Apple: relative valuation with forward PE ratios
Your task is to help stock analyst Kate Huberty at Morgan Stanley to arrive at a price target for the stock of Apple, based on relative valuation. The analyst thinks of three possible valuation scenarios for Apple (1) Valuation in line with large-cap platform companies; (2) Valuation as a product company; (3) Valuation in line with large-cap IT hardware companies. Huberty expects next year’s Earnings per Share (forward EPS) at $10.83 in the first scenario, $10.34 in the second scenario, and $8.47 in the third scenario.
Scenario 1. Apple valuation in-line with large-cap platform companies across industries. Investors believe Apple's platform can extend into new products and industries over time. Revenue grows 13% in FY16 driven by 5% growth in iPhone revenue, 10% upside in Watch shipments, and slight acceleration in Services revenue growth. Gross margin of 41% mainly reflects Watch margin improvements and increasing mix of higher-margin revenue. Under this scenario, we assume a forward 18x PE multiple, in-line with US, large-cap platform companies across industries.
Scenario 2. Apple is valued as a product company. Investors increasingly recognize the value and size of Apple's loyal users and expanding platform. Revenue grows 7% in FY16 driven by the Watch and secondarily new Services, while iPhone revenue remains flat. Gross margin expands 60 bps Y/Y due to improving Watch margins and lower mix of iPads. Under this scenario, we assume a forward 15x PE multiple, similar to where Apple traded in the last year.
Scenario 3. Valuation in-line with large-cap IT Hardware peers on slower growth. Revenue barely grows as iPhone revenue declines slightly, which is offset by growth in Watches and Services. Gross margin also declines slightly Y/Y due to lower iPhone mix and little improvement in Watch margins. Under this scenario, the forward PE multiple falls to 13x.
QUESTIONS: Read the information above and answer the following questions: (a) What are the price targets for the stock under each scenario?; (b) The stock of Apple (Nasdaq: AAPL) is $151.36/share; determine, for each case, whether it is a BUY, a HOLS or a SELL.
Criteria for decision. Calculate the target price of Apple and find its % price change with respect to the market value of $151.36 (target price/151.36 – 1) . If the result is > 15%, then BUY; if the result is < the SELL. If it falls in between, then HOLD.