sales CAGR) and Microsoft (10 EV/Sales, 68% Gross Margin, 11% Sales CAGR) and even Peloton (10 EV/Sales, 46% Gross Margin, 30% Sales CAGR). For Services, the peers were Twitter, Snapchat, Tencent, Spotify, and Netflix (okay with the last two, not with the first three).
- Secondly, Morgan Stanley’s analysts took the current multiples for their peers to estimate Apple’s targeting, while their colleagues have one of the highest targets for Microsoft (15% higher than the current price). If you take a group of peers to estimate targeting, you should not take the current prices, but the targeting multiples for these companies.
- Apple stock can be called overvalued, but only slightly. In general, for a cyclical company at the beginning of a new strong cycle, some overvaluation is acceptable.
- Given the current multiples premium (and the fact that Apple is valued based on target multiples), further outperformance relative to the market is only possible if future earnings forecasts increase.
Which could lead to higher projections:
- Increased market share (unlikely, but Huawei’s problems could help);
- Decrease in smartphone lifespan (may well happen now, but will probably go back to four years in the future);
- increased monetization of users through accessories and services (there is room for maneuver here even relative to current expectations, but not everything depends on Apple).
What’s helping Apple stock now might start playing against it after a while. Even if we do see a new super-cycle of smartphone upgrades, it will come to an end at some point. At that point, the good old discount to multiples will return to Apple stock.
Even though Apple’s investment story is primarily about smartphones and services, there is room for new products or services among the drivers of share price growth (in the long term). The current valuation suggests that the market is not currently pledging any value for these options.
What those options could be: a new device, its search engine (a Google competitor), strong streaming growth. You can also add booming sales growth in India to the list of options. This idea is not new, but it is not believed in because of the low standard of living in this country.