Why Apple Inc. (AAPL) is Worth $80

Jim Cramer thinks AAPL (AAPL) is worth $300 and I think AAPL is worth less than $100. To borrow Jim Cramer's line, 'Where do I get this stuff?' I'll point it back at him and ask, 'Where does he get that stuff'? Perhaps all he did was multiply two numbers? I can multiply two numbers, I have a passion for the markets and I too am opinionated. Can I have a TV show too, please? Jon Stewart, would you like to multiply two numbers? You can do it too. I'll show you how. I'll come on your show and multiply them for you if you like.



Now, just to be clear, I'm not attacking either Cramer or Stewart or their shows. I like watching Cramer, and I like watching Jon Stewart. I like the passion that Cramer has for the markets, but I don't have to agree with all of his stock picks, nor do you have to agree with mine. He'll make some stock picks that he'll get right, and he'll make some that he might get wrong. After all, I think we're doing this to 'entertain and educate'. Stewart, he too does some entertaining and educating (or so I believe). So, let me entertain and educate you just a bit. And if you make money, I'm happy for you, and if you lose money, it's not my fault... this is just entertainment. In fact, probably all of this is B.S. and so don't take anything I say seriously.

A few weeks ago, I was giving an overview of valuation techniques to a student group, and I had decided to demo a variety of valuation tools in the market. So, I'll demonstrate these tools to you as well.

[b]Method #1: What funds own the stock?

Taking a look at the top mutual fund owners of AAPL in MSN Money, I notice that I see a bunch of funds that are called 'index', 'growth', and 'blue chip'. From that first glance, AAPL does not appear to be a 'value' stock, but more of an index, growth and information technology stock. In the top mutual funds, I don't see one fund that is called 'Value'. I'm a 'Value' investor, short AAPL.

[b]Method #2: Some key 'Value' ratios.

Generally (but not all the time), value stocks tend to have a low PE, a low price/book and a low price/cash flow. Utilizing FactSet, I found a PE of 34, a price/book of 6.9 and a price/cash flow of 17.5 for AAPL. Now, the weighted median PE in the market is around 17, price/book is at 3 and the price/cash flow is at 11. All three ratios are higher than that of the market. From that perspective, short AAPL.

[b]Method #3: The Dividend Discount Model (DDM)

I generally do not like the DDM model, as it places an emphasis on dividends. But, I need to mention it as it is commonly used. I read a paper the other day by Richardson, Tuna and Wysocki called "Accounting Anomalies and Fundamental Analysis: A Review of Recent Research Advances", and in it, they asked practitioners, "What valuation method do you use?" and in 5th place at 26% of users, they list the DDM model. Now Bloomberg has a DDM model, and I've noticed that although most stocks that I try don't pass this test, if something passes it, then it's probably a value stock. So, I typed 'AAPL Equity DDM' and it gave me a default target price of $209.



At first glance, it looks like the model and the street are at an agreement. There is a huge problem in this argument, because valuation models depend a lot on the terminal growth rate. In this example, it assumes that AAPL will grow at 18.8% FOREVER, and that gives the target of $209. If I assume that AAPL will grow at 22.7% forever, that gives a price target of $300 (Cramer thinks it's worth $300). Personally, I'll assume that as time goes on and 'forever' occurs, I'll assume the company grows at a growth rate similar to that of the GDP, and so when I enter 5% as the terminal growth, I get a price target of $54. Short AAPL.



[b]Method #4: The Residual Income Valuation (RIV)

Bloomberg also has a model called the RIV model in its system. To get it in Bloomberg, type 'AAPL Equity RIV' and the default price target for AAPL is listed as $94. By including the EPS for the next period, I get a target price of $114. In both cases, the stock is worth less than $300 or even $200. Short AAPL.

