Seeking Alpha
Long/short equity
Profile| Send Message| ()  

Overview

Wow, that was quite a Wednesday. Apple (AAPL) closed down 37 bucks (or 6.43%) at 538.79. This was the worst day for Apple since the depths of the financial crisis four years ago. The selling was blamed on a margin requirement increase from COR Clearing. That may have been the start of the selling, but I seriously doubt a nondescript clearinghouse was entirely responsible for $35B of market cap being erased on Wednesday. Whatever the reasons, it was ugly. The question is what now?

If you are taking a long term view of Apple, their ability to sell gadgets is not 6.43% less than it was on Tuesday so this (really) ugly day should be a blip on the radar for you. However, we all know investors are emotional creatures and we don't like it when our holdings get killed like that. The fact is, you must take a rational view of the situation and realize that decreased margin for traders is likely a very good thing in the long term for Apple shares since this should serve to decrease volatility.

Consider that you are able to buy a piece of Apple for nearly 7% less than it would have cost you just 24 hours ago and also realize that Apple's business is no different today than it was yesterday. This article will take a look at Apple's fundamental prospects and valuation following Wednesday's bloodbath.

Some investors have opined, quite correctly I think, that some selling this quarter has been due to tax-related liquidations. I wholeheartedly believe this is occurring since the children in Congress can't get their act together long enough to agree on something, people are going to sell now for a lower tax bill. Obviously, this issue is transitory since it will be resolved on January 1st. Regardless of what happens in the Fiscal Cliff debacle, there won't be any tax reason to sell more shares on January 1st and I believe this will alleviate some of the pressure on Apple shares.

Apple's last two quarters haven't been pretty, either. Two bad earnings misses have sent the stock reeling, and renewed fears that Apple isn't the dominant giant it appears to be. Couple this with very weak guidance for FQ1 and you have a nasty combination that has caused some investors to lose faith in Apple. These fears are well grounded in that Apple is competing for market share with the rapidly expanding Android user base. Apple is still the dominant player in both phones and tablets but other manufacturers are gaining steam and the Android platform is seemingly ubiquitous. This competitive pressure could cause Apple to have to lower prices or create cheaper products to stay relevant if Android continues to expand via lower cost offerings. This dovetails in with well documented gross margin concerns for Apple. They have had some supply chain issues with their newest products, but again, I think these issues are temporary and are causing short term pain in the stock. I am confident Apple will rectify these operational issues and gross margin will revert higher next year. Gross margin won't rise to all-time highs due to lower margin products being introduced but Apple can certainly improve on its margin next year and claw back some market share it has lost to Android.

Stock Analysis

(click to enlarge)

Given Apple's fundamental backdrop, let's take a look at the stock's prospects. At Wednesday's closing price of $538.79, Apple has a market cap of $506.84B. This is $35B less than it was on Tuesday, which is remarkable. Apple made $44.15/share last year and is expected to earn about $54.50/share in 2013 for a forward PE of only 9.3. With this kind of PE, Apple is being priced like Cisco (CSCO) or Intel (INTC). These companies are very mature, no-growers that people buy for dividends. Apple is still growing at a rapid pace despite being so huge already. As a hardware company primarily, Apple doesn't deserve an enormous multiple but 9 is a joke.

Further proof of Apple's cheap valuation is the PEG ratio of 0.58. I generally look for PEGs of 1 or less and Apple is nearly half that number. As the analysts following Apple expect 5 year growth to average 20.67%, I find a PE of 9.3 to be ludicrous. There is always risk that Apple can't execute and make that 20.67% number but I'll take my chances with such a huge margin of safety; Mr. Market is pricing in close to stagnation for Apple earnings.

Apple has perhaps the best balance sheet I have ever seen. They've got $121.3B of cash, cash equivalents and investments as of last quarter. They also sport zero debt and have $57.653B of current assets. Lastly, Apple has a book value of $118.21B, or $125.66 per share. This company is outrageously well capitalized and it allows them to purchase whoever they want while offering a decent dividend and stock buybacks.

