The Deep Discount Strategy is a value investing approach to buying select stocks at a price below their fair value. The basis of the strategy is as follows:
- Quality: Choose only the highest quality companies with a stellar record of consistently high growth across a number of metrics.
- Value: Determine the fair value of the company based on anticipated future growth and a minimum desired compound annual return of 15%.
- Target: Buy and hold the company only when the share price is below a margin of safety, set significantly lower that the fair value price.
- Enhance: Purchase additional shares if the stock price moves lower, assuming the fair value remains the same.
In this article, we will apply the Deep Discount Strategy to Apple (AAPL) to develop a valuation and target purchase price. Apple continues to be a leader in virtually every market they enter into and although they are facing increased pressure from competitors such as Google (GOOG) and Samsung (OTC:SSNLF), I believe this will have little effect in the long term.
While the largest contribution to Apple's revenue geographically remains North America, the company continues to expand globally, and is placing a priority on developing the Chinese market. While triple digit annual EPS growth can't be expected to continue over the long term, I believe growth prospects at a high, but more sustainable pace are achievable. Through the rest of this article, we will estimate what that growth rate might be, and then use it to develop a fair valuation for Apple. This will ultimately lead to a target purchase price, deeply discounted from fair value to provide a margin of safety.
This strategy borrows heavily from methods taught by Phil Town in his excellent book, "Payback Time". Numbers used in this analysis are sourced primarily from MSN Money.
Quality
In the context of the Deep Discount Strategy, quality is defined by the company's ability to meet a number of criteria with respect to consistent growth and return on capital. Specifically, we look at the following metrics:
- Return on Invested Capital [ROIC] > 10%
- Earnings per Share [EPS] growth > 10% annually
- Sales growth > 10% annually
- Equity growth > 10% annually
- Long term Debt < 3 years of current earnings
Companies that are able to meet these criteria consistently over a long period of time are likely to be more predictable, and this is key to us being able to develop a proper valuation of the company with a strong degree of confidence. Let's see how Apple measures up.
ROIC for last year was 38.3% and the average over the past five years was 31.9%. These both far surpass our minimum requirement of 10%. ROIC is an important number because it tells us how well the company's management is putting money to work.
EPS Growth over the past several years is shown in the following table:
Year | EPS ($) | EPS Growth (%) |
2002 | .09 | - |
2003 | .09 | - |
2004 | .34 | 278 |
2005 | 1.55 | 356 |
2006 | 2.27 | 46.5 |
2007 | 3.93 | 73.1 |
2008 | 6.78 | 72.5 |
2009 | 9.08 | 33.9 |
2010 | 15.15 | 66.9 |
2011 | 27.68 | 82.7 |
EPS growth has surpassed our minimum requirement of 10% per year by a huge margin for every year since 2004. Average EPS growth over the past five years is 65.8% and is an average of 112% over the past 10 years.
Sales growth over the past several years is shown in the following table:
Year | Sales (billions) | Growth (%) |
2002 | 5.74 | - |
2003 | 6.21 | 8.19 |
2004 | 8.28 | 33.3 |
2005 | 13.93 | 68.2 |
2006 | 19.32 | 38.7 |
2007 | 24.58 | 27.2 |
2008 | 37.49 | 52.5 |
2009 | 42.91 | 14.5 |
2010 | 65.23 | 52.0 |
2011 | 108.25 | 66.0 |
Sales are growing at a rate that exceeds our minimum requirement of 10% per year for the past several years. Average sales growth over the past five years is 42.4% and is an average of 40.1% over the past 10 years. This is excellent from the point of view that sales are growing very consistently, and at a high rate.
Equity Growth over the past several years is shown in the following table:
Year | BVPS ($) | Growth (%) |
2002 | 5.70 | - |
2003 | 5.76 | 1.05 |
2004 | 6.48 | 12.5 |
2005 | 8.90 | 37.4 |
2006 | 11.67 | 31.1 |
2007 | 16.66 | 42.8 |
2008 | 25.10 | 50.7 |
2009 | 35.16 | 40.1 |
2010 | 52.18 | 48.4 |
2011 | 82.45 | 58.0 |
Equity is growing at a rate that exceeds our minimum requirement of 10% per year for the past several years. Average growth over the past five years is 48.0% and is an average of 35.8% over the past 10 years. Again, excellent and very consist year after year.
