Wednesday, July 8, 2020

Buying Apple Does Not Rely Only On Dividends





Jul. 8, 2020 
3:24 PM ET
 About: Apple Inc. (AAPL)

Oleh Kombaiev
Commodities, internet, medium-term horizon, ETF investing
Visualized Analytics

Summary


An optimistic approach allows predicting that Apple’s revenue will grow at a CAGR of 5.2% in the coming 10 years.

We also can assume that AAPL's profit margin will increase in the future.

However, the Dividend Discount Model does not point to the current undervaluation of Apple.


Let's solve a simple investment task: buying Apple (NASDAQ:AAPL) shares only for dividends, how justified is such an investment?

To do this, let's build a two-stage dividend discount model. If you forgot what it is, take the time to watch this 8-minute video. By the way, a few days ago, I made a similar model for Microsoft (MSFT).



When performing DDM modeling, the greatest attention must be paid to the revenue forecast of the company. And here, I hope to meet the expectations of the most ardent fans of Apple...

I often hear and read something like this: "... the gradual transformation of Apple into a service company and the potential of 5G should give a new impetus to the development of the company..." OK, then in my model, I will proceed from the most optimistic expectations of analysts regarding the next decade:



Source: Seeking Alpha

So, I assume that, in the next 10 years, Apple's revenue will be growing at a CAGR of 5.2%:



Now, let's go through the rest of the key parameters of my model.

I proceed from the assumption that the profit margin of Apple will gradually increase from the current level to 26% in a terminal year. I repeat, I am very optimistic about Apple. Data by YCharts


Apple spends an average of 25% of its net income on dividends. In the model, I assume that the payout ratio will remain at the current level. And I will separately give results based on the different values ​​of this ratio.  
Data by YCharts

So, let's proceed directly to the model.

Here is the calculation of WACC:

 
Notes:
In order to calculate the market rate of return, I used values of equity risk premium (6.01%) and the current yield of UST10 as a risk-free rate (0.67%). The final indicator amounted to 6.68%.
I used the current value of the three-year beta coefficient. For a terminal year, I used Beta equal to 1.
To calculate the Cost of Debt, I used the interest expense for 2018 and 2019 divided by the debt value for the same years.

And finally, here is the model itself:



So, the DDM-based target price for Apple's shares is $105.

The result of the model is very sensitive to the payout ratio. Therefore, to understand how the changes in this parameter affect the growth potential of the shares, I provide a valuation sensitivity table:


Bottom line

You must first understand, this is just a model. But it allows us to take a more objective look at the company. And the main conclusion is as follows: given the positive development scenario of the company and the acceptable cost of capital, the price of Apple shares can be considered fair only if we assume that the company will spend all its net income on dividends.

Otherwise, when buying stocks of Apple, you should expect an increase in its price. But how reasonable it is, especially looking at the following graph, is the topic of a separate article...



Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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