In our last post we lamented the fact that Apple has discontinued the reporting of its unit shipment numbers. In that post we pointed out that Apple has done this in part, because no one really knows how to value Apple stock, and in this post we want to examine that theme more closely.

First, we would note that no one seems to know how to value anything anymore. The markets are obviously in flux, volatiling all over the place. Trade wars. Constitutional crisis. Fake news. All these things contribute. But the problem with Apple stock predates all of that by several years. And it is worth pointing out that many of Apple’s mega-cap peers also struggle with achieving coherent valuation theses. For example, Amazon’s multiple makes no sense for a company that seems to be able to toggle its profits based on a random number generator in Seattle. But for many of the others, this uncertainty has worked in their favor. Amazon trades at a 61X PE, while Apple limps along at 12X. To be clear, we are big believers in Amazon’s stock, but it is hard to argue the discrepancy in multiples demonstrates a rational, efficient market.

One thing we learned when we were on the Street was that Apple’s stock tends to trade much more on a flow of funds basis than on any intrinsic valuation methodology. Apple is among the most widely held stocks on the planet, so when a large mutual fund enters or exits a position, that tends to be a bigger price driver than actual fundamentals. Examine the history of Apple’s stock price moves and it can be hard to discern any other clear rationale for its movements.

Nonetheless, Apple’s valuation still looks odd, especially when compared to its peers. One argument for this disconnect we have heard is that Apple is “just” a hardware company. No hardware company can keep its earnings going forever. Sic transit Gloria. Certainly the annals of handset companies is littered with one-time high-flyers that went from hero to zero, often over a very short time horizon. This is why so many people (investors, analysts, the company) spend so much time looking at Apple’s services business. The idea being that this is the ‘sticky’ part of Apple’s business which can continue to deliver even after Apple’s hardware business “inevitably” fades.

We are not going to have that debate here. Our outsider’s opinion is that Apple’s business looks incredibly defensible, and while nothing lasts forever, there are no obvious vulnerabilities in Apple’s model right now.

So setting aside the services debate, how does the Street currently value Apple? Just looking at the current business it is hard to justify the company’s current valuation. (Note: Before you ask, No, we do not own any shares of Apple.)

Let’s turn to our trusty old friend, the discounted cash flow (DCF) model to examine this more closely. In Fiscal 2018, Apple generated $77 billion in free cash flow, It’s enterprise value is currently $682 billion (stock at $169, 4.7 billion shares, $122 billion in net cash), or 8.8X trailing cash flow. Yahoo Finance estimates Apple’s 5 year earnings growth at 15%. Using a 7% discount rate, that works out to a net present value of $449 billion. This implies a terminal value of $232 billion. Finance note: the terminal value is the amount tacked onto the end of the end of a DCF calculation to estimate anything way out in the future. For most high-growth tech companies, the terminal value usually works out to 90% of the company’s DCF. In Apple’s case the terminal value is barely one third of the value.  This is decidedly odd, downright pessimistic.

Put another way, this model assumes that Apple goes out of business in 2024 (i.e. where the DCF equals the current enterprise value with $0 terminal value).  We suppose that this is possible, but it is hard to imagine a scenario where that happens, and it is impossible to argue that whatever hurts Apple this badly does not also affect all the other tech companies out there (i.e. war).

Another way to think about this is to torture the model until it comes up with a growth rate where the current DCF plus terminal value work normally. In this scenario, Apple would have to see cash flow decline 10% a year for the next five years. That means Apple’s business in 2023 would be half of its 2018 levels. Again, we suppose this is possible. This is what happened to Nokia, and Motorola, and Research in Motion. But five years ahead of those declines there were already visible cracks in their models, Apple shows no such cracks currently.

We are no longer in the stock picking business. And we certainly have no idea what is going on with the stock market anymore. It is just hard to see why Apple is trading at current levels.