This Valuation Expert Says Apple Is Undervalued by 25%

By Markets Fool.com

IMAGE SOURCE: APPLE.

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Professor Aswath Damodaran of Stern School of Business at New York University is one of the leading world experts in corporate valuation, and according to his calculations, Apple stock is considerably undervalued. In fact, the professor believes Apple could be worth $126 per share under conservative assumptions. That's an upside potential of about 25% from current price levels.

These kinds of calculations always depend on multiple forecasts and assumptions, and even the most renowned valuation experts can make mistakes. For this reason, investors should always do their own homework as opposed to blindly relying on the work of others, no matter how renowned and prestigious. On the other hand, it makes sense to take a look at the numbers behind Damodaran's calculations and try to understand what they mean for investors in Apple stock.

The rationale behind the numbers
It's of utmost importance to pay close attention to the assumptions behind a valuation estimate. There is a popular acronym in computer science and mathematics: GIGO. It stands for "garbage in, garbage out" -- which basically means that the quality of the conclusion or answer you get depends on the quality of the data you start with. If the assumptions behind a valuation model are wrong, then the valuations it produces will also be wrong. Importantly, we can also analyze these assumptions to understand what kind of scenario is being discounted in current stock prices.

Professor Damodaran is using some fairly conservative assumptions to value Apple stock. He estimates that Apple will generate revenue growth of 2.2% annually over the coming five years, and that this growth rate will slow down to 1.9% in his terminal value calculation 10 years from now. Operating margins are also forecast to decline from 30.2% of revenue to 25% of sales over a decade, and the cost of capital to fall from 9.8% to 8% as the business matures over time.

These figures assume that Apple is stable and mature corporation, and that its revenue growth will be roughly in line with inflation, meaning that Apple does not offer much potential for above-average growth in the future. In a nutshell, even assuming that Apple is a slow-growth corporation and that profit margins will decline in the coming years, the stock is attractively priced at current levels.

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What this means for investors in Apple stock
Professor Damodaran is kind enough to make his valuation spreadsheets freely available on his website, so investors can change some of the assumptions and see how the valuation value changes in response. Just for fun, I assumed that revenue growth rates over the coming five years would be 3% as opposed to 2.2%, and that operating margins will remain stable over this period as opposed to slowly declining. Those assumptions yield a valuation estimate of $131 per share.

Apple could in fact deliver financial performances either above or below forecasts over the years ahead. However, I believe there is a higher chance that the company will outperform these forecasts.

The iPhone 6 and iPhone 6 Plus were explosive successes for Apple last year: Customers were avidly attracted to the new models with larger screens, and Apple registered a big sales increase of 28% during the fiscal year that ended in September.

Since the iPhone 6S and 6S Plus didn't feature big changes compared to their predecessor models, year-over-year sales comparisons for Apple are quite challenging in the middle term. Apple registered a modest increase in revenue of less than 2% in the December 2015 quarter. Even worse, management is expecting total sales during the March 2016 quarter to be in the range of $50 billion to $53 billion, which would represent a decline of 11% at the midpoint versus the same quarter last year.

On the other hand, according to management, nearly 60% of all iPhone users have not yet upgraded to the iPhone 6 or iPhone 6S. Their devices are getting increasingly outdated over time, and Apple users are notoriously loyal to the brand. It's not too unreasonable to expect sales to re-accelerate as more customers get around to upgrading their devices in the coming years.

Apple is also entering new categories with products and services such as Apple Watch, Apple Pay, and Apple Music. The company still makes almost 70% of its revenue from the iPhone, but other products and services should contribute a growing share of overall sales in the coming years. As a reference, Apple reported a big increase of 25% in sales from its services segment last quarter, accounting for 8% of total revenue during the period.

Whether Apple can jump-start growth in the coming years remains to be seen, but one thing looks quite clear: Apple stock is attractively valued nowadays, even if growth remains subdued. This puts investors in a remarkably comfortable position: If revenue growth remains stagnant, then this is already incorporated into valuation, and the stock is in fact very reasonable priced for such scenario. On the other hand, if the company can accelerate performance on the back of improving iPhone sales and/or growing revenues from other businesses, then the stock should offer considerable upside potential.

The article This Valuation Expert Says Apple Is Undervalued by 25% originally appeared on Fool.com.

Andrs Cardenal owns shares of Apple. The Motley Fool owns shares of and recommends Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.