Key findings

• Apple’s estimated fair value is $240 based on 2-step free cash flow to equity

• With a share price of $221, Apple appears to be trading close to its estimated fair value

• The analyst price target of $238 for AAPL is 1.1% below our fair value estimate

Today we’ll run through a valuation method that can be used to estimate the attractiveness of Apple Inc. (NASDAQ:AAPL) as an investment opportunity. We do this by projecting future cash flows and then discounting them to today’s value. Our analysis uses the Discounted Cash Flow (DCF) model. Before you think you can’t understand it, just keep reading! It’s actually a lot less complex than you think.

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one valuation metric among many and is not without its flaws. For those who enjoy stock analysis, the Simply Wall St analysis model presented here might be of interest.

Check out our latest analysis for Apple

Is Apple fairly valued?

We use a two-stage DCF model which, as the name suggests, considers two phases of growth. The first stage is generally a higher growth phase that stabilizes toward the terminal value captured in the second “steady growth” stage. First, we need to obtain estimates of the next ten years of cash flows. Where possible, we use analyst estimates, but when these aren’t available, we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate over this period. We do this to take into account that growth tends to slow more in the early years than in later years.

In general, we assume that a dollar today is worth more than a dollar in the future. Therefore, the sum of these future cash flows is discounted to today’s value:

Estimation of free cash flow (FCF) over 10 years

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 1.2 trillion US dollars

The second period is also called the terminal value. This is the company’s cash flow after the first period. For various reasons, a very conservative growth rate is used, which cannot exceed a country’s GDP growth. In this case, we used the 5-year average of the 10-year Treasury bond yield (2.5%) to estimate future growth. In the same way as with the 10-year “growth” period, we discount future cash flows to today’s value, using a cost of equity of 7.3%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = $227 billion × (1 + 2.5%) ÷ (7.3% – 2.5%) = $4.9 trillion

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 4.9 trillion US dollars ÷ ( 1 + 7.3 %)¹⁰= 2.4 trillion US dollars

The total value is calculated by adding the next ten years’ cash flows plus the discounted terminal value, which gives the total equity value, which in this case is $3.7 trillion. The final step is to divide the equity value by the number of shares outstanding. Relative to the current share price of $221, the company appears roughly fairly valued at an 8.1% discount to the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s better to consider this a rough estimate that isn’t accurate to the last cent.

Important assumptions

The key inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. If you don’t agree with these results, try the calculation yourself and play with the assumptions. DCF also doesn’t take into account the potential cyclicality of an industry or a company’s future capital needs, and therefore doesn’t provide a complete picture of a company’s potential performance. Since we’re looking at Apple as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC), which takes debt into account. In this calculation, we used 7.3%, which is based on a leveraged beta of 1.158. Beta is a measure of a stock’s volatility relative to the overall market. We get our beta from the industry average beta of globally comparable companies, with a set limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT analysis for Apple

Strength

weakness

Opportunity

Danger

Next Steps:

Valuation is only one side of the coin when building your investment thesis and ideally shouldn’t be the only analysis you look at for a company. DCF models are not the be-all and end-all of investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows differently or its cost of equity or risk-free rate changes significantly, the outcome could be very different. With Apple, there are three relevant aspects to consider:

1. Risks: Take risks, for example – Apple has 2 warning signs In our opinion, you should be aware of this.

2. management:Have insiders been adding to their shares to capitalize on market sentiment about AAPL’s future prospects? Read our management and board analysis with insights into CEO compensation and governance factors.

3. Other solid companies: Low debt, high returns on equity, and good past performance are the foundation of a strong company. Check out our interactive list of stocks with solid business fundamentals to see if there are any other companies you may not have considered!

PS. The Simply Wall St app runs a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks, just search here.

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This Simply Wall St article is of a general nature. We comment solely on the basis of historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.