I believe that some of the market's most prominent tech stocks, particularly Apple (AAPL, Financial) and Facebook (FB, Financial), still appear cheap compared to their growth potential. In a previous article, I concluded that these companies offered significant margins of safety in terms of the discount to estimated fair value. In this article, we will be taking a look at one other important reason why I think these companies are undervalued: customer attachment, i.e. the "stickiness" of their business models.
Sticky customers
Anyone who has used Facebook or an Apple product will know how difficult it is to leave these platforms. Other technology companies such as Microsoft and Alphabet's Google (GOOG, Financial) (GOOGL) have constructed valuable ecosystems for customers, particularly enterprise customers. These valuable ecosystems mean the cost of switching platforms is relatively high. However, there is no emotional attachment.
Facebook and Apple are different. Both products allow consumers to store their memories, which introduces an emotional attachment. Consumers are more likely to stay with a product if leaving means they have to give up photos in the case of Apple or contact with certain friends in the case of Facebook. This emotional attachment makes it easier to value these businesses, in my opinion.
The most important factor of a discounted cash flow analysis is cash flow. One must have some idea of how sustainable a company's cash flows are in the long run. Only then is it possible to estimate a company's intrinsic value based on free cash flow. In my opinion, Apple and Facebook's emotional attachments increase the chances that both of these companies will still be generating cash five or 10 years from now. So how does this factor into valuation?
Working out a value
Starting with Apple, over the past 10 years, the group's free cash flow has grown at a compound annual rate of 16%.
Using a discount rate of 1.34%, the rate on the 10-year Treasury at the time of writing, the GuruFocus DCF calculator suggests the stock could be worth $628 with a long-term growth rate of 16.2%. I think that seems a bit optimistic. Over the past five years, free cash flow has grown at a compound annual rate of 8%. Using this lower figure, the DCF calculator throws out a value of $232 per share.
To build a margin of safety into the equation, I want to use a higher discount rate. Doubling the discount rate and using the same growth rate gives a fair value of $199 per share. Meanwhile, halving the growth rate provides a value of $128.
These figures are notable because the fair value estimate is only 13% below current levels when the growth rate is cut in half. An average of these numbers suggests a fair value of $163.50 per share. Even this estimate implies Apple is cheap at current levels.
With Facebook, a similar pattern appears. Using a discount rate of 2.6% and a long-term free cash flow growth rate of just 50% of the company's five-year average of 22%, the DCF calculator gives us a fair value of $562 per share.
Cut the growth rate in half again to 6%, and the fair value estimate falls to $319. That is only 13% below current levels. A blend of these two highly conservative figures provides a fair value estimate of $441.
These figures show that even when using incredibly conservative growth estimates and discount rates, Facebook and Apple still appear cheap compared to their long-term potential according to a discounted cash flow analysis, despite their recent performances.
