Hewlett-Packard: Ready To Double

Apr. 1.12 | About: HP Inc. (HPQ)

Founded in 1939 by two fellow Stanford students, Hewlett-Packard Company (HPQ) is one of the world's largest information technology and solutions provider. The company not only provides technological instruments such as laptops, printers, cameras, desktops, but it also offers cutting edge software services. Although Hewlett-Packard was affected from numerous disasters on 2011, such as the tsunami in Japan and flood in Thailand, the company managed to keep its revenues. Its total revenues amounted to $127.2 billion in the last year. HPQ generated a net income of almost $6 billion in the same period.

As of the time of writing, HPQ stock was trading at $23.51 with a 52-week range of $21.50 - $42.01. It has a market cap of $46.49 billion. Trailing twelve month [ttm] P/E ratio is 8.23, and forward P/E ratio is 5.32. P/B, P/S, and P/CF ratios stand at 1.2, 0.37, and 4.5, respectively. Operating margin is 6.66%, and net profit margin is 4.75%. The company has some debt issues. Debt / equity ratio is 0.79 and Hewlett-Packard's dividend yield is 2.04%, supported by a low payout ratio of 16%.

Hewlett-Packard has a 5-star rating from Morningstar. Out of 9 analysts covering the company, 3 have buy, 4 have hold, 1 has underperform and 1 has sell ratings. The average five-year annualized growth forecast estimate is 7.30%.

What is the fair value of Hewlett-Packard 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 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 = 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. 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 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.

E0 = EPS = ($2.86 + $4.42) / 2 = $3.64

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 five-year growth forecast is 7.30%. Book value per share is $19.80.

The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$3.64

V (t=1)

E0 (1+g)/(1+r)

$3.52

V (t=2)

E0((1+g)/(1+r))2

$3.40

V (t=3)

E0((1+g)/(1+r))3

$3.29

V (t=4)

E0((1+g)/(1+r))4

$3.18

V (t=5)

E0((1+g)/(1+r))5

$3.07

Disposal Value

E0(1+g)5/[r(1+r)5]

$27.95

Book Value

BV

$19.80

Fair Value Range

Lower Boundary

$48.06

Upper Boundary

$67.86

Minimum Potential

104.18%

Maximum Potential

188.30%

Click to enlarge

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for HPQ is between $48 and $68 per share. At a price of $23.51, Hewlett-Packard is at least 51% undervalued.

(Click to enlarge)

Click to enlarge

Summary

Technology stocks are pretty cheap in general, and Hewlett Packard is no exception. It is trading at a significant discount to the rest of the market. 2011 was not a great year for its shareholders, but the stock is showing signs of recovery this year. During August, the stock literally collapsed from $31 to $23. Since its dip of $23, the stock reached almost $30 in February. However, it was subject to another sell-off afterwards.

At the current prices, HPQ is trading near the lower-end of its trading range. Its fundamentals look strong enough to encourage long-term investors. The company is going through a significant reorganization. Meg Whitman, a well-known business executive, has been CEO since Sep. 22, 2011. Whitman graduated from Harvard and Princeton, and has a strong track record for business success.

The stock is also significantly undervalued based on its five year historical valuation metrics. Based on my FED+ valuation, HPQ is trading at least 51% below its fair value range. Argus has a buy rating with target price of $30, implying near 21% upside potential in near-term. I rate HPQ as a buy with a target price of $48. It sounds like a bullish call, but as an HP user for the last 10 years, I think it is a great company with solid products. The stock is also cheap. 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.