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Apple - Innovation Can Cause Large Upside Potential

|Includes: Apple Inc. (AAPL)

Overview

In September 2012, the Apple stock price hit its all time high. A couple weeks later Apple (NASDAQ:AAPL) released its annual report for the year showing a strong financial position. For the year ended September 2012 their revenue reached almost $42 billion, which is a YoY revenue increase of 45%. Furthermore, YoY net income increased by 60% and the return on equity reached 35%. However, from September 2012 to April 2013, Apple shares lost almost 50% of its value.

Why is Apple currently valued at $400?

Apple is currently not being valued as its competitors. A broad overview of the different types of investors and their interest in the stock might help us understand some of the issues that have occurred with Apple's stock price. First, Apple's growth might be too slow or too uncertain to please growth investors. Their inventions and products are too unpredictable for traditional value investors and dividends are not large enough or growing fast enough for dividend investors. Either way, Apple is currently not pleasing its shareholders in terms of innovation and product development. Moreover the free cash flow and current cash balance gives them the opportunity to develop and add value to their shareholders. In this article we look at the fundamental analysis to examine that Apple is underpriced. We also see that innovation and product development probably is the main catalyst for keeping the price low.

Innovation & Q2, 2013 Results

Some questions have appeared regarding Apple's ability to further sell their products to consumers. The issue is that because Apple is not innovative enough, the market for their products might be limited in the future. The good news is that Apple has great potential to be innovative because of their large cash balance. They might have to look at un-served emerging markets and adapt their products according to their needs and buying power. I think Apple's future not necessarily lies within the company. It seems that as a market leader with such a large operation they are not able to follow market trends properly. However, they are able to merge with or acquire other small/middle-sized companies with a more horizontal and innovative structure. Apple might have the cash and other companies the idea and with a collaborative structure between different companies they can all benefit. If they are able to do this, the faith in the business will increase, which will probably stabilize the share price as well. While we move much more into a paper-less world I don't believe that Apple's products are outdated, rather the function of the devices will have to adapt properly to the changes. Apple posted a solid quarter in terms of units sold and revenues and more than doubled its capital return program from $45B to $100B by 2015. However, once again we see that the fear and panic over their future products and operation weighs over their financial position.

Financials:

Year

2012

2011

2010

2009

2008

Sales/Share

167,41

117,14

71,73

48,04

36,82

CF/Share

54,40

40,61

20,45

11,37

10,88

EPS

44,64

28,05

15,41

9,22

5,48

BVPS

126,44

82,90

52,56

35,42

23,84

LTD

0,00

0,00

0,00

0,00

0,00

Tot Debt/Equity

48,94%

51,89%

57,32%

50,13%

88,17%

Tot Debt/Assets

32,86%

34,16%

36,43%

33,39%

46,86%

Tot Debt (NYSE:M)

$57 854

$39 756

$27 392

$15 861

$18 542

Current Ratio

1,50

1,61

2,01

2,74

2,46

ROE

35,30%

33,83%

29,32%

26,03%

22,99%

ROA

23,70%

22,28%

18,64%

17,34%

12,22%

Free Cash Flow (USD in Million)

$42 561

$33 269

$16 590

$9 015

$8 397

FCF % increase

27,93%

100,54%

84,03%

7,36%

 

O/Shares (Million)

934,879

924,136

909,345

893,167

882,117

First, we want to assess whether Apple's operation continues to add value to their shareholders and how much value they are able to generate through their operation. If we look at the valuation measurements we see that every year they generate more sales, earnings and cash flow per share outstanding. Moreover, Apple does not have any long-term debt, and if they were to pay off all their current liabilities today with their equity, they would still have over 50% equity left. In 2012, they were able to generate $1,35 for every dollar invested in the company. An important measurement of Apple's operation is also their free cash flow. In 2012 they were able to generate almost $43B in free cash flow, meaning the cash inflows left after laying out the money required to maintain or expand its asset base. Apple has a lot of opportunities for expansion. The reason for that is because FCF allows them to develop new products, make acquisitions, pay dividends or reduce debts, which all enhance shareholder value. If they can be innovative enough and stay in tact with the market, like they have done so many times before, their financial position will only become better, which will enhance shareholder value even more.

 

AAPL

GOOG

DELL

MSFT

5-Yr Sales Growth

76%

26%

-1%

4%

Profit Margin

25%

20%

4%

22%

ROA

25%

13%

5%

13%

P/CF

11,37

21,07

9,56

11,87

P/BV

5,3

3,25

2,22

3,86

P/E Forward

9,3

17,3

8,65

11,17

Source: SmartMoney.com

If we look at Apple's financial position and profitability ratios and compare them to their current stock price we can see that they are not valued as some of their competitors. Apple has the highest profit margin, 5-yr sales growth and ROA, yet their stock price does not reflect these numbers in comparison to their competitors.

