This week saw mixed signals for investors. Initially, the debt-deal brought some sort safety. According to the deal, European banks were supposed to write-off 50% of Greek debt. However, in a surprising move, Greek Prime Minister Papandreou announced that he will take the debt deal to a national referendum. This caused a sharp sell-off in the market. Later on, the referendum plan was killed, but the markets closed the week with significant losses. Financials took the most damage (-5.5%), followed by conglomerates (-3.4%) and consumer goods (-3.3%). Even after reporting blow-out earnings, technology stocks could not resist the market pessimism and closed the week 2.1% lower.
Tech companies are highly diversified. While the technology titans trade at substantial discounts, the relatively smaller tech stocks are trading at a pretty high premium. Choosing the best stock in this environment remains a challenge. There are several ways to determine the fair value of a company. I have been using FED+ discounted earnings model and O-Metrix grading system to estimate the intrinsic value of stocks and also to rank them. So far, the models worked pretty well in distinguishing fairly-valued stocks from irrationally exuberant ones. Here is a brief review of the FED+ 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 fair-valued IPOs. The methodology is based on discounting the present value of the 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. 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. Applying this model to selected technology stocks with updated data resulted in the following trade ideas:
Company | O-Metrix | Fair Value Range | My Take | |
Microsoft (MSFT) | 7.72 | $44 | $51 | Buy |
Google (GOOG) | 5.94 | $764 | $932 | Buy |
Cisco (CSCO) | 4.35 | $22 | $30 | Buy |
Texas Instruments (TXN) | 4.80 | $35 | $45 | Buy |
Qualcomm (QCOM) | 4.57 | $54 | $70 | Hold |
EMC Corp. (EMC) | 3.86 | $24 | $32 | Hold |
Automatic Data (ADP) | 3.39 | $41 | $52 | Hold |
Buy Ideas
Microsoft has an almost-monopoly position in its field. The company is highly profitable with a gross margin of 77%, and net profit margin of 33%. However, the Street does not appreciate Microsoft’s profitability. Although the cash-rich company has almost $7 of cash per each share, it is trading with single digit P/E ratios. Trailing P/E ratio is 9.55, whereas the forward P/E ratio falls to 8.52. Surely, Microsoft does not have the same growth potential as it did in the last decade, but the stock looks pretty cheap. Based on 10.90% EPS growth estimate, it has an O-Metrix score of 7.72. A fair value range of $44 - $51 implies at least 67% upside potential. While not as bullish as the model suggests, analysts mean target price of $32 implies an almost 25% upside potential.
Google showed a highly volatile profile this year. The stock bounced back and forth between $500 - $600 ranges several times throughout year. Google is also highly profitable with a gross margin of 65%, and net profit margin of 27%. The company has $131 of cash per share. Even after returning 11% in the last month, the year-to-date return barely makes it to the positive territory. Based on 20.20% EPS growth estimate, it has an O-Metrix score of 5.94. Fair value range of $764 - $932 implies at least a 28% upside potential. Analysts mean target price of $730 is close to the low-end of my fair value range. RBC Capital has an outperform rating with a target of $800.
Cisco, the star of the techno-bubble show, has been among the losers of 2011. Even after showing a quarterly performance of 30%, the year-to-date return of 10% is way below its peers. From a technical perspective, the stock showed an inverse-curve formation. It looks like after coming down all the way to a low of $13, it is going back to its 52-week high of $24. There is a huge gap between the $22 - $19 range, which I expect to be filled as the stock recovers. Fundamentals look fine. While the trailing P/E ratio is 15.54, the forward P/E ratio falls to 9.59. Based on an annualized EPS growth estimate of 9.60%, Cisco has an O-Metrix score of 4.35. Fair value range is $22 - $30.
Texas Instruments has also been a disappointment in 2011. Similar to Cisco, the stock fell steadily, all the way down to $24 from $36; losing 50% of its market cap between March and September. Thanks to the October recovery, it is moving back to its 52-week highs. The company pays a yield of 2.14%. Based on an annualized EPS growth estimate of 10.80%, it has an O-Metrix score of 4.80. Fair value range is $35 - $45. UBS has a target price of $35, which is at the lower end of my fair-value range.
Hold Ideas
Qualcomm has been an outperformer, returning almost 16% since January. The company is engaged in the development, design, manufacturing, and marketing of digital communication equipments. EPS increased by 14% in the last quarter, and more than 100% since the last year. However, the trailing P/E ratio of 21.56 and forward P/E ratio of 16.33 shows that the company is slightly expensive compared to its peers. Based on an annualized EPS growth estimate of 15.80%, it has an O-Metrix score of 4.57. Fair value range is $54 - $70. Therefore, I rate Qualcomm as a hold.
EMC Corporation provides data infrastructure technologies and solutions worldwide. The stock was deeply affected from the August sell-off, falling from $29 to $19 in a month. Since October, it is in a high momentum mode, returning almost 20%. EMC does not have any significant debt issues. Debt to Equity ratio is 0.19. Based on an annualized EPS growth estimate of 15%, it has an O-Metrix score of 3.86. Fair value range is $24 - $32. Analysts' mean target price of $29.83 fits perfectly at the middle of its fair value range. I think the stock is fairly-valued and one should look for cheaper stocks. Therefore, I rate EMC as a hold.
Automatic Data Processing is one of the best dividend payers among technology stocks. Its current yield is 2.79%. The stock has been an outperformer, returning 14% in 2011. It has no debt issues. Debt to equity ratio is 0. Sales increased by 7.64% in the last 5 years. Annualized earnings growth of 11.62% is also impressive. However, at a trailing P/E ratio of 20.09 and forward P/E ratio of 17.04, the stock looks expensive compared to its peers. Based on an annualized EPS growth estimate of 9.80%, it has an O-Metrix score of 3.39. Fair value range is $40 - $52. As of Friday close, it was trading at the upper end of its fair value range. Therefore, I rate ADP as a hold.