Financial Market Commentary

So Apple finally had their big revenue and earnings miss on July 24, 2012. What’s an investor to do from here? The following article will take you through a fundamental-oriented analysis and valuation process of AAPL, which has been an incredible value creator over the years. The process will contrast AAPL’s metrics with AMZN’s, a stock whose lofty price has little in the way of a firm foundation. The bottom line is that, in the pre-market action on July 25, AAPL’s stock has declined into a range of fair value. The caveat: This miss is likely to be AAPL’s inflection point — I expect it’s stock price to grow much more slowly from here on for the next several years. AAPL is more likely to join the Dow 30 in the next few years than it is to soar above $700 a share.

As the graph below shows, AAPL’s stock has outperformed AMZN’s and GOOG’s in the past 12 months:

AAPL has grown both Total Revenue and Net Income significantly in the past 5 years. The 3-year compound average growth rate (CAGR) for Total Revenue is an amazing 42%.

Notice that AAPL and AMZN have similar Revenue/Share each year:

Operating  Profits, measured as AAPL’s EBITDA and EBIT, have also grown significantly. The 3-year CAGR for EBIT is an astounding 60%:

Here’s where a value-creator like AAPL begins to separate itself from a “concept stock” like AMZN. AAPL flows a far greater percentage of its per-share Revenue to EBITDA:

And all the way to bottom-line EPS as well:

AAPL’s Operating Margin is not only large, it’s expanded every year for the past 5 years. By contrast, AMZN’s Operating Margin is evaporating, having shrunk to a puny 1.8% for FY 2011:

In terms of Relative Valuation, AAPL’s stock has become more reasonably-priced per dollar of earnings, while AMZN’s rising stock price is not not nearly as well-supported by rising profits:

AAPL’s ROA also expands every year, now topping 20%. AMZN’s ROA fell to 2.5% in FY 2011:

Of course, ROA = Net Profit Margin x Total Asset Turnover. AAPL’s large advantage in Net Margin, shown below:

more than overcomes AMZN’s advantage in Asset Turnover (AMZN sells many more small items at low, and often negative, margins):

Operating Profit and Margin (EBIT) is particularly important because Net Operating Profit After Tax (NOPAT) equals after-tax EBIT. In other words, NOPAT = EBIT x (1 – tax rate). AAPL grows NOPAT per share every year:

AAPL thus earns far more Free Cash Flow/Share than AMZN (Free Cash Flow = annual NOPAT minus any change in Total Capital Invested for the year). Because discounted cash flow analysis values a firm’s stock as the present value of expected future Free Cash Flow, AAPL’s stock price will be far better-supported by fundamentals than AMZN’s (analyzed in greater detail below).

NOPAT is also the numerator of Return on Invested Capital (ROIC), which expresses NOPAT relative to Total Invested Capital (ROIC = NOPAT/Total Invested Capital). AAPL has earned ROIC greater than 100% in the past 3 years, while AMZN’s has fallen to 16%:

AAPL also earns far greater Economic Value-Added per share compared with AMZN. EVA is a measure of economic profit, calculated as NOPAT – (Cost of Capital x Total Invested Capital):

AAPL grows EVA each year. Further notice how AAPL’s Market Value-Added grows proportionately with EVA, suggesting that, despite AAPL’s incredible run-up in stock price, the stock is not necessarily overvalued (more on AAPL’s per-share valuation below):

We will next forecast AAPL’s financial statements and conduct a discounted cash flow valuation (DCF) analysis. The historical values of the key income statement variables are shown in the table below.

AAPL has averaged 41% Revenue growth per year, and grown its margins steadily. To build a margin of safety into the forecasts, we’ll taper the growth rate from 15% down to 3%, and squeeze all of its margins back towards average. (Note that the Operating Margin assumption is particularly important because Operating Margin determines the size of projected EBIT, which in turn affects NOPAT, which in turn affects FCF, the variable we discount in a DCF analysis.)

Other key forecasting assumptions pertaining to AAPL’s Cost of Capital and long-term growth rate are shown in the table below. I’m using a market risk premium over bonds of 6.5% (note the incredibly low 10-year yield of 1.52%, used as the risk-free rate). I also eased back on AAPL’s beta — although their 5-year beta was 1.21 (Capital IQ), their 2-year beta has fallen to 1.01. To keep the resulting valuation conservative, I also use a long-term growth rate of 3.0%, which applies after the first 4 years of growth of 15%, 12%, 10% and 8% shown above. This results in a Cost of Capital for AAPL of 8.7%, which is the discount rate we’ll use in the DCF analysis (to take the present value of AAPL’s projected Free Cash Flow).

The analysis shows that AAPL has been a chronically undervalued stock until recently:

After their after-hours price decline on their earnings miss on July 24, 2012, AAPL is now trading in a range of fair value (based on conservative forecasting assumptions) at $573/share:

The table below shows AAPL’s fair value range for 2011-2012 as $564 to $583 share. Further note the tepid trajectory of future per-share prices, however:

Conclusion: AAPL’s stock has grown fundamentals like EBIT, NOPAT and Free Cash Flow dramatically in recent years. The stock has been chronically undervalued for a significant period, but finally surpassed fair value with its price run above $600/share in 2012. Following it’s earnings miss on July 24, 2012, when the stock price fell to $573/share (8:00 a.m.  in the pre-market on July 25), AAPL’s stock is now fairly-valued, but priced for much slower future price increases (at least price increases supported by fundamentals). Traders may turn AAPL into a high-volatility plaything for awhile, but fundamental investors should wait for entry points below $550 to earn above-average returns in future years. AAPL’s stock is no longer “good at every price,” as investors became accustomed to for most of the last 10 years, so pick your spots carefully. If you’re a seller, expect AAPL to drift lower for awhile before rallying to better exit points.

[All data provided by S&P’s Capital IQ. The author currently holds no AAPL stock.]