The markets may be expensive or not, but high quality technology is cheap, cheap, cheap. Perhaps it shall not remain so forever.

When I speak of high quality, I am looking at companies with strong balance sheets, high return on equity, low beta, a strong brand which helps reduce earnings volatility over the course of an economic cycle, and a decent dividend yield.

In this post I am looking at Apple (AAPL), Microsoft (MSFT), Cisco (CSCO), and Intel (INTC). I am wearing the hat of a pessimist in assuming that these companies will see a return of equity of a meager 10% on incremental investment. I am assuming that the very substantial cash net of debt on the balance sheets will be frittered away, and so any nominal growth must come from re-investment of current earnings. I am assuming that their nominal growth will be limited to 6%, which is a 25% discount to global nominal growth potential of 8% (4.2% real growth potential plus 3.8% inflation). With these assumptions, it is clear that these companies will need to re-invest 60% of earnings to generate the 6% target nominal growth rate for the company, and thus the maximum payout potential is 40% of earnings. Unless otherwise stated, I assume that if the actual dividend being paid out is lower than 40% of earnings, then earnings will drop until the dividend is no more than 40% of earnings.

We can calculate the present value of future dividend flows as Dividend multiplied by (1+Growth Rate) Divided by (Investor Return Expectation minus Growth Rate). In the valuation model, I use the present annualized dividend for the stock, the growth rate of 6% as explained in the prior paragraph, and the investor rate expectation computed using the Capital Asset Pricing Model [CAPM]. The Investor Return Expectation is calculated using the CAPM formula: Risk Free Rate Plus Beta Multiplied by (Market Return Expectations minus Risk Free Rate. The beta I am using is the value line beta. Value Line beta coefficient comes:

"… from a regression analysis of the relationship between weekly percentage changes in the price of a stock and weekly percentage changes in the NYSE Composite Index over a period of five years. In the case of shorter price histories, a shorter time period is used, but two years is the minimum. Value Line then adjusts these Betas to account for their long-term tendency to converge toward 1.00."

You can visit the Value Line website to download and view their PDF format reports for Microsoft, Intel, and Cisco by following the links. If you want to view the report on Apple, you need to be a Value Line subscriber.

*Cisco Is So Yesterday: What's To Communicate About*

Cisco is cheap. If we assume that the dividend is all that Cisco can afford to return to its shareholders, then the present value of future cash flows from dividends can be said to be what Cisco is worth.

This is a very pessimistic view. If we assume in utter despair, that Cisco will be able to achieve a return on equity of 10%, and grow at a rate of 6%, they will be able to return 40% of earnings to shareholders. As it happens, I expect Cisco to do far better on return on equity and growth. But let's stay pessimistic and assume that all we shall ever see from Cisco is $0.17 per quarter ($0.68/year), growing at an annualized rate of 6%. What is that worth?

We can calculate the present value of future dividend flows as Dividend multiplied by (1+growth rate) Divided by (Investor Return Expectation minus Growth Rate). What return should an investor want from a stock with a beta of 1.05? Taking the recent 3% yield of the ten-year government security as the risk-free rate, and assuming that 9% represents the very long-term rate of return an investor can expect from the broad market, the rate of return required for Cisco is 9.3%: that is the Risk Free Rate Plus Beta Multiplied by (Market Return Expectations minus Risk Free Rate) = 3% + 1.05 * (9% - 3%).

Present Value = 0.68*106% / (9.3%-6%) is then the present value of future dividend flows. That is equal to $21.84.

By this standard, Cisco is a bit expensive as it closed at $22.56 on 1/23/14. But I don't view the stock as expensive given the pessimistic assumptions. In addition, Cisco earnings expectations for July 2014 are $1.98, which implies a pay-out potential of $0.79 (assuming a 40% payout), which is higher than $0.68 being paid out. Valuing $0.79 growing at 6% for an investor demanding a return of 9.3% returns a result of $25.44, by which standard Cisco is cheap.

*Intel Is History: The PC Is Dead & You Know Naught About Mobiles*

Intel is cheap. If we assume that the dividend is all that Intel can afford to return to its shareholders, then the present value of future cash flows from dividends can be said to be what Intel is worth.

