Original post: Dec. 12, 2012
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Update:        Feb. 26, 2013

Apple has released a new quarterly report.   Running the analysis with the new data raises my ‘Intrinsic Value estimate to $566.00.   With a 25% Margin of Safety, my new ‘Buy’ price is $424.50.

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Apple is a great example of a stock that steadily grows earnings year after year with no negative years. In fact it has been so successful its earning have grown near parabolic in the past:

When we purchase a stock, however, we are buying the future earnings, not the past.  We cannot expect Apple to continue to grow in parabolic fashion for another 10 years.  Here is a look at Apple’s (AAPL) meteoric past 10-year growth in Free Cash Flow, and my more conservative estimate for the next 10 years:

After rising nearly 80 times in the past ten years, I’m giving Apple ‘only’ a double over the next ten.  All numbers are of course my own calculations.  I use the term ‘Owner Earnings’ coined by Warren Buffet, which is an adjusted Free Cash Flow.

To determine a stock’s Intrinsic Value, we discount the future earnings back to the present, and add in the current Book Value.  This process is called Discounted Cash Flow (DCF) Analysis.

Buffet on Intrinsic Value:

“We define intrinsic value as the discounted value of the 
cash that can be taken out of a business during its remaining 
life.  Anyone calculating intrinsic value necessarily comes up 
with a highly subjective figure that will change both as 
estimates of future cash flows are revised and as interest rates 
move.  Despite its fuzziness, however, intrinsic value is all-
important and is the only logical way to evaluate the relative 
attractiveness of investments and businesses.”
                                 Berkshire Hathaway 1994 Letter to Shareholders

Using Discounted Cash Flow analysis, I estimate Apple’s current intrinsic value at $558 per share.  After being as high as $700 this year, it is now trading at $539.

When a stock trades at it’s Intrinsic Value, it is priced to deliver a return equal to the discount rate chosen for the DCF analysis.  I desire a 15% annual return for stocks so that is my discount rate.

As the future cash flows are quite unpredictable, we look to purchase the stock below it’s Intrinsic Value, using the concept of ‘Margin of Safety’ created by Buffet’s mentor, Benjamin Graham.  The Margin of Safety I will use is typically 25 to 50%, dependent on the expected volatility of cash flows.

Giving credit to Apple’s history of positive (even parabolic) earnings growth, I seek a 25% Margin of Safety to the $558 Intrinsic Value.  This results in my current ‘Buy’ price of $419.  This summer AAPL stock price was on a rocket ship to the moon, and that price may have seemed impossible, but AAPL has actually traded below that level even in the past year.  All we need is a temporary setback for the company, or a decent bear market and we could have an opportunity.

Of course there’s more to stockpicking than just the numbers, as accounting is just one part of business valuation.  But this is where we start.  This is how value investing is supposed to work.  Determine a fair price using the principles of ‘Intrinsic Value’ and ‘Margin of Safety,’ then wait patiently.

How to become a Stock Market Value Investor:

Dave’s Complete Guide to Value Investing

My current and historical stock picks:

HealthyWealthyWiseProject – Portfolio