Value of Apple Inc Using the Discounted Cashflows Methodology - Example

Value of Apple Inc using the Discounted Cashflows Methodology The Discounted Cashflows analysis has been rated as one of the most powerful tool to not only help value firms, but also to aid in the pricing of the initial public offerings (IPOs) as well as in other financial assets. Luehrman (1998, p. 51) noted that this powerful tool has become so common in finance that it almost forms the backbone of finance. Investment companies, mangers and consultants can’t seem to get enough of this technique making Luehrman refer to it as the “heart of corporate capital budgeting system”. There is no single person who can comfortably sail through the waters of finance while ignoring this technique1. One of its main advantages is the application of the time value of money principle. A principle that has been enshrined and accepted so deeply in finance while other disciplines like accounting still fail to fully acknowledge it. However the facts of time value of money are real and here to stay. In fact, in finance one cannot ignore this concept as it forms a major background for the greatest of the finance concepts. A.M. Wellington, who was a civil engineer, was one of the advocates of the time value of money concept’s importance. He was explaining the importance of matching future cash flows with the cost of up-front investment2. This was further emphasized by a Southwestern Bell engineer, Walter O. Pennell who came up with the present value equations for annuities. He was trying to evaluate machinery and their productivity over a five-year period3. While looking at the performance of Apple Inc, its best that one considers the performance of the market and that of its key competitors in the industry. This is what is known as the industry based Discounted Cashflows. In this case, it would help in the valuation of Apple Inc based on the performance of the industry. Below is an analysis of Apple Inc (AAPL) based on the industry as per GuruFocus (2014)4. Comparable Companies (Assuming the same growth rates and discount rate) Symbol: AAPL HPQ LNVGY NIPNF P/E: 15.40 12.40 58.50 217.00 P/S: 3.31 0.59 0.00 0.28 P/B: 4.63 2.31 4.23 1.03 Price: $ 645.57 $ 33.84 $ 24.57 $ 3.15 Fair Value: $ 1131.61 $ 74.59 $ 44.41 $ 3.42 Margin Of Safety: 43% 55% 45% 8% As Bodie, Kane and Marcus (2011) notes, the performance of the industry should also be considered as opposed to just the individual firm’s performance5. A look at Apple Inc’s performance shows that the firm is doing twice as good as the average industry’s in earnings. Apple Inc’s fair value is positioned at $1131.61, a value that its comparable competitors’ totals cannot even equate to. The fact that Apple Inc is leading in the market shows the possibilities of market share being equally significant. This goes a long way to the valuation of the firm beyond the monetary returns. The same case applies with the effect of the global economy on the company. The way a company performs is pegged on the performance of the global economy which in turn is a product of the various countries’ economies. While looking at the non-discounted cash flows, Bodie, Kane and Marcus notes that business cycles cannot be assumed. Apple Inc is also not an exceptional performer in the business cycles. Some notable cycles are present, especially in the months of June/July as is the case also in the months of October/ November. Such months have been noted to have relatively low returns and in most cases even negative returns. That’s the power of business Cycles which can help a firm in planning for such periods. While comparing the discounting method to the application of the internal rate of return, Samuelson (1937) examined the main differences between the two and concluded that a rational investor would rather use the discounting factor as opposed to the internal rate of return6. While valuing this firm, one of the most cited corporate finance paper will be used, the Miller and Modigliani (1958)7. This paper advocated for the fact that the cost of capital would not be affected by the changes in the debt ratio in a real world. Of course, this is not quite realistic but all the same one can make some adjustment to the figures available to ensure that a similar effect is felt. Financial Statement Analysis One of the most commonly used methodologies of the determination of the expected after-tax operating cash flow in use is the application of the free cash flow to the firm. To determine this, it is calculated as; Free Cash Flow to Firm = After-tax Operating Income – (Capital Expenditures –Depreciation) – Change in non-cash Working Capital. A look at the available data for Apple Inc provides the following valuation. Financial Data of Apple Inc Apple Inc., cost of capital First we determine Apple Inc’s cost of capital using the following data available at Stock Analysis on Net (2014)8.  USD $ in millions, except per share data Value1 Weight Required rate of return2 Calculation Equity (fair value) 556,082  0.97 14.70% Debt (fair value) 15,900  0.03 1.43% = 1.94% × (1 – 26.40%) Total 571,982 1 1 USD $ in millions    Equity (fair value) = Current share price × No. shares of common stock outstanding = $645.57 × 861,381,000 = $556,081,732,170.00 2 Required rate of return on equity is estimated by using CAPM.  