Discounted Cash Flow Valuation

Let me start by saying that any DCF analysis requires assumptions and estimates and that those are subject to personal viewpoints. You may not agree with all of my assumptions but I believe they are realistic estimates of what might happen to AAPL in the future.

The DCF method requires some assumptions and I will go over them quickly:

  1. Weighted Average Cost of Capital-10% (equal to equity risk premium since Apple is 100% equity financed)
  2. Earnings growth of 10.34% annually out to year 6 (this is half of what analysts are expecting for Apple)
  3. Perpetual earnings growth of 5%
  4. Dividend growth rate of 5% each year
  5. Model does not include share buybacks due to uncertainty as to when and what cost they will occur
  6. Earnings for 2012 and 2013 are Yahoo! Finance sourced analyst estimates (which vary pretty substantially)

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$44.15

$49.28

$57.95

$63.94

$70.55

$77.85

x(1+Forecasted earnings growth)

11.62%

17.59%

10.34%

10.34%

10.34%

10.34%

=Forecasted earnings per share

$49.28

$57.95

$63.94

$70.55

$77.85

$85.90

Equity Book Value Forecasts

Equity book value at beginning of year

$125.66

$163.81

$210.08

$261.75

$319.42

$383.74

Earnings per share

$49.28

$57.95

$63.94

$70.55

$77.85

$85.90

-Dividends per share

$10.60

$11.13

$11.69

$12.27

$12.88

$13.53

$14.21

=Equity book value at end of year

$125.66

$163.81

$210.08

$261.75

$319.42

$383.74

$455.43

Abnormal earnings

Equity book value at begin of year

$125.66

$163.81

$210.08

$261.75

$319.42

$383.74

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

$12.57

$16.38

$21.01

$26.17

$31.94

$38.37

Forecasted EPS

$49.28

$57.95

$63.94

$70.55

$77.85

$85.90

-Normal earnings

$12.57

$16.38

$21.01

$26.17

$31.94

$38.37

=Abnormal earnings

$36.71

$41.57

$42.93

$44.38

$45.91

$47.52

Valuation

Future abnormal earnings

$36.71

$41.57

$42.93

$44.38

$45.91

$47.52

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

$33.38

$34.35

$32.26

$30.31

$28.50

$26.83

Abnormal earnings in year +6

$47.52

Assumed long-term growth rate

5.00%

Nominal value of terminal year

$950.49

Estimated share price

Sum of discounted AE over horizon

$158.80

+PV of terminal year AE (10% disc rate)

$536.53

=PV of all AE

$695.33

+Current equity book value

$125.66

=Estimated current share price

$821.00

Even with my very conservative earnings growth estimates, Apple's share price is a buy under $821.00 based on its prospects for the next several years. Obviously, my estimates could prove to be conservative (or not conservative enough) but I have disclosed my estimates fully and I would ask you to remember they are estimates and subject to error and personal opinion.

Given Apple's fundamental backdrop of extremely robust product lines, fanatic consumers, pricing power and continued innovation, I believe AAPL is a buy here. While we may see it go lower in the coming weeks, I think that this time next year will see AAPL over $700 on improving earnings prospects. In addition, the dividend and stock buyback programs will prove to buoy the stock price under continued weakness. I also believe there is substantial room for dividend and stock buyback increases in the future. I would prefer the board stick to dividends, but they seem committed to at least a small amount of buybacks. Regardless, they are both positives for the stock. One last point, I firmly believe that if Apple conducts a split, it will receive a higher multiple. I believe this due to possible inclusion in the Dow Jones Industrial Average and perceived greater access to the shares by the public if the shares trade in the 50's rather than the 500's. I don't think this will happen any time soon but if it did, AAPL would take off into a powerful rally similar to the rally experienced by Berkshire Hathaway B (BRK.B) shares after they split.

If you have any thoughts, I'd be happy to discuss them with you in the comment section.

Source: Apple's Ugly Wednesday - The Aftermath