The Federal Reserve Board last dropped its federal funds rate to an unprecedented zero amid the Q4 2008 housing bust and credit crisis. From there, Federal Reserve and Treasury officials were to add the terms Troubled Asset Relief Program, Operation Twist, and Tapering to the American financial lexicon. In summary, Federal Reserve officials would be purchasing government bonds on the open market, in order to stimulate the domestic economy.
Interestingly, William C. Dudley, Federal Reserve Bank of New York President, has already admitted, “We don’t understand fully how large-scale asset purchase programs work to ease financial market conditions.” Last December, the Federal Reserve still announced that it would be tapering its monthly bond-buying program by $10 billion to $75 billion.
Over the past eighteen months, Apple (NASDAQ:AAPL) stock was to establish an all-time high at $705.07, on September 21, 2012, before promptly reversing course and descending to a multiyear nadir of $385.10, on April 19, 2013. From there, Apple was to rally sharply off its low to close out the January 21, 2014 trading session at $549.07. The recent volatility in Apple shares may have been the result of Federal Reserve policy and rhetoric. Traders often leverage low interest rates to speculate. The Apple brand, however, has emerged as somewhat of a proven commodity as its ecosystem matures and growth rates slow.
Calculating Apple’s Fair Value
A back-of-the envelope fundamental analysis would indicate that Apple shares now trade for far less than fair value. Apple closed out its 2013 fiscal year ended September 28 with $146.8 billion in cash and investments on the balance sheet. Activist investors, such as Carl Icahn, have suggested that Apple return this cash hoard back to shareholders, as returns on cash reserves are all but nil with the federal funds target rate at zero. Apple has responded to this concern with an ambitious pledge to return $100 billion back to shareholders via stock buybacks and dividends by the end of 2015.
In the near term, Apple’s $146.8 billion in liquid assets were more than enough to cover the $83.5 billion in total liabilities on the Apple balance sheet. The balance sheet did list out $10.1 billion in deferred revenue over top of 899.2 million shares issued. The $10.1 billion in deferred revenue will ultimately be counted as revenue and fall off the balance sheet.
Apple managers therefore operate with the luxury of at least $73.4 billion, or roughly $80 per share in net liquidity, at their disposal. To estimate fair value, this $80 amount will be added to the value of Apple’s future cash flows. This discounted cash flow model will assume ongoing 3 percent growth alongside 10 percent risk-free rates on 10-year U.S. Treasury bonds. Cash flows will therefore be discounted at a 7 percent capitalization rate (Value of Future Cash Flow = Cash Flow / 10 percent interest rate — 3 percent growth.)
For the 2013 fiscal year, Apple generated $53.7 billion in cash flow from operations. This performance alone, when capitalized at the aforementioned 7 percent rate, is worth $767.1 billion. Apple would then be worth an estimated $840.5 billion, after adding $73.4 billion in net liquidity to this discounted cash flow model. This estimate breaks down further to an approximately $900 per share fair value. This estimate leaves Apple with the potential for 67 percent upside returns from current levels.
At $549.07 per share, Apple trades for a relatively meager eleven times current earnings after backing out the net liquidity on the books. For the sake of comparison, Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG) trade for 13 and 33 times earnings, respectively, after posting significantly slower five-year growth rates than Apple. Meanwhile, Facebook (NASDAQ:FB) currently trades for 130 times earnings, after having acquired Instagram for $1 billion and posting a $3 billion bid for messaging application company Snapchat. Both Snapchat and Instagram have yet to close one sale, let alone turn a profit. Wall Street traders also value Amazon (NASDAQ:AMZN) at $180 billion. Amazon banked a mere $34 million in net income off $48.9 billion in sales, through the first nine months of 2013.
Federal Reserve officials may consider a revision in prevailing thought. The asset buying has resulted in cheap capital flooding the most speculative positions on Wall Street. This latest technology bubble has largely been inflated at Apple’s expense. Traders have been falling all over themselves to uncover “the next big thing,” instead of parking money at Cupertino, where executives wax poetic in regards to stock buy backs and dividends. Alan Greenspan may refer to this action as Irrational Exuberance 2.0.
The Apple Brand
Going forward, only a Black Swan event or complete collapse in future earnings may jeopardize long-term Apple shareholder returns. Be advised that the iPhone and iPad platforms now account for more than 70 percent of total net revenue at Apple. Competitors have largely been unable to challenge Apple’s alpha position within the mobile space.
Legendary investor Warren Buffett may describe the Apple business model and its walled-off ecosystem as operating from behind a moat. Shareholders may also take solace in the idea that Kurt Badenhausen and Forbes Magazine already identified Apple as the world’s most valuable brand, for the third straight year heading into 2014. In his November 6, 2013 piece, Badenhausen calculated that the Apple brand itself was worth $104.3 billion. Going forward, Apple shareholders can leverage this goodwill for long-term gains, as the market returns to mean. The Apple playbook remains to combine functional technology alongside minimalist art. The Apple Way connoting chic quality translates into pricing power. Throughout weak employment figures, consumers have happily paid fat premiums to remain part of Apple’s “in crowd.”
A September 25, 2013 report out of research firm IHS iSuppli presented bill of materials and manufacturing estimate costs of $218.30 for the 64GB iPhone 5S. Apple’s fully loaded handset retails for $849.00 In the aggregate, Apple raked in 37.2 percent gross profit margins and 30.6 percent return on equity through 2013. The Apple mystique has surpassed that of Nike (NYSE:NKE) Just Do It. Two generations of youngsters have lined up at stores to purchase the latest editions of Michael Jordan’s shoes. Now, this Apple brand caters more so to a more established crowd that has demonstrated its feverish willingness to spend cash on near annual updates of an entire product line. Indeed, the Cult of Mac is a fitting description for this movement.
Silicon Valley operates amid a hyper accelerated business cycle of growth, maturity, and ultimately, bust, before new products are brought to market. To best manage prospective risk versus rewards, investors can build out an Apple stock position with small, weekly purchases, and dollar-cost averaging through 2014. Apple stock does maintain technical support at $520, but may quickly break down towards $480, if and when share prices drop beneath this key psychological barrier.
Apple shareholders, of course, can collect upon a 2.3 percent dividend yield while waiting for this investment to recover. Apple management does operate with the financial wherewithal to offer a one-time, special dividend. Paying out a special dividend would signal that the iPhone and iPad platforms are both moving towards maturity. At that point, investors can expect Apple stock to perform as a quasi utility that tracks the S&P 500 and offers annual dividend and stock buy back increases, at worst. Again, Apple has pledged to return $100 billion in capital back to shareholders by the end of 2015.
Apple stock is still a solid, long-term investment. For now, Federal Reserve Board policy has distorted the marketplace and the valuations of its most speculative position.