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Apple Is Selling Below Intrinsic Value, So Now We Wait On The Margin Of Safety

|Includes: Apple Inc. (AAPL)

Apple is a great example of a stock that steadily grows earnings year after year with no negative years. In fact it has been so successful its earning have grown near parabolic in the past:

Apple Free Cash Flow, 2004 - 2012

When we purchase a stock, however, we are buying the future earnings, not the past. We cannot expect Apple to continue to grow in parabolic fashion for another 10 years. Here is a look at Apple's (NASDAQ:AAPL) meteoric past 10-year growth in Free Cash Flow, and my more conservative estimate for the next 10 years:

Apple AAPL estimated free cash flow

After rising nearly 80 times in the past ten years, I'm giving Apple 'only' a double over the next ten. All numbers are of course my own calculations. I use the term 'Owner Earnings' coined by Warren Buffet, which is an adjusted Free Cash Flow.

To determine a stock's Intrinsic Value, we discount the future earnings back to the present, and add in the current Book Value. This process is called Discounted Cash Flow (DCF) Analysis.

Buffet on Intrinsic Value:

"We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses." Berkshire Hathaway 1994 Letter to Shareholders

Using Discounted Cash Flow analysis, I estimate Apple's current intrinsic value at $558 per share. After being as high as $700 this year, it is now trading at $539.

When a stock trades at it's Intrinsic Value, it is priced to deliver a return equal to the discount rate chosen for the DCF analysis. I desire a 15% annual return for stocks so that is my discount rate.

As the future cash flows are quite unpredictable, we look to purchase the stock below it's Intrinsic Value, using the concept of 'Margin of Safety' created by Buffet's mentor, Benjamin Graham. The Margin of Safety I will use is typically 25 to 50%, dependent on the expected volatility of cash flows.

Giving credit to Apple's history of positive (even parabolic) earnings growth, I seek a 25% Margin of Safety to the $558 Intrinsic Value. This results in my current 'Buy' price of $419. This summer AAPL stock price was on a rocket ship to the moon, and that price may have seemed impossible, but AAPL has actually traded below that level even in the past year. All we need is a temporary setback for the company, or a decent bear market and we could have an opportunity.

Of course there's more to stockpicking than just the numbers, as accounting is just one part of business valuation. But this is where we start. This is how value investing is supposed to work. Determine a fair price using the principles of 'Intrinsic Value' and 'Margin of Safety,' then wait patiently.

How to become a Stock Market Value Investor:

Dave's Complete Guide to Value Investing

My current and historical stock picks:

HealthyWealthyWiseProject - Wealthy

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