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Aapl Article Written Feb 18, 2013... Pretty Much Nailed It

|Includes: Apple Inc. (AAPL)

It can be incredibly hard to predict where a stock price is going to be in a day, month, year or any other time frame for that matter. Apple (AAPL) stock has been very difficult to predict for the past 6 months. In a short time frame it is hard forecasting whether Apple is done falling or setting up for a huge rally. What if I told you that it does not matter where the stock price is going to be, as long as you know where it will not be?

Current Valuation

Currently, Apple is trading around a measly 10.5 PE ratio. The S&P 500 PE ratio is over 17 and has been rising consistently since September 2011. The last time the S&P 500 had a PE ratio as low as Apple's current ratio, was in 1982. From another prospective, Apple's PE of 10.69 is about a 38% discount from the average S&P Company. Apple is currently paying a 2.2% dividend. That is good for a 7% premium compared to the average S&P Companies' 2.05% dividend yield. Apple also has $137.1B in cash. This equates to roughly 30% of its market cap. As you can see, Apple trades at lower multiples and pays a higher dividend than most companies in the S&P 500, all while stashing a large portion of profits away.

Future Valuation

Predicting the future valuation of a company is difficult. Let us try to examine what Apple will look like next February. We will start with Apple's dividend, cash and earnings. The dividend seems unlikely to decrease. At this time shareholders are actually complaining that the company is not giving more to shareholders. David Einhorn, a hedge fund manager, is actually filing a law suit against Apple for mismanagement of the large cash at hand. This led to Tim Cook calling the lawsuit a "silly sideshow". So, we will assume the yearly dividend will stay at $10.60 a share.

Last quarter Apple had an EPS of $13.81. This was down from $13.87 the previous year. This actually shows a slight decrease in EPS, but this figure is slightly misleading. Q1'13 was a week shorter than Q1'12. On a weekly basis Apple grew EPS from $.99 to $1.15. This is a 16% increase, but Apple has guided earnings estimates lower, year-over-year, for the current quarter. Many analysts predicted around 20% growth for the year. For our exercise we are going to be conservative and assume flat for this year. Assuming flat, we will go with an EPS of $44.11 for the year. Apple added $39.5B in cash from the end of Q1'12 to Q1'13. If we assume no major moves with Apple's cash, the company should add approximately the same amount. This would give Apple $176.6B in cash next February. The last bit to add to Apple's valuation is their scheduled buyback plan. Currently Apple is in the beginning phase of a $10B buyback plan. The company plans to buy the shares back over a three year period, and has currently only bought back $2B worth of shares.

Where Apple's Stock Price Will Not Be

We are assuming a $10.60 dividend, flat EPS, and 176.6B in cash. You are thinking "okay that is a lot of numbers, but where do they get me?".

Earlier I stated that we don't need to know where a stock price is going to be to profit. We just need to know where it will not be. Knowing that Apple will have at least a $10.60 yearly dividend and $176.6B in cash, Apple will not be lower than $355 in January next year. $355 would be a nearly 50% drop from the high of $705. A drop of this magnitude would also push Apple's PE ratio to only 8, under half the average S&P 500 Company. Drops this big are usually meant for failing companies. I would not consider a company that is making $44B in profit a year a failing company.

At $355, Apple would have half of its market cap in cash and adding another 11% to that each year (assuming flat EPS). That is assuming the growth story is over, which is a mild assumption. At that price Apple would also have a dividend yield of 2.99%. With a dividend approaching 3%, Apple would begin to attract a lot of value investors. Between value investors coming in for the dividend and Apple's $8B left on its buyback plan, there should be plenty of money coming into Apple if such a drop should happen.

Stating that Apple is going to stay above $355 is not a bold claim. I am sure I could have made a case for Apple being above $500 next year at this time, but that wasn't the point of the exercise. Apple's growth over the past two quarters has not been up to par and the stock has taken a beating from it, but there is no way that such a profitable company will drop to some of the levels that I have discussed. Apple's downside at this point is extremely limited.

How to Profit

Knowing Apple is going to be over $355 in a year can net you a 25% return on investment with a downside protection of over 20%. Right now a January14 $355-$350 bull put spread is selling for about $1.

  • Sell Jan 14 $355 Put: $12.80
  • Buy Jan 14 $350 Put: 11.80
  • Net Credit: $1.00
  • Max Loss: $4.00
  • Break-even Price: $354

As long as Apple is over $355 on January opex, both puts will expire worthless and you keep the $1 for a 25% gain on your $4 risk. The max loss would occur if Apple was to close under $350, but I have already outlined why this will not happen. This is an extremely safe and easy way to profit 25% in only 11 months. In fact, bull put spreads are theta and delta positive. If the stock would have a major run up the position may be able to be closed out for nearly max gain in just a few months.

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