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After my recent articles wherein I estimated the fair value of Apple (NASDAQ:AAPL) using relative valuation, I received several requests to perform absolute valuation analysis to compare the results between the two valuation techniques. Honoring these requests, in this article, I will be presenting my valuation results for AAPL using the residual income based valuation.

Apple has grown its earnings at an annual rate of 67% during the last 5 years and is projected to grow its earnings at an annual rate of 20% over the next 5 years. The company's current return on equity is 44% compared to the 49% average return on equity of the computer peripherals industry. The company's ROE is, however, significantly higher than the ROE from the previous few years.

For example, AAPL sported an ROE of 35% in 2010 and 28% in 2009. I predict that the company's return on equity will decline and will hover in the range of 25% to 35% over the next 5-6 years. As part of my analysis which was performed for a period of 10 years, the ROE declines to 15% during the steady state. This return would however exceed the cost of equity by 5% providing modest returns to investors during the stable phase.

The valuation itself was performed under 3 different scenarios, identified below:

  • Optimistic Scenario: In this scenario, I assumed that APPL would report 2012 and 2013 EPS meeting the high end of analyst expectations. A growth rate of 20% was assumed for the next 5 years, matching market expectations.
  • Realistic Scenario: This scenario is based on my expectations. I started this analysis by employing the average 2012 and 2013 EPS estimates. Next, my projected long term growth rate of 14% was used to model earnings for the initial 5 year period.
  • Pessimistic Scenario: In this scenario, I assumed that the company would miss average forecasts for 2012 and 2013 and report an EPS matching the low end of analyst expectations. A growth rate of 10% was assumed as part of this analysis for the next 5 years.

A cost of equity of 10% and a stable growth rate of 2% was applied in the case of all three scenarios. Additionally, the declining ROE was used to detemine the corresponding growth rates for years 6 through 10 in these scenarios. The analysis results are present below:

Optimistic Scenario:

  • Growth Rate (years 1 through 10) - 15%
  • EPS 2012 - $46.4
  • EPS 2021 - $183
  • PV of Residual Income = $466
  • PV of Terminal Value = $314
  • Existing Book Value = $96.6
  • Intrinsic Value = $877

Realistic Scenario:

  • Growth Rate (years 1 through 10) - 12%
  • EPS 2012 - $42.7
  • EPS 2021 - $134.4
  • PV of Residual Income = $315
  • PV of Terminal Value = $231
  • Existing Book Value = $96.6
  • Intrinsic Value = $643

Pessimistic Scenario:

  • Growth Rate (years 1 through 10) - 11%
  • EPS 2012 - $33.2
  • EPS 2021 - $93.5
  • PV of Residual Income = $188.4
  • PV of Terminal Value = $160.6
  • Existing Book Value = $96.6
  • Intrinsic Value = $446

As shown the sections above, my valuation of AAPL ranges from $446 to $877. The pessimistic scenario is very conservative, in my opinion. In fact, the 2012 EPS used in the analysis is lower than the TTM EPS of $35.11. I am more in agreement with the realistic scenario valuation of $643. This compares favorably with my relative valuation based price target of $677 a share. At mid-point, my fair value estimate for AAPL is $660 a share. At current levels of $530.26, AAPL offers a return potential of 25%.

Source: Apple: A Residual Income-Based Valuation