Long-term debt: Apple has zero long-term debt (and actually has enormous cash reserves of roughly $100 billion!). This obviously satisfies our criteria that debt be capable of being paid off with 3 years of current earnings.
Summary: Apple meets all of our criteria for a high-quality company that will allow us to calculate a valuation in a predictable manner. EPS, sales, and equity are all growing year after year at a rate that exceeds our minimum requirements. This is a result of management putting capital to good use, as evidenced by the high ROIC. Finally, the company is able to achieve this without relying on external financing (zero debt).
Company Valuation
The value of Apple for our purposes is determined by the expected future EPS growth for the next five years, an estimated future P/E ratio, and finally a minimum acceptable rate of return (MARR) that we desire to achieve. Also required is the trailing twelve months EPS number to use as a starting point. We use these numbers to calculate the future value (NASDAQ:FV) and subsequently the present fair value of the company.
Future EPS Growth: Analyst consensus is that EPS for Apple will grow at a rate of 22.7% over the next five years. Does this make sense? EPS growth over the past five years averaged 65.8% and grew 82.7% last year. Sales and equity grew at average rates of 42.4% and 48.0% respectively over the past five years. All that said, I am slightly more pessimistic on future growth and I'm going to choose a slightly lower growth rate for my calculations of 20%.
Future P/E Ratio: The future P/E ratio is most easily estimated by looking at historical values and trends. The following table summarizes the average P/E ratio for each of the past several years:
Year | Avg. P/E Ratio |
2002 | 112.8 |
2003 | 89.8 |
2004 | 38.8 |
2005 | 24.1 |
2006 | 29.2 |
2007 | 26.5 |
2008 | 24.0 |
2009 | 13.3 |
2010 | 15.1 |
2011 | 12.4 |
Current (08/06/2012) | 14.6 |
The average P/E ratio over the past ten years is 38.6, however this includes some exorbitant outliers in the early years. If we look at the average over the past five years instead, we have an average P/E of 18.6 which is much more reasonable and is slightly higher than the current P/E (as of today) of 14.6. An alternate method is to use double the future EPS growth rate to estimate future the future P/E ratio. Using this method, a future P/E ratio of 40 is calculated. We will use the more conservative of the two methods, and settle on an estimate of 18.6.
Future/Present Value: To calculate the future value, we also need to determine the EPS for the trailing twelve months and our MARR. Apple earned $42.54 per share over the past year so we will use this number as the starting point in projecting future earnings. We will use a MARR of 15% as this is the compounded return we aim to achieve using the Deep Discount Strategy. A 15% annual return doubles the original investment in five years.
Our inputs to the value calculations are as follows:
- EPS [ttm]: $42.54
- Future EPS growth rate: 20.0% / yr
- Future PE ratio: 18.6
- MARR: 15%
Plugging the EPS numbers into a future value equation projects an EPS of $105.85 in five years' time. Assuming our future PE ratio of 18.6, this results in a predicted future share price of $1,968.87 in 2017.
The final step is to calculate the present value of the stock. To achieve our MARR of 15%, we must purchase the stock at a price of $978.88 per share or lower, using a standard present value calculation and the future share price determined above.
In summary, we have determined that the current fair value of Apple is $978.88 per share. If purchased at this price, we predict that we will achieve a compounded annual rate of return of 15% over the next five years.
Entry Price Target
In the preceding section we determined that Apple is currently valued at $978.88 per share. Our goal using the Deep Discount Strategy is to purchase equities at far less than their fair value. This does two things for us. First, it provides a margin of safety, as the future EPS and future P/E ratios used in the valuation calculations are an educated guess. Purchasing stock for a lower price reduces the risk that we were not accurate in the estimate of these numbers. Second, buying at a discount has the possibility of magnifying our returns greatly, resulting in a compounded rate of return significantly higher than our 15% stated minimum.
Ideally, we set a target price based on a 50% discount to fair value. This provides a very large margin of safety if our predictions are wrong, and has the possibility of increasing our returns exponentially. The downside is that for high-quality companies, it may be a very long time (or perhaps never) for the share price to reach this low level. Therefore, we will also accept a discount of as little as 25% to fair value at the investor's discretion.
The following table summarizes target purchase prices for Apple based on the range of acceptable discounts, and also calculates the overall (simple) return based on a future value of $1,968.87 per share.
