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Edited By Adam Isaac

Apple Inc. (AAPL) is one of the biggest corporate success stories of our lifetime. The company has grown at an exceptional rate thanks to its innovative products and the visionary leadership of Steve Jobs. In the field of consumer electronics, it is unusual for a company to have such an iron grip on more than a couple of different markets. Yet, Apple has achieved success in a number of these markets through its many popular products, including the iPad, iMac, Macbook, and iPhone. Each of these Apple products is a leader in its particular market. Over the past two years, more than 100 million iPhones have been sold to a number of different markets. Overall, Apple obtains the majority of its revenue from the Americas (45 percent) and Europe (20 percent).

Recently, I have performed fair value analysis for different stocks. In this most recent effort, I have tried to come up with a fair value for Apple. Like any other financial model, this valuation requires making certain assumptions regarding revenue growth and the cost and capital structures of the company. In my ProForma earnings estimate, I have assumed a declining revenue growth rate for Apple. I have assumed the growth rate will decline gradually to five percent, and then remain stable after 2017.

Currently, the cost of sales for Apple stands around 59 percent of total sales; I expect this number to come down to 55 percent by 2017. At the moment, Apple has a massive amount of cash reserves, and the company is already focusing on vertical integration. I expect the firm to make acquisitions in the future and eliminate some of the channels from its supply chain. As a result, Apple will be able to generate synergies and bring down its cost of sales. However, Apple will need to invest in research and development in order to maintain its edge over its competitors. In the model, I have assumed a 20% increase in the research and development budget, which will gradually come down to 10% by the end of year 2017. Selling, general and administrative expenses will grow in the range of 10% to 15%. For the last two years, the provision for taxes was 24%, which has been carried through the model.

Apple has announced a share buyback plan. The firm plans to buy back $10 billion worth of shares over the next three years. Taking into account different price levels, I expect Apple to buy back 10 million shares over the announced period. Shares in the model have been adjusted for buyback before computing the EPS.

ProForma Earnings:

Reported Earnings

ProForma Earnings

2009

2010

2011

2012

2013

2014

2015

2016

2017

Net Sales

$42,905

$65,225

$108,249

$140,724

$175,905

$211,086

$251,614

$299,924

$314,920

Cost of Sales

$25,683

$39,541

$64,431

$83,027

$100,266

$118,208

$138,388

$164,958

$173,206

CGS %

59.86%

60.62%

59.52%

59.00%

57.00%

56.00%

55.00%

55.00%

55.00%

Gross Profit

$17,222

$25,684

$43,818

$57,697

$75,639

$92,878

$113,226

$134,966

$141,714

Gross Margin

40.14%

39.38%

40.48%

41.00%

43.00%

44.00%

45.00%

45.00%

45.00%

Operating Expenses:

Research and Development

$1,333

$1,782

$2,429

$2,915

$3,498

$3,848

$4,232

$4,656

$5,121

Selling, general and administrative expenses

$4,149

$5,517

$7,599

$8,739

$10,050

$11,055

$12,160

$13,376

$14,714

Total Operating Expenses

$5,482

$7,299

$10,028

$11,654

$13,547

$14,902

$16,392

$18,032

$19,835

Operating Income

$11,740

$18,385

$33,790

$46,043

$62,092

$77,975

$96,834

$116,934

$121,879

Operating Margin

27%

28%

31%

33%

35%

37%

38%

39%

39%

Other Income and Expenses

$326

$155

$415

$498

$598

$717

$861

$1,033

$1,239

Income before Provision for Income taxes

$12,066

$18,540

$34,205

$46,541

$62,689

$78,693

$97,694

$117,967

$123,118

Provision for Income Taxes

$3,831

$4,527

$8,283

$11,170

$15,045

$18,886

$23,447

$28,312

$29,548

Tax Rate

32%

24%

24%

24%

24%

24%

24%

24%

24%

Net Income

$8,235

$14,013

$25,922

$35,371

$47,644

$59,806

$74,248

$89,655

$93,570

Earnings Per Share

Basic

$9.22

$15.41

$28.05

$38.38

$51.87

$65.32

$81.12

$97.95

$102.23

Diluted

$9.08

$15.15

$27.68

$37.84

$51.08

$64.26

$79.78

$96.34

$100.55

Shares used in Computing EPS

Basic

893.00

909.40

924.58

921.58

918.58

915.58

915.28

915.28

915.28

Diluted

907.00

924.17

936.65

934.65

932.65

930.65

930.60

930.60

930.60

According to my earnings estimate, Apple should be able to maintain healthy margins. I expect Apple to post EPS of $102.23 by the end of 2017. Apple should be able to maintain healthy growth after the valuation period.

