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Tuck Into Apple

Posted: Nov 25, 2008 09:39 AM by Ben McClure

Tickers in this Article: RIMM, NOK, AAPL

Tech stocks have taken a wholesale pounding in the recent market selloff. Investors, dumping stocks indiscriminately, haven't given nearly enough thought to what they are selling. With its rock-solid balance sheet and underappreciated earnings and cash flow, Apple (Nasdaq:AAPL) deserves more credit. (Learn about the components of the statement of financial position and how they relate to each other in Reading The Balance Sheet.)

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No iPresents Under the Tree
Of course, in today's fragile market, no stock is a sure-fire bet. That includes Apple. The computer device company relies on spending by consumers and businesses. Scary credit conditions and skepticism about the economy are bound to translate into weaker sales of Macs, iPods and iPhones. It's not obvious whether cash strapped consumers will treat Apple's nifty gadgets as essentials or as something to put off buying for another time. Indeed, sales this Christmas season could be much slower than the last one.

Even so, I'd say the selloff in Apple stock is overdone. In 2008, Apple's stock has fallen by more than 53% as of market close November 24. That's more than the Dow (-36%), the S&P 500 (-42%) and the Nasdaq (-44%), leaving shares of this superbly managed company trading too low.

When you consider the amount of cash that Apple has in the bank, Apple's share value seems unreasonable. Take away the company's $24.5 billion in cash and liquid investments from its $83 billion market capitalization, and the market gives Apple an enterprise value of about $58.5 billion or $65.80 per share.

In today's shaky economic environment, forecasting revenues and earnings growth with much precision can be a bit a of a mugs game. So, let's say Apple does not grow its earnings from last year's $5.36 per share. That gives Apple a P/E of just over 10 times. Trading at this level, the stock is practically a give-away.

Discounted Cash Flow
If that doesn't convince you, then consider a discounted cash flow model as a reality check - plug-in the share price and, working backwards, calculate the amount of free cash flow needed to justify the price. Assuming a discount rate of 9%, if Apple were to produce free cash of $7.5 billion per year in perpetuity, the stock would be fairly valued today. But, the thing is, Apple produced $9 per share or $8.6 billion worth of free cash in fiscal 2008. (To learn more, read Taking Stock Of Discounted Cash Flow.)

While free cash could certainly fall this year from last year's number, there are reasons to think it won't fall off the cliff. After all, sales of the iPhone, Apple's key revenue driver, grew six fold in 2008. Having recently dislodged Research In Motion (Nasdaq:RIMM) from the top spot in the smart-phone market space and gaining on No. 1 Nokia (NYSE:NOK), Apple has momentum on it side. Meanwhile, this is a company that keeps capital expenditure to a minimum. The company outsources manufacturing, and its major investment is its Apple stores.

Bottom Line
Of course, Apple isn't going to escape a recession unscathed. The stock could fall further given the market's frantic mood. That said, it looks like Apple stock is probably worth more than where it trades today. For investors willing to accept some risk, it's may not a bad time to tuck some away.

By Ben McClure

Ben McClure is director of McClure & Co., an independent research consultancy. Before founding McClure & Co., Ben was a highly-rated European equities analyst at London-based Old Mutual Securities. He also spent several years as a business/technology journalist at the Economist Group. McClure graduated from the University of Alberta School of Business with an MBA.

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