Expected Rate of Return   Assumptions Rate of return on LT Treasury Composite1 RF 3.16% Expected rate of return on market portfolio2 E(RM) 13.40% Systematic risk (β) of Apples common stock βAAPL 1.13 Expected rate of return on Apples common stock3 E(RAAPL) 14.70%    Required rate of return on debt is after tax.    Estimated (average) effective tax rate = (26.15 + 25.16 + 24.22 + 24.42+ 28.56 + 29.89) ÷ 6 = 26.40% WACC = 14.33% Apple Inc., free cash flow to the firm (FCFF) forecast USD $ in millions, except per share data   Year Value FCFFt or Terminal value (TVt) Calculation Present value at 14.33% 01 FCFF0 44,590  1 FCFF1 56,951  = 44,590  × (1 + 27.72%) 49,814  2 FCFF2 69,656  = 56,951  × (1 + 22.31%) 53,290  3 FCFF3 81,422  = 69,656  × (1 + 16.89%) 54,485  4 FCFF4 90,766  = 81,422  × (1 + 11.48%) 53,125  5 FCFF5 96,266  = 90,766  × (1 + 6.06%) 49,283  5 Terminal value (TV5) 1,234,865  = 96,266  × (1 + 6.06%) ÷ (14.33% – 6.06%) 632,183  Intrinsic value of Apples capital 892,179  Less: Debt (fair value) 15,900  Intrinsic value of Apples common stock 876,279  Intrinsic value of Apples common stock (per share) $1,017.30 Current share price $645.57 From the above data and calculation, based on the five year statistics available, the value of the firm would be $892,179. This means that it would be okay to purchase Apple Inc for the said value at the moment. Using such data helps in the determination of the value of the firm using the stated projections. This goes into showing the importance of knowing the source of capital for a firm. Where debt capital is used, the interest resultant is high and this leads to a lower FCFF of $876,279. When valuing Apple Inc using the FCFF methodology therefore, its evident that presence of debt capital leads to a lower valuation of the firm. Considerations made in the valuation process of The main advantage of the application of the discounted cashflows methodology is the application of the time value of money principle. This acknowledges the fact that a dollar today is not equal to a dollar tomorrow. Two main reasons for this include the fact that Apple Inc can invest today’s dollar at a risk free interest rate and have something interest and the dollar. The other reason is from the fact that the dollar tomorrow will have already had the inflationary pressure on it already. With the level of inflation already relatively high, Apple Inc would rather have the money today than tomorrow. This makes the discounting factor ideal for one to ensure that the aspect of time value of money is employed9. The nature of the industry that Apple Inc operates is generally volatile, however with the use of the discounted cash flows methods, it is possible to make some certainty out of the uncertain cash flows. This is achieved through the discounting of the uncertain cash flows to certainty equivalents at the risk free rates. These conversions make it easy to work with the said figures. In an uncertain market like that of Apple Inc’s, certainty is not only elusive but unrealistic as well. There is no business that has a risk aspect that one can determine for sure what they are likely to make out so easily. For those with such cash flows, the amounts are usually minimal and thus there is little motivation for investors into such fields. The other consideration or assumption made in the calculation is that the cash flows that were received in the current year, which is $44,590, would grow in a way that is determinable in advance that is at 27.72%, 22.31%, 16.86%, 11.48% and 6.06% respectively over the next coming years. While the determination of such growth is accepted in finance, the exact values are at times subject to discussions which could have an impact on the value of the firm.10 The main advantage with Discounted Cashflows methodology is that the effectiveness of the valuation will depend on the data an individual feeds into the model. When one uses high quality data, the information expected will equally be helpful and high quality. The problem could only arise with the determination of what really is quality data. Works cited Barth, M., W. Beaver and W. Landsman. The relevance of the value-relevance literature for financial accounting standard setting: another view. Journal of Accounting and Economics 31: 77-104, 2001. Bodie, Kane and Marcus; Investments 9th ed. 2011, Irwin/McGraw-Hill (ISBN-13 978-0-07-353070 Copeland, Thomas E., Tim Koller, and Jack Murrin. Valuation: measuring and managing the value of companies. 3rd Ed. New York: Wiley, 2000. Print. Gurufocus. (2014). Screeners:Gurufocus. Retrieved June 9th, 2014, from Gurufocus: http://www.gurufocus.com/dcf/AAPL Luehrmann, T. A. Whats it worth? Harvard Business Review, 135, 1997. Modigliani, F. and M. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, v48, 261-297,1958, Pennell, W.O., Present Worth Calculations in Engineering Studies, Journal of the Association of Engineering Societies. 1914, Samuelson, P., Some Aspects of the Pure Theory of Capital, Quarterly Journal of Economics, v51, 1937. Stock Analysis on Net. (2014). Research & Analysis: Stock Analysis on Net. Retrieved June 9th, 2014, from Stock Analysis on Net: http://www.stock-analysis-on.net/NASDAQ/Company/Apple-Inc/DCF/Present-Value-of-FCFF Wellington, A.M., The Economic Theory of the Location of Railways, Wiley, New York, 1887. Read More