This is a very pessimistic view. If we assume in utter despair, that Intel will be able to achieve a return on equity of 10%, and grow at a rate of 6%, they will be able to return 40% of earnings to shareholders. As it happens, I expect Intel to do far better on return on equity and growth. But let's stay pessimistic and assume that all we shall ever see from Intel is $0.225 per quarter ($0.90/year), growing at an annualized rate of 6%. Keep in mind that when I say growing at an annualized growth rate of 6%, I accept that some years there will be no growth in the dividend, while in others, the growth will be higher. What is that worth?

We can calculate the present value of future dividend flows as Dividend multiplied by (1+growth rate) Divided by (Investor Return Expectation minus Growth Rate). What return should an investor want from a stock with a beta of below 1? For Intel, I am assuming that investors will demand a 9% long-term return, ignoring beta. In the case of Intel, the beta is below 1, thus the 9% return required in the valuation is higher than what the capital asset pricing model suggests markets should demand, and so the computed value of the stock is lower than it should be.

0.90*106% / (9%-6%) is then the present value of future dividend flows. That is equal to $31.80. Intel trades well below this level. But for Intel, earnings for December 2014 are $1.85 and a payout potential of 40% implies a dividend level of $0.74. If we value this $0.74 as the dividend, the stock is worth $26.14. Thus, Intel is cheap by both standards.

*Apple Who: Android Gotcha*

Apple is cheap.

If we assume in utter despair, that Apple will be able to achieve a return on equity of 10%, and grow at a rate of 6%, they will be able to return 40% of earnings to shareholders. Let us further assume that Apple's earnings drop to $40 before they are at a level where sustainable growth of 6% is feasible. As it happens, I expect Apple to do far better on earnings, return on equity, and growth. But let's stay pessimistic and assume that all we shall ever see from Apple is a dividend of $4 per quarter ($16/year) (40% of earnings), growing at an annualized rate of 6%. What is that worth? Note that present dividend is $3.05 per quarter or $12.20 annually. But we should see a hike in the dividend very soon. And in any case, the value returned through buybacks takes the value presently returned way over the $16 level.

We can calculate the present value of future dividend flows as Dividend multiplied by (1+growth rate) Divided by (Investor Return Expectation minus Growth Rate). In the valuation, I have used a notional dividend of $16, which represents a 40% pay-out ratio. What return should an investor want from a stock with a beta of below 1? For Apple, I am assuming that investors will demand a 9% long-term return, ignoring beta. In the case of Apple, the beta is below 1, thus the 9% return required in the valuation is higher than what the capital asset pricing model suggests markets should demand, and so the computed value of the stock is lower than it should be.

$16*106% / (9%-6%) is then the present value of future dividend flows. That is equal to $565.33. Apple is clearly cheap. Valuing the $12.20 actual dividend returns a value of $431 - at this level Apple is no longer merely cheap: it is a steal.

*Microsoft: The PC Is Dead, Your O/S Stinks, & Google Gives Me Software For Free*

Microsoft is cheap. If we assume that the dividend is all that Microsoft can afford to return to its shareholders, then the present value of future cash flows from dividends can be said to be what Microsoft is worth.

This is a very pessimistic view. If we assume in utter despair, that Microsoft will be able to achieve a return on equity of 10%, and grow at a rate of 6%, they will be able to return 40% of earnings to shareholders. As it happens, I expect Microsoft to do far better on return on equity and growth. But let's stay pessimistic and assume that all we shall ever see from Microsoft is $0.28 per quarter ($1.12/year), growing at an annualized rate of 6%. What is that worth?

We can calculate the present value of future dividend flows as Dividend multiplied by (1+growth rate) Divided by (Investor Return Expectation minus Growth Rate). For Microsoft, I am assuming that investors will demand a 9% long-term return, ignoring beta. In the case of Microsoft, the beta is below 1, thus the 9% return required in the valuation is higher than what the capital asset pricing model suggests markets should demand, and so the computed value of the stock is lower than it should be.

1.12*106% / (9%-6%) is then the present value of future dividend flows. That is equal to $39.57.

All four stocks trade below levels at which they can deliver a long-term return of over 9%. What more, the assumptions are pessimistic: I believe the long-term return potential could be over 13.5% because the long-term potential payout is likely near or over 60%, instead of the 40% pay-out potential I have assumed.

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