How to value large cap growth companies if they are a bargain ?

Is Apple's P/E of 40 justified. Please read to find out.

Few years ago I read a very interesting article by McKinsey and Company that changed my outlook of valuing a company. Prior to reading this article, I was valuing companies just based on price to earnings multiple without regard to their return on invested capital and growth rate. Understanding this concept made a world of difference in how I look at a company.

If anyone wants to read the article directly they can go to this link[McKinsey.com].

Sometimes, a very high price to earnings multiple of a relatively slowly growing company may be justified. Any growth company's valuation is dependent on interaction of two main variables: growth rate, and return on invested capital. 

Based on this article “ All P/Es are not created equal”, I will try to show you how I evaluate companies like Apple is worth adding to your portfolio.

This process involves breaking down any companies value into three different parts:

1. Current performance

2. Return premium

3. Value from growth.

What is current performance?

It is “value of current after-tax operating earnings in perpetuity, assuming no growth”

What is the return premium?

It is a value company earns on its growth capital. High moat companies tend to have high returns on invested capital. It is estimated by “discounting a company's cash flows as if they grew in perpetuity at some normalized rate, such as nominal GDP growth.”

What is value from growth?

The value company creates by growing more than nominal GDP. It is calculated indirectly by value left after subtracting current performance and return premium.

Let us work out an example. I will use Apple, the world's largest and the most iconic brand.

Total market cap. 2200 B

After-tax operating earnings TTM: 64 B

Free cash flow TTM: 80 B

Discount rate: 10%

Nominal GDP growth: 4% ( 2% inflation + 2% productivity growth)

Value from current performance: 

After tax operating profit/ Discount rate 

Since by definition, the value of current performance is calculated by discounting after tax operating profit as if there was no growth. If I use discount rate of 10%; then 

After tax operating profit/Discount rate = 64 B/ 10% = 640 B

Value from Return premium

Free cash flow / (Discount rate - nominal GDP growth rate) = 80 B/ 10% - 4% = 80 B/ 0.06 

= 1333 B

Value from future growth ?

Current market cap - ( return premium + value from current performance) 

= 2200 - ( 640 + 1333) = 2200-1973 = 227 B

In my opinion, Apple is currently fairly valued. It’s current P/E of 40 and NTM (Next twelve month) P/E of 30 is justified as the market is not discounting much of future growth.  Future return is squarely based  on Apple’s cash flow growth.  Apple’s current P/E is 40; 60% of that P/E is derived from return on invested capital; 30% from current performance without growth and 10% from future growth.

Long $AAPL

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