Historically High Valuation Portends An Underwhelming Decade For Apple (NASDAQ:AAPL)


Source: quora.com

Introduction

Apple’s (AAPL) shareholders have been handsomely rewarded in 2020, with the stock registering year-to-date gains of ~55%. This move highlights precisely why Apple is a stock to own and not to trade. To that end, “Buy The Dip” is a time-tested investment strategy for Apple. As I will demonstrate, tip buyers have done very well for the past 10-20 years. At the start of September, Apple made new all-time highs before declining by nearly 20%. So, naturally, you may be wondering, “Should I buy the dip in Apple?”

In this article, we will look at the historical results of a “buy the dip” strategy and re-evaluate Apple using a sum-of-parts analysis. I have previously evaluated Apple’s Wearables and Services segments as standalone businesses; however, I will provide a fresh valuation today.

According to my sum of parts evaluation, Apple is worth $108 per share, i.e., the stock is currently overvalued. As the expected returns are only marginally greater than my investment hurdle rate, I am opting to stay on the sidelines for now and recommend my readers to avoid the temptation to buy this dip. Read on to find out the price at which Apple should be bought aggressively.

Ultimately, we will answer the question: “Is Apple facing a lost decade due to its massively inflated valuation relative to historic norms? Or is this the time to buy the dip?”

Past Success of A “Buy The Dip” Strategy

Over the last two decades, buying Apple on a ~15-20% correction has been a very, very successful investment strategy, as evidenced by the graph below:

Source: YCharts

After making an all-time high of $137.98 on 1st September 2020, the stock has retreated by around 15-20% over the last month. Hence, if the historical pattern is anything to rely upon, investors should be buying Apple right now. However, I am not convinced about buying Apple at this moment in time because its valuation remains stretched (even after the correction), and the projected returns are only marginally above my investment hurdle rate.

As can be seen below, Apple has not seen its current valuation since (the chart doesn’t illustrate this) the release of the iPhone in the mid-2000s. Furthermore, aside from the period during which the iPhone was released, Apple has never been valued this richly.

Source: YCharts

Not only does this not bode well for investors in the QQQ and SPY, to which Apple contributes a significant amount of change in value, but also it should give investors in Apple significant pause in blindly buying the dip.

According to Investopedia, there are around 630,000 publicly-traded companies on earth. To that end, it’s okay to be very skeptical of Apple’s valuation at this stage, as it’s certainly not the only game in town.

Next, let’s get into Apple’s valuation.

Valuing Apple Using Sum Of Parts Methodology

Since Tim Cook assumed the leadership of Apple nearly nine years ago, the company has made significant progress in evolving the fundamental pillars of its business. In recent years, Apple has been diversifying its revenues away from a stagnating traditional product lineup (iPhone, iPad, Mac) towards high growth Wearables and Services segments.

Now, Wearables and Services make up a significant portion of Apple’s business, and they are expected to be the primary drivers of future revenue (and free cash flow) growth. Additionally, the company now has a handful of very important verticals, and therefore, in order to truly assess Apple, we must value it from a sum of parts perspective, so as to wash away the potential diversification discount it’s receiving presently.

To estimate the fair value of each segment (traditional products (iPhone + Mac + iPad), Wearables, and Services), I will leverage my proprietary valuation model, with which many of you are already familiar. For those of you who have not yet seen it, here’s specifically what it entails:

  1. In step 1, we use a traditional DCF model with free cash flow discounted by our (shareholders) cost of capital.
  2. In step 2, the model accounts for the effects of the change in shares outstanding (buybacks/dilutions).
  3. In step 3, we normalize valuation for future growth prospects at the end of the ten years. Then, using today’s share price and the projected share price at the end of 10 years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.
  4. In step 4, the model accounts for the effect of dividends.

Let’s apply it.

Defining The Parts

Apple’s trailing twelve-month disaggregated revenue is as follows (in millions):

Source: Created by Author using Apple’s 10-Q and 10-K

Now, let’s take a look at the reclassification of these revenue segments and certain assumptions for each of those business segments.

TTM revenue (Billion)

FCF Margin Potential

TTM FCF Per Share

FCF Growth Rate 10-Yr

Price To FCF At Yr-10

Traditional Product Lineup (iPhone + Mac + iPad)

$192.863

20%

$2.21

5%

20x

Wearables

$29.264

25%

$0.42

15%

20x

Services

$51.730

40%

$1.19

15%

30x

Notes related to the assumptions above:

  • Apple’s gross margin profile shows that it commands a product margin of ~35% and services margin of ~65%. Hence, the variation in FCF margin potential for Traditional Product Lineup (20%), Wearables (25%), and Services (40%).
  • The common shares outstanding utilized in TTM FCF per share calculation are 17.42 billion.
  • The FCF growth rate assumptions come from long-term guidance provided by Apple’s management.

Valuing The Parts And Projecting Expected Returns

After defining the conservative cash flows that could be generated from Apple’s individual business segments, we can easily value these segments and project the future share price (10-yr) using my digitally coded model.

Below is a summarization of our results. Alright, so based on our assumptions, Apple’s fair value is $108.33 per share or $1.887 trillion. Now, to derive the total expected return we will first grow the FCF per share of each business segment with their corresponding growth rate assumptions from the previous section, and then multiply the results with the assumptions for Price to FCF ratios, thereby generating a 2030 share price target.

According to these results, Apple’s stock could be worth $313 by 2030. Hence, if an investor were to buy at today’s price of $115, he/she could expect to generate a price CAGR return of ~10.53% over the next decade or so from share price appreciation alone.

However, we know that Apple is a dividend-paying stock, and hence, it is important to analyze the total expected return after accounting for its dividend payments. Currently, Apple has an annual dividend of $0.82 per share, and I expect the company to maintain its cash dividend payout ratio at ~20%. Here’s the result for total expected return:

Source: L.A. Stevens Valuation Model

As you can see, Apple’s total expected CAGR returns without and with reinvestment are 11.02% and 11.27%, respectively. Since this return is only marginally higher than my investment hurdle rate of 9.8% (which is the 90-yr annualized return of the S&P 500), Apple is currently a hold for me, as it won’t dramatically outperform the market. However, if a broad market correction takes Apple down into the 90s, I would be buying the stock for my dividend growth portfolio.

Concluding Remarks

I view Apple as approximately General Electric (NYSE:GE) in the mid-20th century, in that I believe it has many decades of fruitful growth and shareholder prosperity ahead of it.

With that being said, Apple has become an obvious winner in the eyes of many market participants, such that its risk has become very low, and therefore, its returns have become commensurately low.

Key Takeaway: I rate Apple a hold at $115 for anybody looking to outperform the market by a wide margin and a buy for dividend growth investors.

As always, thanks for reading; remember to follow for more stock ideas; and happy investing!

Beating the Market: The Time Is Now

There has never been a more important time in stock market history to buy individual stocks at the heart of secular growth trends. Mature market performers/underperformers and index funds simply will not cut it, as we face a decade during which there is absolutely no guarantee the overall markets will rise.

This is why the time is now to discover high-quality businesses with aggressive, visionary management, operating at the heart of secular growth trends.

And these are the stocks that my team and I hunt, discuss, and share with our subscribers!

Disclosure: I am/we are long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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