I have recently been exploring the valuations of technology stocks. Even though these have been some of the best-performing investments to own over the past 10 years, certain companies still appear relatively cheap on some metrics.
That's not saying the entire technology sector is cheap. I do not think that is true at all. I think some parts of the industry are incredibly expensive and in bubble territory. But that is not true for every company in the technology sector.
Valuing tech stocks
I think Apple (AAPL, Financial) is a perfect example of an undervalued tech stock. Some investors might look at this company and think it is expensive. After all, the stock is up 442% in the past five years. However, looking at a stock price's recent performance alone can produce misleading conclusions.
If I take a step back and look at Apple without having made any prior conclusions, a different picture emerges. I favor Warren Buffett (Trades, Portfolio)'s favorite method of valuing stocks: to review the cash flow discounted at an appropriate rate for perpetuity.
Using a discount rate of 4% and a long-term free cash flow growth rate of 5%, the Gurufocus DCF calculator suggests the stock has a fair value of $123.30.
However, I think these are highly conservative numbers. With the 10-year treasury rate sitting at 1.2% as of the writing of this article, one could argue that a discount rate of 2% to 3% would be more appropriate. What's more, I think a long-term free cash flow growth rate of 5% is also conservative. With the company's competitive advantages and strong customer ecosystem, it could have the ability to hike prices and continue growing its customer base in the coming years. In my opinion, a long-term free cash flow growth rate of 10% is more acceptable.
Using a discount rate of 3% and a long-term free cash flow growth rate of 10%, the Gurufocus DCF calculator suggests the stock has a fair value of $238.29. That's a premium of nearly 39% to the current price.
It's not just Apple that appears cheap on these metrics.
Using a discount rate of 3% and a long-term growth rate of 10%, the DCF calculator suggests Facebook (FB, Financial) could be worth $476.88 per share, an increase of 25% from current levels, while Microsoft (MSFT, Financial) could be worth as much as $315.96, which is 10% more than its current value.
Of course, there is one caveat to all of the above, and that is the idea that each one of these companies can continue to grow at the proposed rates. I think there is an excellent argument to be made that they can. All of these companies have substantial competitive advantages, high profit margins and returns on invested capital. They also benefit from network effects and customers are relatively sticky. Anyone who has had an iPhone for an extended amount of time will know how challenging it can be to change devices. It is also challenging to move away from Facebook and Microsoft's offerings. These competitive advantages are the reasons why I believe all three companies can continue to report double-digit free cash flow growth rates.
Another potential challenge is that of interest rates. Interest rates are incredibly low at the moment. If they begin to rise in the years ahead, the valuation models will need to be revisited for tech stocks with high amounts of debt. Still, the figures above appear to show that these companies remain undervalued despite their impressive performances over the past 24 months.