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Fair value estimation based on discounted earnings formula is a well-defined economic model, which is also accepted by many investment bankers. In fact, many IPO prospectuses use this model as one of the fair value estimation tools, along with other methods such as tangible book value, and price to earnings ratio. As Professor Donald F. Kuratko from Indiana University, Kelley School of Business, states:

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

The methodology is based on discounting the present value of future earnings to the current period:

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)7/(1+r)7 + E0(1+g)7/[r(1+r)7]

The earnings after the last period act as a perpetuity that creates regular earnings:

CVt7 = Et7 / r

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 3 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.

Historically, the average return of DJI has been around 11% (including dividends). Therefore, for this analysis, I will use a discount factor 0.11. The excess-return potential is calculated in the same way as Benjamin Graham’s Margin of Safety. Data is obtained from Finviz, and Zacks Research. Applying the discounted earnings growth formula to the largest U.S.-based technology stocks gives us the following outperformers:

Outperformers

Company

EPS Growth

Fair Value

Excess Potential

Micron Technology (NASDAQ:MU)

11,75%

30,76

67,01%

Novell (NASDAQ:NOVL)

7,00%

15,34

62,27%

DST Systems (NYSE:DST)

10,00%

113,35

56,13%

Western Digital (NASDAQ:WDC)

7,18%

75,13

54,82%

SanDisk (NASDAQ:SNDK)

12,50%

94,74

54,51%

Vishay Intertech. (NYSE:VSH)

12,00%

33,13

48,69%

Teradyne (NYSE:TER)

15,50%

31,70

46,59%

Corning (NYSE:GLW)

11,50%

38,74

46,28%

AT&T (NYSE:T)

6,16%

51,43

45,86%

Computer Sciences (NYSE:CSC)

8,18%

87,00

45,49%

TW Telecom (NASDAQ:TWTC)

25,10%

33,65

45,26%

Lam Research (NASDAQ:LRCX)

10,00%

90,28

43,64%

Intel (NASDAQ:INTC)

11,00%

34,35

41,96%

Harris (NYSE:HRS)

6,00%

77,61

40,06%

Lexmark (NYSE:LXK)

-6,27%

59,31

39,50%

Microsoft (NASDAQ:MSFT)

10,55%

40,07

37,58%

Hewlett-Packard (NYSE:HPQ)

10,06%

66,42

36,87%

AVX (NYSE:AVX)

12,00%

23,07

35,77%

Atmel (NASDAQ:ATML)

18,33%

17,28

35,15%

Dell (NASDAQ:DELL)

6,60%

21,69

33,92%

National Semi. (NYSE:NSM)

8,23%

20,53

32,11%

Novellus Systems (NASDAQ:NVLS)

13,00%

49,32

28,43%

Texas Instruments (NASDAQ:TXN)

10,29%

44,48

25,50%

Cisco Systems (NASDAQ:CSCO)

11,85%

22,85

24,11%

Xilinx (NASDAQ:XLNX)

13,38%

41,28

23,50%

IBM (NYSE:IBM)

10,68%

196,98

20,68%

KLA-Tencor (NASDAQ:KLAC)

15,95%

55,19

18,86%

ON Semi. (NASDAQ:ONNN)

13,33%

11,68

18,27%

One might notice that there is a strong and negative correlation between excess potential and P/E ratio. Thus, value stocks are expected to outperform in the long run. Warren Buffett is a value investor who made substantial profits by holding on to the value stocks in his portfolio. Based on the discounted future earnings model, Micron, Novell and DST systems have the greatest excess return potential over 7 year period.

Micron is a semiconductor company that produces memory chips. Insiders own 8% of the shares and institutional ownership ratio is 88%. It is quite intriguing to see such a low P/E ratio for a company that has an almost 90% institutional ownership. The current profit margin of 21.33% is well above the industry standards. Analysts have consistently updated the target price for Micron. Recently, UBS upgraded the company with a target price of $14. The investment guru, David Tepper, is also extremely bullish about MU.