Historical Growth Rates:

The chart shows the YoY growth rates as well as a 5-year average growth rate. By looking at this we can see that Apple has a very stable growth when it comes to revenues and net income. Even through the economic downturn we have experienced the last years, Apple has been able to generate and maintain high profits. Every year they issue more shares, however for every share outstanding they increase earnings by 62% on average. These are all very stable and strong growth rates.

Possible Economic Scenarios and its Impact on the Stock Price:

By looking at Apple's previous revenue growth rate we are able to calculate the average and also a standard deviation measure to assess possible economic scenarios for the firm.

Revenue

         
   

Bad

Average

Good

 

 

21,85%

46,00%

70,14%

 

One standard deviation for the revenue growth is 13,64% and the average is 46%. In a bad year, revenue increases by 21,85%, which deviates 1,75 standard deviations on the left axis from the mean. On the other hand, a good revenue year deviates 1,75 standard deviations on the right axis, which gives us a value of 70,14%.

With the growth rates we can calculate pro forma statements based on last years financials and measure the impact on the firm's future financial positions. From there we can calculate the projected stock price based on the economic outcomes.

Worst Case Scenario

The worst case would be that Apple grows at a rate of 21,85%. Based on their previous financial statements, and by looking at fixed and variable expenses, average 5-yr tax rate and assuming they don't take on any long-term debt (interest expense) the best estimate of their net income is $52B. This will give us an EPS ratio of $55. If this happens, every dollar invested in the company will return $1,29 and their operating margin will be 37,1%.

Most Likely Case

The most likely case is that Apple's revenue will increase by 46% the next year. If this is the case, they will most likely generate $64B net income, which gives an EPS of $68. Also, a return of $1,34 for every dollar invested in the company can expected as well as an operating margin of 38,2%.

Best Case Scenario

The best case would be if Apple grows at a rate of 70,14%. This will generate a net income of $75B and an EPS of $81. The ROE will be 39% and an operating margin of 39,0% can be expected.

 

Current

Bad

Average

Good

Gross Margin

43,87%

43,87%

43,87%

43,87%

Operating Margin

35,63%

37,11%

38,23%

39,03%

ROA

23,70%

21,39%

24,91%

28,05%

ROE

35,30%

29,73%

34,28%

38,74%

BVPS

$126,4

$185,6

$198,7

$209,2

EPS

$44,6

$55,2

$68,1

$81,0

CFPS

$54,4

$64,9

$77,7

$90,6

Price-Book Ratio

3,20

2,18

2,04

1,94

Price-Earnings Ratio

9,07

7,34

5,95

5,00

Price-Cash Flow Ratio

7,45

6,24

5,21

4,47

The table shows current financials and pro forma projections for a bad, average and good scenario. Based on the future economic impact we are able to project the stock price for each scenario. For conservatism, I have calculated the expected return for each valuation measurement based on how likely the economic outcome is. This gives us a better projection of the stock price because we don't know the economic outcome for the future.

Projected Stock Price

Bad

Average

Good

Expected [R]

BVPS

$185,6

$198,7

$209,2

 

P/B=3,20

$594,6

$636,4

$670,0

$634,8

EPS

$55,2

$68,1

$81,0

 

P/E=9,07

$500,7

$618,0

$735,3

$618,0

CFPS

$64,9

$77,7

$90,6

 

CF/S=7,45

$483,0

$578,7

$674,4

$578,7

The expected return for each of the valuation measurements give us a projected stock price range of $580 - $635, which gives us an upside-range from 43% - 57%.

Current Stock Price

$405,00

Upside Potential

Low Price Projection

$580,00

43,21%

High Price Projection

$635,00

56,79%

Risk Measurements:

 

Beta Coefficient

Price

AAPL

1,11

 

NASDAQ

1,00

 

52 Week-Low

 

$385

52 Week-High

 

$705

Compared to the NASDAQ Composite, Apple has a beta coefficient of 1,11. This means that theoretically or based on previous stock movement, Apple is 11% more volatile than the overall market. Based on the CAPM, assuming that the risk free rate is 3% and that the expected market return is 12%, investors should be compensated with an expected return of 13% for their risk-taking, which seems reasonable.

Conclusion:

Apple has shown a good financial position for years. Their operation is highly efficient and they are able to generate high profits after expanding or maintaining their asset base. This gives them a unique ability to enhance shareholder value by developing their business, sharing their profits or acquire new ideas. Currently their financials is not reflected in their share price, mainly because of uncertainty in expectations about their future products. Because the market and Apple are not on the same page as of today one have the possibility to buy an undervalued stock, which possibly has an upside of 40-55%, which is a very good investment.

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