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 = E_{0} + E_{1 }/(1+r) + E_{2 }/(1+r)^{2} + E_{3}/(1+r)^{3} + E_{4}/(1+r)^{4} + E_{5}/(1+r)^{5 } + Disposal Value
V = E_{0} + E_{0 }(1+g)/(1+r) + E_{0}(1+g)^{2}/(1+r)^{2} + … + E_{0}(1+g)^{5}/(1+r)^{5} + E_{0}(1+g)^{5}/[r(1+r)^{5}]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E_{0}(1+g)^{5}/[r(1+r)^{5}] = E_{5} / 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.
E_{0 }= EPS = (24.73 + 20.99) / 2 = $22.86
The rest is as follows:
V0 | E_{0} | $22.86 |
V1 | E_{0 }(1+g)/(1+r) | $24.14 |
V2 | E_{0}((1+g)/(1+r))^{2} | $25.49 |
V3 | E_{0}((1+g)/(1+r))^{3} | $26.91 |
V4 | E_{0}((1+g)/(1+r))^{4} | $28.41 |
V5 | E_{0}((1+g)/(1+r))^{5} | $30.00 |
D | E_{0}(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.