[b]Method #5: The AFGView Model

My favorite quick valuation method is through The Applied Finance Group's AFGView.com. You can certainly read about it atwww.economicmargin.com. From personal experience, if the stock doesn't pass this test, it's not a value stock. Mind you, sometimes I'm wrong and this is just an opinion. Anyways, if I take the default assumptions, and assume the default of a competitive advantage period of 21 years and a discount rate of 7.68%, I get a price target of $114 for AAPL. Short AAPL.



I can get a price target of $300 for AAPL, but I need to assume a discount rate of 6% and that AAPL will dominate (AAPL fans rejoice) for the next 35 years. Now, when I run models, I like to use a discount rate of 8%, and I'll assume that AAPL has a competitive advantage over its peers of 10 years. That gives me a price target of $64. Short AAPL.



[b]DISCOUNTED CASH FLOW MODELS

Analysts spend a lot of time trying to figure out the EPS for this period and the next, but the power in the DCF model does not come from the short term, but the long term. If an analyst does a DCF model, many will focus in on the EPS estimates, but ask them these 4 key questions (and you might be surprised by their answers). If they don't have an answer, but claim to do DCF, think a bit more about their analysis.

What is the time horizon you used? Was it 5, 10, 20 years?

Personally, I like to use 10 years for consistency.

What is the 'discount rate' that you used? Was it 6%, 8%, 10%, 12%?



Personally, I like to use 8% for consistency. Some will argue that it should be higher/lower depending on the industry, but I'll disagree with that as I like to know over time how the valuations change, and know that they changed while I kept some value constant. When I value the discount rate for the market, almost always I get a target between 7% and 9%. So, I use 8%. With regard to AAPL, AFGview gave me a discount of 7.7%, Bloomberg's WACC default model had it at 9.7%, FactSet's WACC default model had at 9.1%, eVal uses a default of 10% and I use 8%. Which one is right? I don't know. I use 8% for consistency.

What is the terminal 'sales growth' that you used? Is it much higher than long term GDP?



Personally, I like to use 5%. Generally I see numbers between 3% and 6%. Anything higher and you better justify the number.

And this question can destroy some of the best valuation models / analysts:

What is the terminal ROE in your model for the company? Why is it so high? Was it historically that high?



In general, if a company is making a profit and you increase the time horizon, lower the discount rate, increase the sales growth and increase the terminal ROE, you can get a very high target price. If you do the opposite, you'll lower the target price. An analyst that wants to be optimistic about a company might actually use a short time horizon, a low discount rate and a low sales growth, but by making a model that has a high ROE they can make almost any company look good. Let me try to demonstrate.

[b]Method #6: The Discounted Cash Flow Model (eVal model)

Using a product called "eVal" by Lundholm and Sloan, I entered AAPL's 10-K and did a bit of analysis. I made a model that had a 10 year forecast and taking the default assumptions that it had, I got a target price of $291 and EPS estimates of $9.35 this year and $11.89 for the next.



But that model had many flaws. Modifying the shares outstanding to reflect the number I see in Yahoo finance and lowering the discount rate to 8% from 10%, I was able to get a stock price of $527 and estimates of $9.27 this year and $11.79 the next year!



Notice, the strength wasn't coming from the EPS assumptions, but from other factors. What was causing the difference? It was primarily the terminal ROE, as it was saying the AAPL would have a ROE of 23.5% forever! Perhaps I would accept that terminal ROE for AAPL, but look at AAPL's history and you'll see that through the years the ROE fluctuates as they innovate and stagnate, innovate and stagnate, and so I'll argue that they cannot maintain that high ROE forever. I'll change the model, so that as time goes on and more competition occurs, their COGS/Sales, R&D Sales and SG&A/Sales will increase, but they'll stay within historical levels and AAPL's ROE will approach that of the cost of capital of 8%. That model gave me a target price of $76 and EPS estimates of $8.01 and $9.36.

