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Apple (NASDAQ:AAPL) reported earnings last month and although record revenue and profits were seen, shares were punished, falling almost $64 in one day to settle in the $450 area they still trade in today. So why did market participants punish Apple shares so harshly? Disappointing guidance was the culprit. To my view, the market has decided that Apple no longer knows how to make and sell its products and that the company is going to slowly die off in the coming years. Of course, this is ridiculous as Apple's domination among consumers is still intact. Apple is facing intense competition from the likes of Samsung and others but Apple's phone business is still enormous and carries with it huge margins. So what does the market actually expect out of Apple? We'll use a DCF analysis to put the pieces together and see what Apple's doomsday expectations look like.

This DCF analysis has some assumptions that must be made and here are mine: 1) analyst earnings estimates are Yahoo! Finance analyst compilations 2) book value is from the most recent 10-Q 3) perpetual earnings growth of 4% is my number 4) dividends are expected to increase 5% per year (my number) 5) discount rate is equity risk premium of 10% as Apple carries no debt.

You may disagree with some or all of my assumptions but any forecast is subject to conjecture.

 

 

  

2013

2014

2015

2016

2017

2018

Earnings Forecast

       

Reported earnings per share

  

$44.75

$46.09

$47.48

$48.90

$50.37

x(1+Forecasted earnings growth)

  

3.00%

3.00%

3.00%

3.00%

3.00%

=Forecasted earnings per share

 

$44.75

$46.09

$47.48

$48.90

$50.37

$51.88

Current Analyst Expectations

 

$44.75

$50.90

$57.52

$64.99

$73.44

$82.99

        

Equity Book Value Forecasts

       

Equity book value at beginning of year

 

$135.62

$169.24

$203.65

$238.85

$274.87

$311.70

Earnings per share

 

$44.75

$46.09

$47.48

$48.90

$50.37

$51.88

-Dividends per share

$10.60

$11.13

$11.69

$12.27

$12.88

$13.53

$14.21

=Equity book value at end of year

$135.62

$169.24

$203.65

$238.85

$274.87

$311.70

$349.38

        

Abnormal earnings

       

Equity book value at begin of year

 

$135.62

$169.24

$203.65

$238.85

$274.87

$311.70

x Equity cost of capital

 

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

 

$13.56

$16.92

$20.36

$23.89

$27.49

$31.17

        

Forecasted EPS

 

$44.75

$46.09

$47.48

$48.90

$50.37

$51.88

-Normal earnings

 

$13.56

$16.92

$20.36

$23.89

$27.49

$31.17

=Abnormal earnings

 

$31.19

$29.17

$27.11

$25.01

$22.88

$20.71

        

Valuation

       

Future abnormal earnings

 

$31.19

$29.17

$27.11

$25.01

$22.88

$20.71

x discount factor (10%)

 

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

 

$28.35

$24.11

$20.37

$17.09

$14.21

$11.69

        

Abnormal earnings in year +6

      

$20.71

Assumed long-term growth rate

      

4.00%

Value of terminal year

      

$345.12

        

Estimated share price

       

Sum of discounted AE over horizon

 

$104.12

     

+PV of terminal year AE

 

$194.81

     

=PV of all AE

 

$298.93

     

+Current equity book value

 

$135.62

     

=Estimated current share price

 

$434.55

     

What we see from my model is that Apple is currently priced to grow earnings by only 3% in the coming years, despite analyst expectations of over $80 per share in earnings in 2018. I understand that a big reason why Apple has fallen so precipitously is because when earnings estimates are falling and guidance disappoints, no one knows where the bottom is and nobody wants to be caught holding the bag. However, when shares have gotten so preposterously cheap, it is hard to ignore. If we look at priced-in expectations, we can see that as long as Apple can exceed three percent earnings growth for the foreseeable future, shares should outperform. In addition, if we assume that Apple will make $80 per share in earnings in 2018, even at the ludicrous valuation of 8 times earnings, shares should trade at $640, or roughly 40% higher than they are today. If we apply a 10 times earnings multiple, shares would trade near $800.

I also happen to think that when the Board meets this month that a new buyback and dividend increase will be announced. Apple's book value increased another $10 per share this last quarter and that was mostly cash added to the balance sheet from the record profits the company earned. Investors are tired of Apple making nothing on its cash hoard while it sits on the balance sheet when the Board could use it to buy back depressed shares and issue larger dividends to shareholders. It is my personal feeling that the anemic $15 billion share buyback that was announced last year to soak up compensation-related share issuances will be increased to actually reduce the float. Apple could afford an enormous buyback but I think management will start off cautiously, perhaps doubling the $15 billion from last year. Also, I think a hefty dividend increase is in the cards as Tim Cook has seen shares fall from $705 to $457 on his watch and a larger dividend would serve to buoy the shares until bearish sentiment subsides. Again, Apple can afford whatever dividend it wants but I think management will start off conservatively and perhaps increase the payout by 20% to 30% or so, offering a potential yield of 3% or so. This would put no strain whatsoever on Apple's cash hoard as a dividend that size can easily be covered by Apple's current free cash flow. Any announcement of increased dividends or buybacks would serve to increase the share price as it would reflect a change in Cupertino from Steve Jobs' near disdain for shareholders to a company that actually cares what shareholders think.

Regardless of whether or not the dividend and buyback increases come through this month, there is no denying that Apple has become so cheap that value investors, dividend investors and growth investors can all consider Apple shares viable for their respective portfolios. In addition, I believe sentiment has gotten so negative that a bullish reversal is inevitable as the market has swung too far to one side. I will agree Apple at $705 was too far too fast, but $457 is a joke. If you think, as I do, that Apple can beat 3% earnings growth per year, being long the shares at $457 is a no-brainer.

Source: Apple's Earnings Expectations Have No Basis In Reality