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The Developing Risk/Reward Of Investing In Apple

|About: Apple Inc. (AAPL), Includes: MS, XOM

My last major finance project in college was a report last April where my team and I had to place a buy, hold, or sell recommendation on Apple (NASDAQ:AAPL) stock. We said Buy, valuing the stock around $420 when it was trading around $350, and got an A. Before looking at the financials, all I knew was that Apple was a popular brand, had a stock price that tripled over a 2 year span, and was challenging Exxon Mobil (NYSE:XOM) to be the most valuable company in the world. These facts put together make Apple sound like a bubble stock, but once you look at the almost $100 billion in cash (Q1 FY 2012 balance sheet), and $33 billion in net income over the last 4 quarters, its valuation of $416.38 billion at the close of trading on January 25th makes Apple one of the top value stocks in the tech sector. However, there are still some risks.

About 72.5 percent of Apple's revenue in Q1 came from the iPhone and iPad, two products that didn't even exist 5 years ago. This is calculated from the quarter's iPhone revenue of $24.4 billion and iPad revenue of $9.15 billion. Ranked by many consumer reports as the two hottest gifts last holiday season, it is not surprising that they are now Apple's cash cows. What is surprising is how two hand held devices can be so valuable. If you net out $95 billion in net financial assets from Apple's market cap and then multiply by .725, you come out valuing the iPhone and iPad at $233 billion. This can be segmented out to value the iPhone and iPad at $169.5 billion and $63.5 billion, respectively. This obviously assumes that Apple's profit margins are consistent across its product line, but these estimates go to show how much of Apple's valuation is driven by two products that now have several imitations on the market. If Apple loses significant market share or has to lower prices on just one of these two products, Apple's stock price can take a significant hit.

The other risk factor that is consistently brought up is Apple's use of the Foxconn factories to exploit cheap labor. The argument is with $33 billion in earnings, it's hard to justify that they really need to pay assemblers less than 70 cents an hour to compete. However, this is the industry standard and everybody does it. Apple has launched an initiative to improve the working conditions for the employees of its suppliers and at the end of the day, Apple and other consumer electronics companies have all of the value chain leverage when it comes to their suppliers. From a valuation standpoint, I believe that the Foxconn concerns will be muted over time and will have almost no effect on Apple's stock price.

Last August, I gave Apple a 3 year price target of $600 and right now, I think that's more of a 2 year estimate for an annualized expected return of 15.9 percent. Yahoo! Finance has Apple's 1 year target at $516.02 and this number should go up once more of the numbers in that estimate are readjusted after Tuesday's earnings announcement. Morgan Keegan gave Apple a $650 price target and Morgan Stanley (NYSE:MS) gave Apple a $515 one year target. Ed Zabitsky from ACI Research gave Apple a $270 price target, but his price targets have been notoriously pessimistic and wrong.

Right now, I believe that Apple stock is still a buy for the foreseeable future. If the rumors are true and Apple is in the process of revolutionizing television, an additional mega product added to Apple's product portfolio can send its stock price even higher. However, if Apple fails to continue its string of releasing products that people from all over the world want to buy (58 percent of its revenue is international now), Apple shares will move more towards Zabitsky's estimate.

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