Next, I modified the model so that the model reflected the analyst estimates of growth, but that it also reflected the EPS estimates given by analysts. According to Cramer, he argued that analysts would increase their earnings targets as AAPL would change their revenue recognition and EPS would sky-rocket. I'll give a simpler argument... analysts should change their EPS estimates, because the consensus estimate of 30+ analysts missed AAPL by $0.37 last quarter. How 30+ analysts can miss this EPS so badly I'm not sure. Perhaps AAPL is superb? Is there an accounting anomaly? Are the analysts just missing the boat? You do realize that next quarter, if AAPL doesn't beat by $0.37, the stock could drop? According to MSN Money, I note that the highest EPS estimate for 2010 is $7.87 and the highest is $11.04. Presuming that AAPL will beat by $0.37 each quarter, I'll make a model that reflects a model with $9.35 for 2010 and 12.52 for 2011.



I get a target price of $80. Note... by changing the short term ratios, it only moved the target from $76 to $80, the strength of DCF on AAPL is at the terminal assumptions. Once again, short AAPL.



[b]Method #7: The Discounted Cash Flow Model (FactSet template)



FactSet has a cool DCF model as well, and within it I was able to create a similar model and 'justify' a target price between $247 and $292. Again, the results relied not so much on the short term, but on high terminal revenue growth estimates. And if you look a bit closer, you would realize that the price target came from the default assumptions that AAPL would grow at 36% forever! That's not a mistake of FactSet, that's a mistake of the user or the analyst.

Adjusting the numbers, once again I got a price target< $100. Short AAPL.



[b]Method #8: The Quant Model

There are a number of ways to run 'quant models', but to simplify the process it can look like this: Take a bunch of 'anomalies' that are illustrated in academic literature. You can go to websites like www.aaii.com or www.ssrn.com to find such anomalies. Test the anomalies, weight the anomalies, and give stocks a score on how it performs in each anomaly. For example, suppose I create a quant screen (and this is best done in FactSet), and in that quant screen I place a lot of factors relating to value, 'smart money', quality, and momentum. Stocks that appear nice on such a screen can appeal to a wide variety of investors, as I can take the stock and pitch it to a value firm, a momentum firm, a quality firm, and that in turn might lead to more 'investor recognition' which would drive up the price more. Now AAPL has some 'nice' qualities that 'help' the stock: it has low short interest, a decent 'Piotroski Score' (financial health score), earnings momentum and price momentum. AAPL also has some negative qualities that can hurt the stock, as it has a: high PE, high price/book, high accruals, some insider selling and a high fscore (read the paper called 'Predicting Material Accounting Misstatements' by Dechow, Ge, Larson and Sloan). So, there are some good qualities to AAPL, but there are also some bad qualities to it as well, and since I hate to say 'HOLD' as analysts love to do, I'll say.. AAPL... short.

[b]Method #9: Muliply PE * EPS. Hey Jon Stewart, check it out.

Multiply PE * EPS. That's it. Forget everything I told you and multiply those numbers. I hate this method, but it's quite common. In the paper listed earlier, Richardson et al. ask practitioners, 'What valuation method do you use?', and 74% of them look at earnings multiples (59% use DCF)! Wow. It's quite common to hear something like this: "Taking the forward EPS estimates by our distinguished panel of analysts, and multiplying it by the industry PE, we get a price target of $$$". Then, for the next 20 pages, the analyst will discuss how they got the EPS estimate and spend 95% of the time marketing the product. If they don't like the stock, instead of saying 'sell', they might just drop the stock. After all, people don't like to hear about bad news. The problem is, is that analysts sometimes only focus on the EPS estimates now, and they forget to look at the future beyond. Some look at the EPS estimates now as they'll get in the news, and if their estimate matches that of the company, it sure makes the analyst look good. But, how do you do this? A few weeks ago, I was looking at Yahoo Finance and noted that the highest PE listed for AAPL was at 30.37 and the highest EPS estimate was at 8.68.

Price Target: 30.37 * 8.68 = $264.

A few days later, Cramer came on his show and gave a price target of $264. Then, just a few days ago, Cramer came on his show again and gave a target price of $300. Guess what? On the night of his show, I saw the 8.68 and this time the PE was at 34.75.

