Will Apple's Products Cause Speculative Stock Valuation?

| About: Apple Inc. (AAPL)

"Risk" and "uncertainty" are words that have become almost foreign with respect to Apple (NASDAQ:AAPL) over the years, as the release of successful new Apple products has kept analysts delivering favorable reports about the financial position of the company. The company's numbers and tables have reflected positive results amid uncertainty in a volatile and energetic pool of competing companies. However, most analysts assume that the phenomenon will not last for very long. The company's size is against it, as we will discuss later. There has never been a company in history that has generated so much speculation about its products. But does this necessarily mean that investors are paying for all that speculative future success when buying Apple stock?

What Is the Root of Speculative Valuation?

If we look at stock as business (classic value investing mindset), part of the price we pay for buying a stake in the company is for the money already invested in the business (as reflected by the assets on the balance sheet), and part of the price is paid for the speculative future success of the company's products (which will translate into cash and other assets on the balance sheet in the future). The more investors pay for speculative future success (not yet reflected on the balance sheet), the greater are the chances that they will get burnt (unless investors are really good at picking growth stocks).

The thing is, how much investors pay for speculative value is not a function of Internet buzz about a company's product, but rather a function of the price that those investors paid for the stock. For example, if we estimate that a company's present assets are worth $100, and we pay $200 for the company, we are hoping that the success of the future projects of the company will result in a value of more than $100. If we paid $250 for the company, we need to be more certain about the success of future products. Thus, the question is: Can investors hope to buy Apple stocks at a certain price, without betting too heavily on the spectacular success of its future products?

At the end of the last financial year, AAPL's book value per share stood at $82.49. However, only 13.65 % of the current price is explained by the assets on Apple's balance sheet. By this simple metric, one is betting a lot on the success of Apple's future products, but this cannot be compared by any stretch of the imagination to the speculation in the era of dot-coms, when P/B ratios were extremely high.

Apple does not have a long-term debt. The average CFO over the last five years has been approximately $16 billion (this average is a conservative measure of CFO, as the company's cash flow is increasing). If we assume a 4% rate of interest on the debt issued by Apple, we can estimate that the company is easily capable of servicing a $100 billion debt. A simple valuation formula estimates the value of a company as 175% of debt capacity plus surplus cash, which suggests a value of between $220 billion and $240 billion for Apple. Thus, some $320 billion in market capitalization seems rather speculative. This is a high percentage, but it is nonsense to compare this to speculative valuations from the dot-com era.

What Does the Future Hold?

The only thing that seems to be a hindrance to the continuing growth of the company is its large size. The market capitalization of Apple has multiplied eight times over the last six years, and it currently stands at about $560 billion. If the market capitalization were to grow at the same rate for a few more years, it would exceed the GDP of India, but a $2 trillion to $3 trillion valuation of the company sounds unreal. Perhaps equally nonsensical is the iPhone and iPad mania -- maybe the madness will last long enough for Apple to reach such an unbelievable valuation. One can keep on speculating, and a reader's guess is perhaps as good as any expert's guess. One cannot expect to make a lot of money in markets by guessing at such things.

Do note, however, that Apple's market capitalization on Sept.19, 2012, was approximately $660 billion. This means a swing in market capitalization of $100 billion in less than a month. Given that the overall economic scenario is volatile and the company is operating in a very dynamic industry, a couple more wild swings in market capitalization may present an investor with an opportunity to buy the stock without betting on the speculative success of its products. Thus, at the right price you don't need to do much analysis regarding the success of the iPad Mini.

What Is a Fair Apple Stock Price?

There are many ways to estimate the fair stock value of a company. For this purpose, we applied the discounted-earnings-plus-equity model developed by EFS Investment analysts to the Apple case. The calculations based on this model allow us to suggest the following: At a price of about $595, Apple stock is considerably undervalued. According to the discounted-earnings-plus-book-value model, the fair-value range for Apple is between $1,043 and $1,169 per share. Hence, EFS's fair stock price valuation indicates that currently undervalued APPL stock has at least 75% upside potential to reach its fair value.

Make or Break for Investors?

According to data from Morningstar on Nov. 1, 2012, out of 12 Wall Street analysts evaluating Apple, nine indicate a "Buy" rating, two have an "Outperform" rating, and one recommends a "Hold" rating. Thus, Wall Street has primarily positive positions on Apple's future.

While evaluating Apple's stock, keep in mind that despite the decline, Apple stock is strong enough to rise again -- even within a matter of few weeks. It is sensible to bear in mind that smartphones are expected to cover 54% of the worldwide cell phone market by the end of 2013. In addition, Apple's flagship product, the iPhone, generates almost two-thirds of Apple's profit. That indicates that growth opportunities for AAPL are pretty bright. I expect AAPL stock to rise on the back of strong sales. Additionally, a share repurchase program started by Apple in October 2012 will assist an EPS increase, while stronger iPhone 5 sales fuel the company's reign at the top.

Bottom Line

I consider Apple to be a strong buy. With anticipated sales and dividend increases at a considerably undervalued price, this is a stock that, even though it is surrounded by uncertainty, has a solid future. The current price dip seems a rare chance to buy cheap Apple shares before the stock begins its upturn.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.