Valuation:

For the valuation purposes, I assumed a discount rate of 10%. Apple has a strong history of revenue growth, healthy cash reserves and immensely strong business model. Taking into account the strong position of the company, I believe a discount rate of 10% is justified.

Valuation

2012

2013

2014

2015

2016

2017

Earnings

$38.38

$51.87

$65.32

$81.12

$97.95

$102.23

Discount rate

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Present Value Factors

0.95

0.91

0.83

0.75

0.68

0.62

Discounted Earnings

$36.59

$47.15

$53.98

$60.95

$66.90

$63.48

Terminal year Value @5% constant growth

$1,073.38

Discounted Terminal Value

$666.48

True Value

$995.54

There are two conventional methods to calculate the terminal year value; multiple of terminal year earnings and a constant growth model. I have used the latter, and assumed a 5% constant growth rate after the high growth period of five years. I believe Apple will be able to generate impressive growth figures after the hyper growth period. Furthermore, the terminal year earnings of $63.48 are discounted using the single stage growth model, where the earnings are first adjusted for constant growth and then discounted by the discount rate of 10%.

The single stage growth model also adjusts discount rate for growth by deducting the terminal growth rate from the discount rate. Once the terminal year value is calculated; it is then discounted to reach at the present value. On the other hand, earnings before the terminal year are simply discounted to reach at the present value. Finally, the discounted earnings are added to the discounted terminal value to calculate the fair value of the stock. According to my valuation model, Apple should trade at about $995. At a price of $684, the stock is currently trading at a significant discount to its fair value. I expect the stock to keep its steady rise to the fair value.

Competitor Analysis

Apple operates in a variety of markets. For smartphones, Apple's primary competitor is Samsung Electronics Co Ltd (OTC:SSNLF). In the software sphere, it competes mainly with Google (GOOG) and Microsoft (MSFT). In its personal computers and laptops sector, the company's main competitor is Hewlett Packard (HPQ)

Apple

HPQ

Microsoft

Samsung

Google

Operating Margin

35.60%

6.10%

29.50%

10.70%

30.48%

Net Profit Margin

27.00%

4.20%

23.00%

9.10%

25.74%

ROE TTM

44.30%

12.60%

27.50%

13.50%

19.04%

Debt to Equity Ratio

0

0.6

0.2

0.00

0.10

P/E Ratio

16

6.8

15.5

17.40

20.94

P/B Ratio

5.7

0.8

3.9

2.20

3.57

P/S Ratio

4.3

0.3

3.6

1.60

5.35

EPS Growth

59.80%

0.70%

7.30%

21.40%

24.50%

Source: Morningstar.com

An in-depth comparison with its competitors shows that Apple is very attractively priced. The company has healthy margins and strong growth prospects. There is also no debt, and the firm has massive cash reserves. With attractive multiples as well, Apple is clearly a smart investment target. It has the highest profit margins and the return on equity. While the P/B ratio is a bit higher than its competitors, given the company's business prospects, it is well justified.

Summary

There are not many companies, which can sustain such strong growth levels, yet Apple has managed it and is showing no signs of decreasing its growth rate. The firm has an extremely loyal customer base, so revenue growth ought to continue at an impressive pace. Apple products have created new markets, and through invention, the company can have incredibly high level of growth. I believe I have kept my assumptions a bit on the conservative side; still the stock seems to be massively undervalued at the moment. There is no doubt that the growth rates for the firm will come down, but it represents a great investment opportunity at the current price levels. Even if Apple's revenue growth slows to 5% within the next 5 years, the stock is still trading at a deep discount.

Moreover, the recent announcement of dividends should also include an investment incentive for dividend hunters. Apple is currently trading at a discount to its fair value; it is certainly a stock I would like added to my own portfolio. Even after returning 60% in this year alone, the stock has still substantial upside potential. My fair value estimate suggests a fair price of $995. At the current valuation, Apple has almost 45% upside potential.

Disclosure: Long Apple. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Apple: 45% Upside Potential