[b][b]Price Target: 8.68 * 34.75 = $302

Perhaps Cramer did some fancy math to get his target price and deep analysis like I did above with the valuation models, but I was able to get the same result by multiplying two numbers. Who knows what procedure he followed, but I was able to replicate it rather easily.

[b]Here are some common questions I get about AAPL:

[b]Do I hate AAPL?

No. I actually love I-Tunes, I-Phones and I-Pods. It's important to note that although I love the products, it doesn't mean that I have to think the stock is undervalued. I hate it when I see or read stock pitches and 95% of it sounds like a marketing commercial. I'm concerned about numbers, risk, ratios, insider transactions, and earnings. I know the company gets products for a widget, makes the widget, and sells it. If I want to hear a marketing pitch, I'll go to the store.

[b]What about the change in revenue recognition?

As Cramer explains on his show, he mentions that AAPL should have an increase in EPS as they recognize some revenue earlier. Although perhaps true, this confirms one of my beliefs that analysts spend a lot of time on the near term EPS estimates and sometimes neglect the long term estimates. Realize that if AAPL recognizes some revenue earlier, that is revenue they would have announced later, so although it might produce a short temporary jump in EPS, at some point the upcoming EPS should be lower than expected since they won't be announcing the revenue that they would have recognized then (and instead announced it earlier). Also, some companies like to smooth earnings and although I'm unsure AAPL would do this, I don't like seeing EPS numbers that fluctuate wildly.

[b]What about Steve Jobs?

A common argument about AAPL relates to how Steve Jobs is loved by AAPL users and so the stock should go up as he is a creative influence. Fine, I'll agree to that argument, but... if that is true, then what do you think of DIS? Why is it that when DIS announced that they were buying Marvel comics, that I don't remember hearing one interview asking Steve Jobs, "Steve, what do you think of the Punisher character and the image of him carrying a machine gun with Mickey Mouse ears"? Oh, you didn't know... I was looking at FactSet and noticed that Jobs has about $1 billion (0.6%) ownership of AAPL, but he also has about $4 BILLION (7.4%) ownership of DIS. Which company do you think I'd be concerned about if I was him? AAPL or DIS? If you like Jobs, perhaps you should buy the company he has more of, buy DIS. Analysts, next time you talk about Steve Jobs, talk about DIS, please.

[b]Haven't I had bad luck with timing AAPL?



Yes and no. In 2007, I wrote a blog about how I thought AAPL was worth $75 and that blog went on MSN Money when it was trading around $130. The stock shot up $200 and I looked like an idiot. The stock ran down to $120 in 2008 and MSN had an article called "One Who Saw Trouble" and I felt good. Bad luck came around to me, and AAPL flew up to $190 once again, and I felt crappy. It dropped again, but it fell more than the S&P 500 and it came close to my target with a low of $78 - I felt good once again. Now, in the past year, AAPL is up at $200 and again I look dumb. So, yes, I do think AAPL is worth $80, but timing is critical with this stock. I might be wrong, I might be right, but unlike most of the 30+ analysts covering the stock with high target prices, I'll say sell/short to AAPL.

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[b]This is too long. Write shorter sentences.

So, there you have it. Take it as entertainment. Here's an opposing view to the crowded world of analysts who love AAPL. I'm bearish on AAPL, and I think it's worth $80.

Kai Petainen

[www.valueexpectations.com]



ValueExpectations.com, by the founders of The Applied Finance Group and Toreador Research and Trading, provides institutional quality research to the investment community. Select Research Topics Include: Equity Valuation Analysis; Management Quality; Market Outlook and Impact Discussions; Recent Market Movement Reviews; Macro Valuation Trends; Sector Analysis; Political Impact on Markets; and Special Studies. The term Value Expectations is derived from our ability to calculate market expectations embedded in stock prices, sectors and indexes.

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