Discount (%) | Purchase Price ($/share) | Future Return (%) |
0 | 978.88 | 101 |
25 | 734.16 | 168 |
30 | 685.21 | 187 |
35 | 636.27 | 209 |
40 | 587.33 | 235 |
45 | 538.38 | 266 |
50 | 489.44 | 302 |
Apple is currently trading at a price of $622.55/share (08/06/2012), which is already a significant discount to fair value. We will set our target price for the initial purchase at $489.44, which represents a 50% discount to fair value and is 21.4% lower than today's price. If the predicted future share price of $1,968.87 is reached, this will represent a simple return of 302%.
Position Sizing
The second aspect of the Deep Discount Strategy that seeks to improve our returns is with respect to position sizing. We attempt to reduce the effects of bad market timing by only allocating a portion of our capital to the initial purchase, and then add to the position over time, particularly if the share price drops.
For this exercise, we will assume that we have $100,000 that we wish to invest in this company. We will allocate 25% of our capital to the initial purchase, or $25,000. At the target price of $489.44, this translates into a purchase of 50 shares.
We will add to the position based on two triggers:
- If the share price continues to move lower, we will allocate an additional 25% ($25,000) of capital to purchasing additional shares for every 10% drop in share price. For example, if our initial purchase is at $489.44, our next purchase will be at $440.49 for an additional 60 shares. By allocating the same amount of capital to each purchase, a larger quantity of shares are purchased at the lower price, which lowers our average cost and maximizes return. (One important note: Fair Value and subsequently the discount price must be re-evaluated prior to each purchase. The purchase is only made so long as the purchase price is below the new target price.)
- If no purchase is made within one month of the initial purchase or any subsequent additional purchase, fair value and a new discounted target price will be recalculated. If the current share price is less than this target price, an additional 25% allocation will be purchased. This trigger allows us to add to the position over a period of time if the share price does not move significantly lower.
Exit Strategy
When implementing any investment strategy, it is imperative to have an exit plan in place. This is to ensure that profit is maximized and to limit losses in the event that conditions change or the numbers used to determine present value were so far off that the margin of safety is not able to protect us.
There are just two situations that will trigger us to exit all or part of our position in this company:
- We exit 50% of our position when the share price increases to fair value. In this case, assuming no change in company valuation we will plan to sell when the price reaches $978.88 per share.
- We sell our entire position when the share price increases to a level 20% above fair value. Again, assuming no change in company valuation, we will close out our entire position when the price reaches $1,174.65 per share.
An important clarification is required here. It is very possible (actually quite certain) that the valuation of the company as determined by our method in the preceding sections will change over time. It's important that the above triggers be applied to the current fair value of the company, and not the original fair value when the shares were initially purchased.
Example 1: The company becomes valued at $1,200 / share based on better than expected EPS growth using our valuation method. Our target price to exit 50% of our position is now $1,200 and we will exit our entire position at $1,440.
Example 2: The company becomes valued at $500 / share caused by a huge earnings miss (which lowers the EPS for the trailing twelve months and affects our valuation). Our target price to exit 50% of the position is now $500 and we will exit our entire position at $600. This is a situation where we may actually end up with an overall loss. In this case our exit price will quite possibly be less than our average cost per share.
Execution Plan
Following is the plan set out by the Deep Discount Strategy to purchase, manage, and profit from Apple (assuming $100,000 total capital):
- Fair Value: $978.88 / share
- Target Initial Purchase: $489.44 (50 shares)
- Target 2nd Purchase: $440.49 (60 shares)
- Target 3rd Purchase: $396.44 (60 shares)
- Target 4th Purchase: $356.80 (70 shares)
- Alternative entry: One month following previous entry, if current price is below $489.44
- Target Partial Exit Price: $978.88 (50% of position)
- Target Final Exit Price: $1,174.65 (entire position)
If capital is allocated to this investment in accordance with points 2 - 5 above, we will hold 240 shares at an average cost of $415.27 per share and will have invested a total of $99,664 excluding commissions. If the fair value of the company remains at $978.88 / share, and we exit in accordance with points 7 - 8, we will achieve a profit of $158,759 or a 159% simple return. Our strategy will begin to realize a loss if the fair value drops to $415.27 which is 57.6% lower than our current valuation.
Disclosure: I am long AAPL.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.