Sunday, January 27, 2008

Is Apple a Bargain?

After the recent fall in price of AAPL, which I suffered from (but only with a 25 share position - my initial position in any single industrial stock is roughly 1% of net worth), you might think that AAPL was overvalued and saw a fall back to reality or perhaps it still has a way to fall. After all AAPL has a trailing PE of 28 now at the current price and so it was much higher at the recent peak in prices. Analysts are forecasting growth of 22% next year and in the next five years.

However, the correct way to value a company is based on the discounted sum of future free cash flows - cash earnings minus the investments required to maintain and grow earnings at the forecasted pace. If you need to reinvest earnings in order to grow them then you can't as an owner spend those earnings and they shouldn't count towards your valuation of the company. Only those earnings that could be paid out or used to buy back shares without jeopardizing the company's growth should be counted. When you dig into the cashflow statement of many companies you quickly find that the net free cash flow is close to zero or at least much lower than earnings. Take SBUX for example. Operating cash flow in the most recent year was $1.3billion but capital expenditures were close to $1.1billion. The difference - free cash flow was around one third of the $672million earnings number. This is why I won't buy Starbucks as an investment.

But as the table above shows, for AAPL, operating cash flow in the most recent year was $5.47billion and capital expenditures were only $735million. The $4.735billion in free cash flow exceeded the $3.496billion in stated earnings. AAPL is currently valued at 24 times that free cash flow. I wouldn't say that was a bargain, but for a growing firm it is not bad. It is a lot better than a whole lot of other growing tech companies out there. Some analysts play further games with AAPL's earnings by taking out the huge cash stash the company has ($21 per share) from the share price and generating a lower P/E on the remaining earnings. You couId do this with free cash flow too, I guess, though this always seems a convoluted justification for a high share price to me.

BTW don't worry about the "investments" in the investing cash flow section. These are just "short-term investments" if you look at changes in the balance sheet. Apple hardly does any acquisitions so these aren't an important factor in doing a cash flow analysis.

Please criticize this analysis. Maybe I'm completely offbase?


Andy said...

I think Apple will be a good buy in the next few months. Just suffering with the rest of the tech sector. I am taking a bit hit on Google...

Great blog - just discoverd it. I am an Aussie expat in the US so in a similar position you were in. I write about pf and investing at my blog Finance Viewpoint . I'll include a link to yours in my blogroll and subscribe.


mOOm said...

Cool - what part of the US are you in? I'll add you to the blogroll.

Andy said...

I am from the DC google nightmare got worse today. I should stick to the ASX...smaller market, less volatile.