It wasn’t long ago when Apple became the first $1tn company on Western stock markets in 2018.
At the time of writing, Apple has a market value of $1.92tn, and has recently become the first company to breach the $2tn mark.
Apple is undeniably a great company – and you could reasonably make a case that the iPhone has been the most important consumer product this century. But can it possibly be worth that much?
Can Apple really have doubled in value again in just two years?
Apple return (including dividends)
Past performance is not a guide to the future. Source: Refinitiv Datastream, 10/09/20
We’ve recently written an article where we take a closer look at Apple’s revenue and where the money’s coming from. In this article we’ll be focussing on Apple’s valuation and whether the numbers stack up.
Our articles are not personal advice. If you are unsure, please seek advice. All investments fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future.
Read more about Apple’s revenues
The Fundamentals
When valuing a company, a good place to start is revenue and free cash flow. Free cash flow is the amount of cash generated by the business, after any capital investment in property, plant and equipment. It’s a measure of the amount of money available to pay dividends or invest in growing the business. The free cash flow margin is just the percentage of revenues that end up as free cash – a bit like a profit margin.
The chart below shows how Apple’s cash generation has varied over time.
Apple's fundamentals ($m)
Past performance is not a guide to the future. Source: Refinitiv Eikon, 10/09/20
A few things jump out. Revenue grew quickly until 2015, after which growth has been much more sluggish. In 2016 both margins and revenues fell. While growth has returned more recently it hasn’t been as fast as pre-2015, and margins have not recovered. As a result, free cash flow has stalled in the (still eye watering) $50bn to $60bn range.
Valuing Apple – historic metrics
One way to assess the price you’re paying for a company is to compare its current valuation to its historic average. This tells you whether you’re paying more or less for a business than past investors.
A common approach is to look at a price to earnings ratio. However, we’ve chosen EV/EBITDA. It’s a very similar idea, but adjusts for the cash on Apple’s balance sheet. EV stands for ‘Enterprise Value’ and is the market cap minus net cash. EBITDA is a rough and ready measure of cash flow and stands for ‘Earnings Before Interest, Taxes, Depreciation and Amortisation’.
Apple has around $92bn in net cash and marketable securities. That’s quite a lot of petty cash, so it makes sense to adjust for it to get a better sense of how investors are valuing the actual operating business.
We’ve written some explainers on EV and EBITDA if you want to find out more. But in this case it doesn’t really matter which metrics you use because the story is pretty much the same either way.
Apple's historic valuation
Past performance is not a guide to the future. Source: Refinitiv Datastream, HL 10/09/20
Apple is currently more richly valued than it has been at any point for the last 10 years. And by a long way. The green line shows the 10 year average valuation. The blue lines show + or – one standard deviation, which is a statistical measure of the variation in the data. What matters is that Apple has spiked way outside its historic range.
You get a similar result using other metrics like a price to earnings ratio or price to book ratio.
The graph also shows Apple’s valuation has been on a strong run since 2016, momentarily reversing at the start of 2019 and earlier this year with COVID. Both times Apple fell alongside the broader market. It looks like recent growth has been even faster, but that’s largely an illusion – the overall pace of the valuation change has only moderately increased.
It’s worth noting that the recent increase in valuation has come after the strong revenue and free cash flow growth, not alongside. Remember, sales and revenue grew fastest in the years before 2015, while the share price has only really taken off in the years since then.
Are analysts expecting explosive growth?
For Apple’s valuation to make sense one of two things need to be true. Either, Apple was significantly undervalued in the past or the company’s prospects have greatly improved in the last few years.
So are analysts expecting explosive growth in the next few years?
In the three years ending in September 2019 Apple’s revenue grew by 4.8% a year, and analysts are expecting 5.5% growth in the three years ending September 2022. Cash profits (EBITDA) grew 2.0% in the past 3 years, and are expected to grow 4.4% in the next three.
That’s hardly earth shattering.
However, analysts are expecting a certain kind of revenue to grow.
Service revenue, from the App Store and Apple Music etc, grew 17.4% in the last few years and is expected to grow 10% a year in the next three. This could be interesting as service revenue tends to be reliable and high margin. Investors might be attaching more value to this revenue stream than the traditional hardware sales.
Other valuation approaches
There are lots of ways to value companies. Above we’ve used multiple based approaches, which compare some measure of a company’s price to a relevant underlying profit or revenue figure. A good example is the price to earnings ratio. Another method is called a ‘Discounted Cash Flow’ valuation, or ‘DCF’.
To do a DCF valuation an analyst makes forecasts for a company’s cash flows and then uses a formula to convert these back to their present value. This gives an indication of what investors should be willing to pay for future earnings. DCF valuations are theoretically attractive, and don’t rely on comparisons with the past or with peers.
However, DCF valuations are only as good as the analyst’s forecasts. They’re often a great example of ‘garbage in garbage out’, as by tweaking the forecasts and assumptions they can be made to spit out any ‘value’ you like.
Even with taking that into account, the exercise is often still worth doing. It forces you to be explicit about your expectations for a company, and can give a useful sense check when you use it with other methods.
Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU, teaches valuation and has written several books on the subject. Conveniently, he also did a DCF valuation for Apple on 20 August 2020.
Damodaran’s forecasts for Apple reflect his view that “The iPhone continues to be the profit engine, allowing the Apple cash machine to churn on, but Apple finds supplementary growth in its service and entertainment businesses.”
Based on his forecasts for Apple, which are slightly ahead of the consensus expectations shown above, Damodaran found Apple to be overvalued by about a third on 20 August 2020 (the shares are down about 5% since then).
So, is Apple worth $2tn?
Apple is a great company, and it looks likely to continue generating prodigious amounts of cash for the foreseeable future.
But even the best business can be a poor investment if you pay too high a price.
Apple is currently valued more richly than it has been at any time in the past 10 years. Analysts are not forecasting explosive growth, although high margin service revenue is expected to become ever more important.
It’s entirely possible that Apple was seriously undervalued five years ago. We take this consideration quite seriously, as at one point you could get Apple shares for just 10 times earnings.
On the whole though, Apple’s valuation looks stretched to us.
But it takes two views to make a market. Plenty of investors obviously disagree with us and think Apple’s current valuation is attractive enough to add it to their portfolio. Your own view will depend on what you think of Apple’s prospects.
Will Apple be able to protect its margins against ever fiercer competition? Will services generate more growth than currently expected? Will competition lawyers clip Apple’s wings? Are Apple shares relatively less risky because sales have been secure?
No one can say for certain, but your judgement will be based on your answers to these kind of questions.
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Unless otherwise stated estimates are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments and income they produce can rise and fall in value so investors could make a loss.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.
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