Apple has outperformed for decades, but the company is arguably still a bargain. In this article, I present three arguments why I believe Apple (NASDAQ:AAPL) shares should and could considerably higher within the next 12-36 months: 1. New market opportunities including VR/AR and the Apple Car, 2. Accelerating strength in Apple’s service portfolio, and 3. Continued financial engineering.
I value AAPL shares based on a residual earnings framework and calculate a fair base-case target price of $247.51/share, implying upside of >75%.
New Product Opportunities
Let us start with the most tangible value/growth thesis: Apple’s ambitions for new product initiatives. For many years, the market has been speculating on Apple developing a VR headset (2) and a car (1).
Although Apple has not officially announced a VR device, CEO Tim Cook has talked up the company’s ambition in this market. Cook called VR as “critically important” and ranked VR amongst the “few profound technologies.” That said, many investors – me included – were slightly disappointed that Apple did not launch a VR headset during the WWDC 2022 already. But according to analyst Ming-Chi Quo the headset could arrive as early as within the next six months. According to Bloomberg Research, the mixed-reality headset could support annual sales of approximately $15 billion until 2025 (Source: Bloomberg Terminal, Intelligence Primer). But accelerating sales could be likely for after 2025, especially if Apple is complementing the headset with an ecosystem of services.
With regard to the Apple Car, speculation is still running hot and much uncertainty persists. I do believe, however, that Apple will eventually enter the automotive industry. The argument is simple: Apple is very cash-rich and likely not to forgo any industry revolution with secular growth potential in the technology vertical – especially considering that the future of mobility will be based on connectivity, artificial intelligence and MaaS. That said, Apple’s service ecosystem could be leveraged into the automotive market, with arguably great economic potential. Some anchors for Apple’s software strength could include autonomous vehicles, in-vehicle entertainment and multi-device connectivity.
Accelerating Strength In Service Portfolio
Apple has more than 1 billion installed devices and a comprehensive ecosystem of services – including the App store, iTunes, Apple Music, Apple Pay, etc. Monetization of these services in relation to smartphone/PC hardware sales has continuously increased in the past few years . As of 2021, for every $1 of product hardware revenue, Apple generates approximately 25c of service revenues. In my opinion, the service revenue per dollar of hardware sale will likely expand to 45c-55c by 2025, as Apple is highly focused on expanding its software portfolio and monetization. If we model a 55c service revenue by 2025, Apple would effectively grow at a >7% CAGR, all else equal. That said, even without new product launches such as the VR headset or the Apple car, the company’s sales growth will likely remain in the high-single-digits.
Continued Financial Engineering
Apple is one of the companies that has been highly successful in financial engineering without increasing risk to shareholders. The company’s strategy is based on two key points: operating liability leverage and share-buybacks, including debt arbitrage.
High operating liability leverage is a financing strategy where companies use their bargaining power against suppliers to finance their business operations through supplier financing. That said, the lower a company can reduce capital from shareholders, the better. As of March 2022, Apple’s book value per share was $4.16. This basically means that investors do not need to commit investments/capital for the company to generate significant profits. For reference, based on $4.16 book value, Apple generates net-income >$6/share. That said, if for example, you consider a residual earnings valuation, where you charge a required return on capital against net-income, you do not record a significant cost and thus achieve a much higher company valuation.
Secondly, Apple is engineering considerable EPS growth through share buybacks. Generating >$100 billion of annual FCF and a >$70 billion net-cash position, Apple has lots of buying power to repurchase shares. Moreover, Apple management has proven willingness to allocate capital to share-repurchases for multiple years. That said, I strongly believe that share buybacks will continue to contribute to significant EPS growth going forward, likely in excess of 3% annually. In that context, investors should appreciate AAPL stock’s current share price weakness, as buybacks are even more EPS accretive.
How Analysts See AAPL
Analysts are very bullish on Apple stock. Based on 44 analysts who cover the stock, there are 27 strong buy ratings, 7 buy ratings and only 1 sell rating. The average target is $186.51/share, and the highest target stands at $226/share. Notably, the average target would imply approximately 30% upside.
Moreover, according to the Bloomberg Terminal, as of June 2022, analysts see Apple’s business fundamentals to remain strong. Revenues for 2022 and 2023 are estimated at $393.9 billion and $415.3 billion. Respectively, EPS is estimated at $6.14, and $6.54. While I personally model higher EPS, in this article I do not want to challenge analyst consensus.
Usually, analyst consensus estimates not for target prices, but for revenues and earnings, are quite indicative of a company’s future performance.
Residual Earnings Valuation
So, if analyst consensus is right about AAPL’s business forecast, what could be a fair per-share value for the company’s stock? To answer the question, I have constructed a Residual Earnings framework and anchor on the following assumptions:
- To forecast revenues and EPS, I anchor on consensus analyst forecast as available on the Bloomberg Terminal. As I mentioned, challenging analyst consensus is out of scope for this article.
- To estimate the cost of capital, I use the WACC framework. I model a three-year regression against the S&P to find the stock’s beta. For the risk-free rate, I used the US 10-year Treasury yield as of June 23, 2022. My calculation indicates a fair WACC of 7.5%.
- To derive Apple’s tax rate, I extrapolate the 3-year average effective tax-rate from 2019, 2020 and 2021.
- For the terminal growth rate, I apply expected nominal GDP growth at 3.5% plus one percentage point. Higher than GDP growth is justified, in my opinion, as the company is spending aggressively in R&D and management is arguably best-in-class.
- I model share buyback at 3.5%/annually until 2025.
Based on the above assumptions, my calculation returns a base-case target price for AAPL of $247.51/share, implying upside of >75%.
I understand that investors might have different assumptions with regard to Apple’s required return and terminal business growth. Thus, I also enclose a sensitivity table to test varying assumptions. For reference, red-cells imply an overvaluation as compared to the current market price, and green-cells imply an undervaluation. The risk/reward looks highly favorable to me.
I would like to highlight the following downside risks that could cause Apple stock to materially differ from my price-target of $247.51/share:
First, a worsening macro-environment including inflation and supply-chain challenges could negatively impact Apple’s customer base. If challenges turn out to be more severe and/or last longer than expected, the company’s financial outlook should be adjusted accordingly. However, Apple’s strong brand equity should cushion the company against price-sensitive consumer choices.
Secondly, Apple’s exposure to offshore manufacturing is considerable. In fact, more than 90% of the company’s hardware is sourced in Asia, especially China. That said, supply-chain challenges and ongoing geopolitical tensions could considerably disrupt Apple’s value creation chain.
Thirdly, the success of Apple’s new product initiatives is – of course – dependent on smooth management execution and market feedback. While Apple has a stellar track-record for both dimensions, the past is not necessarily indicative of the future. And a smartphone/PC launch is not necessarily indicative of a success in the car industry, or in the metaverse (VR).
Finally, much of Apple’s current share price volatility is currently driven by investor sentiment towards risk and growth assets. Thus, investors should expect price volatility even though Apple’s business outlook remains unchanged. In addition, inflation and rising-real yields could add significant headwinds to Apple’s stock price, as the higher discount rates affect the net-present value of long-dated cash-flows.
In my opinion, Apple is well positioned for another decade of outperformance. I value AAPL shares based on a residual earnings framework and calculate a fair base-case target price of $247.51/share, implying upside of >75%. Thus, investors should consider the current share-price weakness of the company’s stock as an enhanced buying opportunity.