Potential Trade: Buy Apple Inc. (NASDAQ:AAPL) around $500 | Stop-loss: $450| Target: $780
Much time has been wasted stressing over the latest operating moves Apple might make. No matter how you look at it, Apple, Google (GOOG), Nokia (NOK), Samsung (OTC:SSNLF), and every other large company in the industry is driven by brilliant employees who devote their lives to inventing the next best thing. Odds are those professionals who are paid to analyze, innovate, and market their company's products, know significantly more about the cellular phone industry than you or me.
I try not to waste time analyzing company pricing strategies or product designs - these strategies can be debated infinitely and there still will not be a "right" or "wrong" answer. I am an investment analyst, so I focus on factors that may or may not make a good investment. It does not matter if Apple makes the "perfect" decision when it comes to its product strategies; all that matters is if the company is currently overvalued or undervalued. Of course an analyst must analyze and understand the subject company's strategy, but the majority of his or her time should be spent conducting financial analysis - after all, he/she is a finance expert, not a VP of Software Engineering. As financial professionals we should focus on our area of expertise: valuing countries, industries and companies.
With that said, here are the 3 reasons buying Apple is a smart trade:
1. Based on my financial models, Apple is grossly undervalued
2. The possible positive catalysts are more probable and significant than the negative catalysts
3. The risk-reward of the trade is solid
1. Valuation of Apple using discounted cash flow model
Discounted Cash Flow:
P = E1Q + E2Q2 + ... + ENQN + ENQN x Q/(1 - Q)
Discounted Cash Flow Inputs
Earnings expected to grow at
For the next
Before leveling off to an annual growth rate of
Return Available on S&P 500
Stock Value Per Share
My valuation: 768.1
Market price: 500.75
According to my valuation, with what I consider conservative inputs, AAPL is $267.35 (35%) undervalued.
Based on this valuation, I believe entering a trade on AAPL would be wise as there is significant potential for a short-term upside of 6%, a mid-term correction of 35%, and long-term income.
2. Overview of potential positive and negative catalysts
- Negative economic data can have an effect on the overall market and subsequently Apple's stock price. If economic data in China and the U.S. worsens, it may be a good time to get out of Apple or at least hedge your investment with a short position. For example, if any U.S. or Chinese economic indicators of "High Importance" are released at 10% worse than expected, I believe this will have an immediate and significant negative effect on the market of between 5 to 15% over the course of a few days. Since Apple has a beta of .88, I believe it would be wise to exit the position immediately or go short SPY to protect your trade from systemic risk. I believe the probability of significant negative economic data of 10% worse than expected being released within the next year is about 50%.
- If Apple introduces a new product that is clearly rejected by the consumer market after months on the consumer market, it is time to exit your position in Apple as this could be a sign of waning talent among the ranks of the executives at Apple or the market's weariness of the company which would have a significant effect on the present value of Apple's future cash flows and hence a 10-15% negative impact on its stock price between one to three months. I believe there is a 30% chance this will happen within the next year.
- If a buyback, increased dividend, or significant string of acquisitions is not consummated by the company's management within the next year, it is time to get out of Apple as this would be a sign that management is too incompetent or uncooperative to maximize the wealth of Apple's shareholders. Depending on the severity of the bad management decision, I believe there would be a 4 to 15% decline in the stock's price within a few days. I give this scenario a 20% likelihood of occurring.
- Strong Chinese or U.S. economic data would be good for Apple. If U.S. or Chinese economic indicators of a "High Importance" are released at 10% better than expected, this will probably have a positive effect on the market as a whole, especially for Apple. Specifically for Apple, if the Chinese economy improves, the company has a better chance at selling more of its notoriously high-priced products to Chinese consumers. Since Apple's management has alluded to China being the largest source of Apple's growth, strong Chinese economic data should have a largely positive effect on Apple's stock price of between 5-15% within a few days of the data being released. I am giving this scenario a 50% likelihood of occurring within a year.
- If Apple introduces another innovative product category in 2014 that is broadly accepted as being up to par to Apple's reputation of being the most innovative company in the world, I believe this will have a positive impact of 10-30% on Apple's stock price within 1-3 months of the new product's release. Apple is forever changed by Steve Jobs and the talent he had for innovation. Although I believe he will never be replaced, Tim Cook worked alongside Jobs since 1998 and I am betting that a large amount of his wisdom and foresight was instilled within Cook. Because of this, I believe there is a 70% likelihood that Apple's next product will be a success.
- If management significantly increases its dividends, creates a significant increase in its stock buyback program, or executes a solid acquisition or string of acquisitions, I believe this would have a positive impact on share prices of between 5-20% within a week of the announcement by management. Not only would a good management decision create immediate tangible value for Apple's shareholders, it would also probably improve investor confidence in Apple's management-something that can have a significant effect on the stock price of a company. I give this scenario an 80% likelihood of occurring within a year since failing to execute one of the aforementioned actions could possibly make Apple's management vulnerable to derivative action by shareholders since having such a large amount of cash and cash equivalents on Apple's balance sheet is harmful to the shareholders.
3. Risk-reward analysis:
The table below shows the probability of each catalyst occurring independently within one year from today, 01/30/2014, based on my calculations and forecasts, and the share price impact of the catalysts. I will use these values to analyze the risk and reward of making a trade in AAPL.
Keep in mind this chart shows the estimated probabilities of these catalysts occurring independently.
The calculations I am about to present are based on the following assumptions:
- The investor who is taking on this trade will have the ability to exit the position as soon as one of the negative scenarios occurs.
- The probability of a share price movement of any percent between the low and high end of the scale is equally likely.
- Once an event occurs, no other event can happen.
The probabilities of the events occurring are presented in the graph below. All six events are mutually exclusive since once the first event occurs, whether positive or negative, a re-analysis is required.
Probability of each event happening first
Strong Economic Data
New Product Acceptance
MNGT + Shareholder Value
Weak Economic Data
New Product Rejected
Financial Management Folly
Strong Economic Data 16.67% Probability
New Product Acceptance 23.33% Probability
MNGT + Shareholder Value 26.67% Probability
Weak Economic Data 16.67% Probability
New Product Rejected 10% Probability
Financial Management Folly 6.7% Probability
Time frame: 1-3 months (this time-frame is based on the probability of one of the six catalysts occurring at any time within a year. Odds are, the first event will happen within 1 to 3 months).
Max Return: 30%
Expected return: 6.12%
Max Loss: -15%
Probability of a positive catalyst event occurring first: 66.67%
Probability of a negative catalyst event occurring first: 33.33%
Since I never allow myself to lose more than 10% on any given trade, I set the stop-loss at -10%.
Risk-Reward Ratio: 3:1
Apple is grossly undervalued and is offering investors and traders the opportunity to buy in cheaply, enjoy short-term capital gains and long-term growth. I believe the upside could be tremendous for this company as my forecasts and estimates are extraordinarily conservative and still yield a value on the company well above the current market price. Less conservative numbers gave astounding values of up to 3x the current price of the company.