Apple Valuation: Upside Potential is Huge

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Everybody agrees on the fact that Apple (NASDAQ: AAPL) is trading at cheap valuations, especially after the recent pullback, but that's not enough reason to buy a stock.  The relevant questions are: How undervalued is the stock? How big is the potential for profit? Does it compensate the risk in case the company performs worse than expected?

Let’s crunch some numbers and put Apple's valuation in perspective, so we can estimate possible price targets for the stock and get a better idea about the risk and return trade off.

Tech Leaders

It's not easy to compare Apple to any other company; any association will be necessarily flawed to a certain extent. But we could probably agree on the fact that Apple deserves to be considered a leader in the technology space, so I decided to match it up with other big tech leaders like Amazon (NASDAQ: AMZN), Facebook (NASDAQ: FB), Google (NASDAQ: GOOG) and Microsoft (NASDAQ: MSFT). In any case, Apple has higher profit margins and a stronger financial position than any of the other companies in the table, so other fundamental metrics are favorable for the company.

Apple has a lower P/E than any of the companies in the table; Amazon and Facebook are dramatically more expensive, se we will consider them exceptionally expensive stocks and leave them aside from the calculations. Google and Microsoft are much cheaper than Amazon and Facebook, so they may provide a more conservative basis for the comparison.

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Amazingly, Apple is not only cheaper than these two in terms of P/E ratio, it's sensibly undervalued if we include growth expectations into the equation. The PEG ratio is obtained by dividing P/E by estimated growth rates over the next five years, and Apple, with an estimated growth rate barely below 20%, has a PEG ratio of 0.6, which is less than half the same metric for Google and Microsoft.  

Scenario Planning and Price Targets

To begin with, we could forget about growth estimates for a moment and simply calculate price targets for Apple if it were to trade at the same P/E ratio of Google or Microsoft.  Apple reported earnings per share of $44.15 for the last twelve months, so the stock would need to trade at $971 or $662 to carry the same P/E as Google or Microsoft respectively; an average of the two would produce a price target of $817.

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This means some serious upside potential for the stock using fairly conservative figures. I really don't understand why the market values a dollar of earnings in Microsoft more than a dollar of earnings in Apple; the Cupertino giant is much better positioned for growth. But even if Apple and Microsoft were to trade at the same P/E ratio, this would mean an upside potential of nearly a 30% for Apple from current levels.

And things get more exciting if we include growth prospects in the valuation. If Apple achieves the currently forecasted growth rate in the area of 20%, and the stock were to trade in line in line with Google and Microsoft (adjusted for its higher growth rate), the shares would need to trade at a P/E ratio near 28/30, which means a price for the stock of more than $1,200.

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This price target seems like a very optimistic scenario for investors, but it's not out of the question for a company like Apple in terms of growth possibilities. An increase of 20% annually in earnings per share over a five year period is no easy task for such a big company, but Apple still delivered a growth rate of 27% in sales and 24% in net income for the last quarter.

Considering that consumers were postponing their purchases of Apple products due to new product launches across the board, this was not a particularly strong quarter, so Apple could do much better over the next quarters now that it has completely revamped its lines of products.

On the other hand, many Wall Street analysts have been concerned about increasing competition and profit margin compression for Apple in the following years, so we should consider what would happen to these price targets if growth estimates continue getting slashed in the future.

Fortunately, even if we reduce growth estimates from 20% to 15%, Apple would still have plenty of upside room from current levels. We could even reduce the estimated growth rate in half, to 10%, and the stock would still be reasonably valued. If Apple will face slowing growth in the future, that seems already incorporated in its current valuation.

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Bottom Line

Overall, considering different scenarios and growth possibilities, Apple is trading at a very compelling valuation levels. Investors have overreacted to recent concerns, and the stock has much more upside potential than downside risk from a valuation point of view.

 


acardenal owns shares of Apple, Google and Amazon.com. The Motley Fool owns shares of Apple, Amazon.com, Facebook, Google, and Microsoft and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Apple, Amazon.com, Facebook, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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