Applied Materials Inc. (AMAT) is a diversified semiconductor company. The company is a major equipment and service provider to liquid crystal displays and solar photovoltaic industries worldwide. Founded in 1967, Santa Claraheadquartered AMAT is one of the leading players in the semiconductor and solar sectors. The company is doing fine and was able to double its earnings this year. However, the stock lost 22% in 2011, primarily due to the oversupply concerns in the solar industry.
As of the time of writing, AMAT stock was trading at $10.7 with a 52week range of $10  $17. It has a market cap of $14 billion. Trailing twelve month [ttm] P/E ratio is 7.4, and forward P/E ratio is 9. P/B, P/S, and P/CF ratios stand at 2.6, 1.4, and 5.9, respectively. Operating margin is 22.8%, and net profit margin is 18.3%. The company does not have any significant debt issues. Debt/equity ratio is 0.2. AMAT is a nifty dividend payer. The company was able to boost its dividends by almost twofold in the last 5 years. Current yield is 3% with a payout ratio of 21%.
AMAT has a 5star rating from Morningstar. Out of 21 analysts covering the company, 7 have buy, 2 have outperform, and 10 have hold ratings. Wall Street has diverse opinions on AMAT's future. Top line growth estimate is 31%, and the bottom line growth estimate is 17% for the next year. Average fiveyear annualized growth forecast estimate is 12%.
What is the fair value of AMAT given the forecast estimates? We can estimate the fair value using discounted earnings plus equity model as follows.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from longterm projects. It is also frequently used to price fairvalued 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} + â€¦ + 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 currentperiod earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.
Valuation
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.
E_{0} = EPS = ($1.45 + $1.23) / 2 = $1.29
Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average fiveyear growth forecast is 12%. Book value per share is $6.7.
The rest is as follows:
Fair Value Estimator  
V (t=0)  E_{0}  $1.29 
V (t=1)  E_{0} (1+g)/(1+r)  $1.31 
V (t=2)  E_{0}((1+g)/(1+r))^{2}  $1.33 
V (t=3)  E_{0}((1+g)/(1+r))^{3}  $1.35 
V (t=4)  E_{0}((1+g)/(1+r))^{4}  $1.37 
V (t=5)  E_{0}((1+g)/(1+r))^{5}  $1.39 
Disposal Value  E_{0}(1+g)^{5}/[r(1+r)^{5}]  $12.60 
Book Value  BV  $6.74 
Fair Value Range  Lower Boundary  $20.6 
Upper Boundary  $27.4 

Minimum Potential  92% 

Maximum Potential  155% 
(You can download FED+ Fair Value Estimator, here.)
I decided to add the book value per share so that we can distinguish between a lowdebt and debtloaded company. The lower boundary does not include the book value. According to my 5year discountedearningsplusbookvalue model, the fairvalue range for AMAT is between $20.6 and $27.4 per share. At a price of $10.75, AMAT is at least 92% undervalued.
Summary
Technology stocks are pretty cheap in general, and Applied Materials is no exception. 2011 has been a great year, where the profits showed a strong recovery. However, the stock has been heading to the south for a while. The stock lost near 22% in 2011, but the technical indicators suggest $10 as a strong resistance level.
AMAT did not perform well in this year. The stock is trading close to its midrecession prices. As Bret Jensen suggests, Applied Materials is trading at the very bottom of its five year valuation range based on fundamental valuation.
Based on my FED+ valuation, AMAT is trading at least 92% below its fair value range. Oppenheimer has an upgraded target price of $16, implying near 60% upside potential in nearterm. I rate AMAT as a buy with a target price of $20. I think it is a great dividend stock for 2012, and beyond. The current price offers a compelling entry point for those interested.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.