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Apple (NASDAQ:AAPL), the world's largest high-tech company, has a remarkable growth record. In the last 5 years the company was able to boost its earnings by a whopping 60.03% annually. In 2006, EPS was \$2.27, whereas the ttm [trailing twelve month] EPS is \$20.99.

Apple, a relatively small high-tech company of the last decade, became a truly global titan. It is also the most popular stock among hedge funds, as well as Apple fans. As of June 9 close, the stock was trading at \$331.49 with a ttm P/E ratio of 15.8, and forward P/E ratio of 11.5. Wall Street has diversified opinions on Apple's future. The bottom line is 7.2% growth, where the top line annualized growth estimate is 34.1%. Average five year growth forecast estimate is 17.2%. What is the fair value of Apple given the forecast estimates? Let's calculate it together using discounted earnings plus equity model.

## Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price normal IPOs (surely not LinkedIn (NYSE:LNKD)).

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

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

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]

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

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / 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. To be as objective as possible, I use Morningstar data for my estimates. 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). Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of \$20.99 with the mean estimate of \$24.73 for the next year.

E0 = EPS = (24.73 + 20.99) / 2 = \$22.86

The rest is as follows:

 V0 E0 \$22.86 V1 E0 (1+g)/(1+r) \$24.14 V2 E0((1+g)/(1+r))2 \$25.49 V3 E0((1+g)/(1+r))3 \$26.91 V4 E0((1+g)/(1+r))4 \$28.41 V5 E0((1+g)/(1+r))5 \$30.00 D E0(1+g)5/[r(1+r)5] \$272.71 BV per Share Equals \$66 Fair Value Equals \$430.51

I decided to add the book value per share so that we will distinguish between a low-debt and debt-loaded company. According to my 5 year discounted earnings model, the fair value estimate for Apple is \$430 per share. As of June 9 close, Apple was trading at \$331. Apple is undervalued by \$100. While I do not expect this gap to be closed by this year, I think Apple will beat the market in the next 5 years.

## O – Metrix Confirmation

If the math above looks too complicated for you, try estimating the fair value using O-Metrix such that

O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5

Dividend Yield: Higher is better.
EPS Growth: Higher is better.
P/E Ratio: Lower is better.

I multiplied the original formula mentioned by Jeremy Siegel by 5 to get a scale over 10. The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as 5 years. I am also continuously checking on specific sectors, and the formula works very well so far.

## What is the O-Metrix Score of Apple?

• Apple does not pay any dividends, so yield equals 0.
• Growth estimate is the same as discounted earnings model, and is equal to 17.2%.
• Since we are at the middle of the year, taking the average of ttm [15.8] and forward [11.5] P/E ratios will smooth the results. Thus, average P/E ratio to be used in the model is 13.65.

O-Metrix = [(0 + 17.2) / (13.65)] * 5 = 6.3

As of June 9 close, the average P/E ratio of stocks tracked by finviz is 16.18, while the forward P/E ratio is 12.23. The EPS growth estimate for the next five years is 12.19%, and yield is 1.89%. The average market O-Metrix score is calculated as follows:

O-Metrix = [(1.89 + 12.19)/14.25]*5 = 4.94

Apple's O-Metrix score is 27% higher than the market average. Back-testing of this ranking system shows that companies with high-than-average O-Metrix scores beat the market with lower volatility. Apple is in the high-return safety zone.

## Summary

The stock is trading for \$331, which is 30% lower than my fair value estimate. While I do not expect this gap to be closed in a short period of time, I think Apple will beat the market returns. Do not expect above 40% annualized returns of the last 5 years. However, a return of 15% to 20% is easily attainable. Apple has been testing its \$330 support level, several times. Thus, \$330 is very a strong support level. Unless something really bad happens, it will stay above \$330. The downside is minimal, whereas there is a large upside potential in Apple.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.