The model also accounts for growth, as well. Companies with double digit P/E ratios such as TW Telecom and Microsoft are still in the Top 30 list thanks to their high earnings potential. Western Digital, SanDisk, AT&T, Intel, Lexmark, Texas Instruments, Cisco, and IBM are other noticeable companies in the long-term outperformers list. Let’s look at the stocks with worst long-run upside potentials:

Underperformers

Company

EPS Growth

Fair Value

Excess Potential

Molex (NASDAQ:MOLX)

7,18%

21,37

-14,87%

Amphenol (NYSE:APH)

10,07%

47,38

-17,40%

Waters (NYSE:WAT)

13,03%

71,72

-17,41%

International Game (NYSE:IGT)

13,94%

13,40

-18,61%

Adobe Systems (NASDAQ:ADBE)

13,92%

26,44

-21,84%

Automatic Data (NASDAQ:ADP)

10,23%

39,21

-26,13%

Cree (NASDAQ:CREE)

21,97%

38,50

-27,90%

Qualcom (NASDAQ:QCOM)

15,84%

39,98

-28,41%

Oracle (NYSE:ORCL)

14,02%

23,80

-29,78%

MetroPCS (PCS)

24,43%

11,57

-30,02%

Windstream (NASDAQ:WIN)

0,18%

9,79

-30,44%

Compuware Corp (NASDAQ:CPWR)

11,00%

8,37

-31,35%

NCR (NYSE:NCR)

21,00%

13,88

-32,30%

Quest Software (NASDAQ:QSFT)

13,00%

18,49

-33,55%

Symantec (NASDAQ:SYMC)

9,38%

12,85

-34,82%

Rovi (NASDAQ:ROVI)

18,57%

39,92

-35,20%

Telephone & Data (NYSE:TDS)

10,00%

22,91

-39,48%

ADTRAN (NASDAQ:ADTN)

11,75%

30,76

-43,03%

Beckman Coulter (NYSE:BEC)

8,93%

54,08

-53,30%

NetApp (NASDAQ:NTAP)

18,09%

30,99

-53,59%

MICROS Systems (NASDAQ:MCRS)

19,00%

30,31

-54,75%

Syniverse Holdings (SVR)

11,00%

20,00

-54,93%

Synopsys (NASDAQ:SNPS)

10,00%

16,84

-58,28%

Teradata (NYSE:TDC)

11,23%

30,35

-62,98%

EMC Corporation (NYSE:EMC)

14,34%

15,83

-63,76%

FactSet Research (NYSE:FDS)

14,80%

59,25

-65,67%

Maxim Integrated (NASDAQ:MXIM)

13,20%

14,66

-65,84%

Frontier Com. (NASDAQ:FTR)

0,50%

4,76

-70,23%

Acuity Brands (NYSE:AYI)

11,50%

32,03

-71,33%

Brocade Com. (NASDAQ:BRCD)

10,33%

3,38

-72,24%

Looking at the underperformers list, one might notice that stocks with higher P/E ratios are destined to be underperformers in the long run. I was not surprised to see Adobe turned out to be in the underperformers list. Until Adobe acquired Macromedia for $3.4 billion, there was a fierce competition between Adobe and Macromedia. Somehow, the company still could not create the synergy in multimedia applications. Symantec, Oracle, and EMC are other well-known companies in the underperformer list. Analysts expect double digit growth for these companies in the next few years. However, this is already factored in the stock prices driving them beyond their fair value.

Disclaimer: Do NOT blindly trust any formula and short any of the stocks with negative potential. An excess return of “0” implies that I expect the annual return to be around the discount rate. A negative excess return potential does not necessarily imply that these stocks will have negative returns. Thus, these stocks are expected to perform lower than the preset discount rate.

Source: Best and Worst Technology Stocks for the Long Run