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How do we estimate the fair value of a company? Professor Donald F. Kuratko from Indiana University, Kelley School of Business, suggests at least 10 different valuation methods: Tangible Book Value, Multiple of Earnings, Price to Earnings Ratio, Replacement Value and Liquidation Value, to name a few.

One of the most commonly used valuation methods that is well accepted in the academy is the discounted cash flow model. As Prof. Kuratko states:

This model attempts to establish future earning power in current dollars. Projects future earnings (five years), calculates present value using a then discounted rate based on projected “timing” of future income.

While the cash-flow model is theoretically well-defined, it lacks the clarity and has limited practical use. One needs to determine all future cash flows in order to calculate the fair value. A practical, fair-value approximation is the discounted future earnings model. Similar to the discounted cash-flow model, this methodology discounts the future earnings in current dollars. Here is the simple formula:

Fair Value = Earningst0 + Earningst1 + Earningst2 + … + Earningst5 + Capital Valuet5

Discounting the present value of future earnings give us the following:

V = Et0 + Et1/(1+r) + Et2/(1+r)2 + … + Et5/(1+r)5 + CV5/(1+r)5

Estimating the capital value at the last period is a challenge. Assuming that the earnings will remain stable after five years, we can use the fundamental algebra to determine the capital value at the last period. This way, one can think of the earnings after the last period as a perpetuity that creates regular earnings:

CVt5 = Et5 / r

The formula is finalized as follows:

V = Et0 + Et1/(1+r) + Et2/(1+r)2 + … + Et5/(1+r)5 + Et5

We can redefine the future earnings based on estimations about earnings growth:

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

While this formula might look scary for many of us, it easily calculates the fair value of a stock. The entire complexity of stock metrics is reduced to just three parameters. All we need is the current-period earnings, earnings growth estimate and the discount rate. You can set these parameters as you wish according to your own diligence. If you require a higher return, set the discount rate higher. If you think that the growth rate is overly optimistic, set the growth rate lower. The discount rate is truly subjective, and it might vary from sector to sector. Historically, the average return of DJI has been around 11% (including dividends). Therefore, for this analysis, I will use a discount factor 0.11 since a return lower than that rate is not acceptable for me. The upside potential is calculated in the same way as Benjamin Graham’s Margin of Safety. Applying the discounted earnings growth formula to the largest 40 technology stocks that have a maximum P/E ratio of 30 gives the following results:

Company

Expected Growth

Fair Value

Current Price

Potential

Telecom Italia (TI)

5,85%

$32,63

$15,40

111,86%

Telefonica, S.A. (TEF)

5,90%

$45,21

$24,68

83,16%

Vodafone (VOD)

-0,35%

$47,44

$28,55

66,17%

AT&T (T)

6,16%

$46,61

$28,19

65,33%

Corning (GLW)

11,50%

$34,11

$21,42

59,23%

Research In Motion (RIMM)

21,59%

$97,63

$62,35

56,58%

Nippon T & T (NTT)

5,00%

$34,69

$23,19

49,61%

Intel (INTC)

11,00%

$30,33

$20,84

45,55%

Hewlett-Packard (HPQ)

10,06%

$58,96

$41,49

42,11%

Microsoft (MSFT)

10,55%

$35,47

$25,69

38,08%

France Telecom (FTE)

8,50%

$29,23

$21,38

36,72%

Dell (DELL)

6,60%

$19,61

$14,97

31,00%

China Mobile (CHL)

2,30%

$61,74

$47,85

29,02%

Taiwan Semiconductor(TSM)

15,00%

$15,66

$12,16

28,77%

BT Group (BT)

13,45%

$37,96

$30,28

25,37%

NTT DOCOMO (DCM)

3,90%

$21,46

$17,67

21,43%

Nokia (NOK)

6,63%

$10,03

$8,30

20,80%

Rogers Communications (RCI)

10,23%

$40,92

$34,67

18,02%

Texas Instruments (TXN)

10,29%

$39,44

$34,56

14,12%

Cisco (CSCO)

11,85%

$20,07

$17,85

12,45%

IBM (IBM)

10,68%

$174,25

$161,39

7,97%

America Movil (AMX)

10,11%

$56,29

$55,63

1,19%

Applied Materials (AMAT)

9,67%

$15,06

$14,96

0,69%

Mobile Telesystems (MBT)

21,55%

$20,55

$20,74

-0,90%

BCE, Inc. (BCE)

3,28%

$34,36

$35,48

-3,16%

Siemens AG (SI)

21,47%

$111,53

$126,48

-11,82%

Apple (AAPL)

19,27%

$292,40

$353,56

-17,30%

Broadcom (BRCM)

17,31%

$31,70

$40,56

-21,84%

Yahoo! Inc. (YHOO)

9,41%

$13,39

$17,31

-22,63%

Google (GOOG)

19,03%

$428,34

$569,99

-24,85%

China Telecom (CHA)

17,20%

$43,18

$59,21

-27,07%

Automatic Data (ADP)

10,23%

$34,77

$50,10

-30,60%

Chunghwa Telecom (CHT)

2,10%

$20,17

$29,72

-32,12%

LM Ericsson (ERIC)

10,00%

$8,08

$12,11

-33,30%

Oracle (ORCL)

14,02%

$20,63

$31,59

-34,68%

QUALCOMM (QCOM)

15,84%

$34,25

$53,48

-35,95%

Infosys Technologies (INFY)

17,55%

$40,60

$67,83

-40,14%

SAP AG (SAP)

11,97%

$32,27

$58,79

-45,10%

Wipro (WIT)

16,75%

$7,48

$13,70

-45,37%

EMC Corp. (EMC)

14,34%

$13,69

$26,21

-47,75%

Average

11,19%

9,77%

Based on the discounted future earnings model, foreign telecommunications companies have the greatest upside potential. Telecom Italia (Italy) and Telefonica (Spain) are the lowest-priced stocks with upside potentials of 110% and 83%, respectively. Telecom Italia’s net profit ratio is 20%. Current P/E ratio of 6.5 is the lowest in the industry. With a dividend yield of 5.5%, Telecom Italia is a solid dividend company. Vodafone (U.K.) ranked third followed by AT&T. Note that Vodafone has a large stake in Verizon (VZ). Cash-rich Microsoft and Intel have upside potential of 38% and 45% respectively.

When we look at the bottom of the list, one can see that America’s favorite high-tech companies, Apple and Google, are well-overpriced. It is an undeniable fact that both Apple and Google are excellent companies. They are the leaders of innovation. They introduce the latest, top-of-notch gadgets and make our life much easier. It is hard to think of a life without searching through Google. My iPad 2 will be the best thing I own after my iPhone. They are great companies but not great stocks. The analysts have optimistic growth expectations, but their stocks are priced above their intrinsic value.

Source: Top Technology Stocks With Highest Upside Potential