Apple ‘Should’ be Valued on a P/FCF Basis

A few of my readers have asked me to valuate, and place price targets on shares of Apple, Inc. (Nasdaq: AAPL). I continue to be quite cautious about publishing such an analysis for a number of reasons. First, a shrewd day trader once told me that issues touching on whether and when to buy, sell or hold a stock should be left to the individual investor to consider with their own professional financial advisors. My goal as a financial journalist is to contribute certain thoughts and insights which might help investors form their own opinions as to the merits of different investment strategies—it is not my purpose to make such recommendations in and of themselves.

Secondly, giving price targets is always good in theory but fatal in fact. And the fact of the matter is Wall Street always seems to be preoccupied with some "looming disaster." Whether it's the rising price of oil, the credit crises, the inflation bogey-man, the slowing economy, the housing correction or the fictitious recession, Wall Street continuously hyper-inflates relatively minor issues and wallows in the inconsequential. This naturally paves the way for irrational decision making by "Wall Street's finest" not to mention the added bonus of wild market volatility. The endless stream of pandemonium underlying Wall Street's psyche makes it difficult for any reasoned analysis to navigate its way to the frontal cortex of institutional investors, and makes it even more difficult to give price targets within any reasonable range of confidence.

Furthermore, Wall Street has the habit of designating the narrow concerns of a particular sector as being the concerns of every stock in the entire market. Apple might as well have been called Apple Financial, Inc. for the month of January as Wall Street was dead set in believing that Apple was in the primary business of trading mortgage-back securities—or at least that's the impression it gave observers when it sold Apple off to the tune of 42% in one month. Tech stocks have slid as much as 15% in 2008 due to a credit crisis that has nothing to do with the tech sector. The tech bellwethers actually reported phenomenal earnings this past quarter demonstrating solid fundamental growth. Yet, tech stocks such as Google, Amazon and Microsoft are all down significantly since January—Apple is down 7.97% in 2008 despite posting a 45% yearly growth rate as of June 30, 2008 (and that's with the subscription accounting for the iPhone).

The bottom line is, who the heck knows what Wall Street will be concerned about a year from now not to mention which irrelevant sector's troubles it will attribute to Apple in the 2009? Given Wall Street's general unpredictability, it seems almost naïve to give price targets notwithstanding the market's fascination with the absolute. Apple could be trading at $150 or $250 a year from now depending on the market's conditions at the time.

That being said, I think something can be taken from the theoretical modeling of stock valuation. Stock prices trade on their own fundamentals in bull markets and trade on the market's fundamentals in bear markets. Keeping this concept in mind, valuation models should always contemplate a variety of different potential market conditions.

Furthermore, as a practical matter there is really only one way to valuate stocks in this particular market—the P/E method. While it is obviously not the most intelligent method used when it comes to valuating Apple, it's by far the most widely applied. While it is clear to any knowledgeable analyst that Apple ought to be valued on a price to free cash flow basis (P/FCF), many market participants continue to focus on Apple's GAAP-based net income and P/E multiple in determining Apple's valuation. Just yesterday, Mathew Ingram writing for Seeking Alpha notes, "From a stock point of view, Apple's shares are trading at higher multiples than Google's in most cases (price/earnings ratio, price to book value, etc.) but Google's profitability exceeds Apple's, with a profit margin of 25 per cent to Apple's 15 per cent, and an operating margin of 30 per cent to Apple's 19 per cent."

Financial writers continue to focus on Apple's P/E and write about it on a daily basis. Even analysts who should know better still remain transfixed on Apple's P/E: Steve Biggs, CFA at Zacks.com writes, "At its current price of $175.27 per share, Apple's stock is trading at 33.9x our fiscal 2008 estimate of $5.17. We set our six month price target at $184.00. This represents a P/E multiple of 35.6x our fiscal 2008 estimate, which is still a premium to the industry, but more accurately reflects the current outlook."

This analysis is plainly problematic. By saying that Apple is trading at a premium to the industry is to say that Apple's P/E is comparable to other companies similarly situated in the industry. Nothing could be further from the truth. Many of these other companies in the industry record all of their revenue from their primary operating activities (while Apple does not). Thus, Apple's P/E is not comparable to other companies similarly situated in the industry. Yet, this doesn't stop Larry Bellehumeur from making such comparisons. Bellehumeur, choosing to focus on Apple's P/E rather than its P/FCF, calls Apple's valuation "expensive" when compared to others in the industry.

The subscription method of accounting for the iPhone makes Apple's P/E artificially higher due to the fact that the iPhone's deferred revenue mechanism has the effect of lowering Apple's net income on a GAAP basis—thus causing the P/E to rise on the artificially lower EPS. In the "real" world, Apple has actually received about $2 billion in revenue from the iPhone over the past year that it has completely "deferred" and not recorded on a GAAP basis when arriving at net income—that's $2 billion "missing" from Apple's income statement.

One of the most intelligent, detailed and well-written articles on Apple's valuation over the past month was published by Turley Muller concerning the issue of valuating Apple on a price to free cash flow basis. Muller writes, "I believe investors have become overly fixated on Apple's expected accounting income, while ignoring Apple's impressive free cash flow generating ability. Free cash flow, not earnings reported in the accounting statements, determines the true value of a firm."

A slew of articles have been written on the subject by the more enlightened on Wall Street. Stephen Coleman, a known Apple bull and founder of Daedalus Capital in St. Louis, recently published an article entitled Replacing P/E in Valuating Apple Stock. Coleman writes, "The price earnings multiple (P/E) is an increasingly useless metric when valuing Apple Inc.'s (AAPL) stock price"; further noting that "Apple's stock price is cheap, if you use CGM as your valuation metric," rather than the P/E multiple.

I completely agree with Muller's and Colman's analysis on Apple's stock valuation. Yet, I still think that Wall Street will continue to focus on Apple's P/E as long as the market is bearish, or until Apple's deferred revenue and cash generation have become so large that it can no longer be ignored. Yet, Apple investors should view this as a positive rather than a negative. The analysts who tend to focus on Apple's P/E are the same individuals who tend to overlook the future financial impact of the iPhone's deferred revenue system, and offer way off the mark consensus estimates.

The fiscal 2009 consensus estimates on Wall Street are so off the mark that it's almost comical. Analysts are generally looking for Apple to earn a mere $6.05 in EPS on $40.43 billion in revenue in 2009—growing at a relatively meager 16.12% over 2008. That's well below my expectations of about $7.50 in EPS on $43 billion in revenue. I expect that by Apple's fiscal Q2 2009 earnings report, one of two things will occur: (1) Apple's conservative guidance for fiscal Q3 will be well above consensus estimates leading to the first comprehensive blow out of earnings when it reports next April, or (2) Analysts will "wisen-up" after reviewing Q1 results and significantly raise their consensus estimates with consecutive upgrades. Either way, Apple's stock price should benefit from analyst revisions or earnings blowouts in 2009. By that time, investors could reasonably expect to see the general shift in Wall Street's valuation of Apple. Yet, I do not expect Wall Street to change its general attitude towards Apple until well into 2009.

Disclosure: Andy owns 2009 and 2010 call options in Apple. The information contained in this article is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.