Apple Is Significantly Undervalued

Mar.12.13 | About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) is not a company that I particularly like. Even though I own an iPhone and have used many other Apple products, I believe that the brand is extremely overrated. However, in recent months, I have become increasingly interested in this stock, and believe that it is significantly undervalued.

The biggest concern for investors right now is the lack of innovation, which might eventually lead to lower margins and lower growth. While these are certainly valid points, I believe that the selling has been overdone.

This article will only focus on valuation. I will attempt to prove why I believe Apple is a good buy at the current price.

Valuation Formula

Before I proceed, I first want to take the time to introduce the valuation formula I will be using. It is a formula that I have invented, which means that most people reading this have never seen it before.

Most experienced investors know that precise valuation is impossible. However, as Benjamin Graham used to say - "it is quite possible to determine that a man is obese even if we do not know his precise weight." Likewise, it is quite possible to determine that a stock is undervalued even if we do not know its precise value.

Even Philip Fisher, the father of growth investing, once said that the investor cannot pinpoint just how much a certain company will grow three, five or ten years from now. The investor can at best judge this within such general and non-mathematical limits as "zero growth," "slow growth," "moderate growth," or "fast growth." As a matter of fact, the company's top management cannot come a great deal closer than this. However, it is possible for the investor to come pretty close in judging whether a sizable increase in earnings and revenue will occur a few years from now. But just how much increase, or the exact year in which it will occur, usually involves guessing on enough variables to make precise predictions impossible.

This is where my valuation formula comes in. Since it is impossible to know a company's precise future growth rate, it is much easier to use a "range of growth rates" and assign a multiple to that range. For example, I think most of us can agree that a company like Amazon (NASDAQ:AMZN) will continue growing at a high rate for the foreseeable future. However, if we were to get ten different analysts to forecast Amazon's "exact" long-term growth rate, I can guarantee that we would get ten different projections. My formula overcomes this problem by assigning a specific multiple to a range of growth rates. In other words, it does not require mathematical precision, which makes it very robust.

Most of the variables in the formula are pretty self-explanatory. The "E" stands for normalized owner earnings, "C" stands for total cash and investments, "D" is total debt (including off-balance sheet leases), and "S" stands for diluted shares. However, the "(5 + 10G)" is what makes the formula unique. It helps the user figure out what multiple to pay for a certain company's earnings when taking into account growth.

The formula is designed in such a way that all we need to do is make one of four growth assumptions: "zero," "slow," "moderate," or "fast" growth. Once we figure that out the rest will take care of itself. And, as I mentioned earlier, mathematical precision is not required here.

  • Zero growth company (0% per annum); (G = 0) and the earnings multiple = 5x
  • Slow growth company (1% to 9% per annum); (G = 1) and the earnings multiple = 15x
  • Moderate growth company (10% to 19% per annum); (G = 2) and the earnings multiple = 25x
  • Fast growth company (20% or greater per annum); (G = 3) and the earnings multiple = 35x

The idea here is that we have a formula that is simple enough to use in the privacy of your own skull, without needing a computer or calculator. The formula is simple and much more accurate than more complex valuation methods, such as the discounted cash flow model or something similar.

Now that we understand how the formula works, we can use it to come up with a fair value for Apple. The formula will also demonstrate that Apple does not need to grow at a high rate to be an attractive investment. In fact, even a growth rate slightly above inflation would make this stock a bargain.

What is Apple worth?

As of this writing, Apple had a market capitalization of $405 billion and an enterprise value of approximately $273 billion (excluding all cash and investments and including capitalized operating leases). The trailing twelve month normalized owner earnings come out to be just under $29 billion, giving us an earnings yield of almost 11%. To me this seems cheap considering this company has grown its revenue at about 40% per annum over the past decade.

Click to enlarge

Note: It is important to mention that I have excluded interest and dividend income from owner earnings, which allows me to exclude total cash and investments in my calculation of enterprise value. Also, the trailing twelve month owner earnings number in the table above has been normalized.

I will now attempt to prove why I believe Apple's current valuation is overly pessimistic. Before I continue, it is important to mention that Apple will not be able to grow at the rate it has grown in the past. In fact, it will not even be able to grow at half that rate (~ 20% per annum). Again, I want to remind readers that I am talking about long-term growth rates here. The reason why I know that Apple cannot sustain these high growth rates is quite simple - it is called the "law of large numbers," which states that a variable will revert to a mean over a large sample of results. In the case of the largest companies, it suggests that high earnings and revenue growth and a rapid rise in share price will slow as those companies grow ever larger.

Since I know that Apple will not be the growth story it once was, I will not value it like one. Nevertheless, Apple's current valuation is attractive enough that even a long-term growth rate slightly above the rate of inflation would make this stock a bargain.

Below I use my formula to show what I believe Apple is worth as a business.

I estimate that a conservative fair value for this stock is just under $600 per share. The formula assumes that the company can grow at a rate slightly above inflation but less than 10% per annum. The fair value estimate implies a 15x trailing twelve month owner earnings multiple. The formula also takes into account net cash (net of capitalized operating leases of $4.5 billion), which adds about $140 per share to the fair value estimate. With the shares currently trading for around $432 per share, this gives us a margin of safety of close to 40%.

There is absolutely no reason why Apple shares should be trading at a discount this large. I think most investors would agree that this company has never been more valuable than it is at this very moment. Yet, for some strange reason, the share price is lower than it has been in years. In other words, as the company is becoming more valuable - its stock is becoming cheaper. Should it not be the other way around? In my opinion, this alone disproves the efficient market hypothesis. George S. Patton, the famous World War II general, once said - "if everyone is thinking alike, then somebody is not thinking." I am willing to bet good money that most investors are just "following the herd." The only reason they are pessimistic about the future of this company is because everyone else is. But, as Mr. Market has shown us countless times, following the herd has never been the most profitable investment strategy. Over the long run, the stock price will reflect a company's intrinsic value. Those who are patient will make huge profits.

Conclusion

The simple truth is that Apple is cheap. The company has a perfect balance sheet and is still extremely profitable. Considering the current valuation, even a single-digit growth rate will make this stock an extremely attractive investment. I believe that long-term investors will be rewarded if they buy now.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.