Apple on Target to Hit a P/E of 5 in 2014?

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

It is always interesting to do some forward-looking calculations to understand what your margin of safety on a stock might be.  Apple (NASDAQ: AAPL) continues to grow its top and bottom lines respectably, and as the stock trades lower the earnings multiple (P/E) becomes even further compressed.

You can now grab a share of Apple on an ex-cash basis cheaper than you could before Jobs returned and Apple was headed for what looked like possible bankruptcy.  The recent negative sentiment on Apple has become incredible and it is something we have seen a few times before in the past.  However, each time has been a buying opportunity.

Some History

I did this exercise in 2008 when the stock dropped from $200 to $80.  People were saying Apple was over back then, much like they are today.  Looking back at my purchase at $80 shows what can happen if you buy with a margin of safety and hold on for just a few years.  Apple now has $40/share MORE in cash than my purchase price of $80/share.  It is on deck to earn $50/share next year, and at that rate the company earns back my original purchase price in less than two years.  Today the dividend is $10.65 per year, and likely to rise.  This means that I get back 13% of my original investment each year. 

Can Apple Do It Again?  Let's Run the Numbers!

Using this same exercise, we first look at Apple's share price today of $540.  2013 EPS is going to be about $50/share.  Add that $50/share to cash of $120/share Apple has now, and you have net cash of $170/share.

Now let's subtract that $170/share in cash from today's share price of $540, and we are left at the end of 2013 (about a year away) with $370/share.  This $370/share is what you will be paying for Apple in one year after backing out its net cash.

Earnings estimates by 40 analysts put Apple's 2014 fiscal year at $58.70.  So let's divide the $370/share by GAAP EPS of $58.70.  We are left with a P/E of just 6.3.  There are few operating companies out there now with a debt free balance sheet and earnings growth trading near this low multiple.  In fact, I don't know if you can even find one. 

Microsoft (NASDAQ: MSFT) trades for a forward P/E of 8.77, and their growth is estimated at just 6.2% this year. There is little indication Windows 8 phones and tablets are going to carve out significant market share.  How much excitement is left for Microsoft in the post-PC era now dominated by Apple?

Likewise Cisco (NASDAQ: CSCO) trades for a forward P/E of 8.17 with 4.9%, with 7.2% growth expected for this year as well as next year.  Networking is headed towards virtualization more and more, with Open Network on the rise.  Because of this trend I would venture Cisco is one company with a bleak future. Is Apple really in the same class as these companies? 

How about Amazon (NASDAQ: AMZN)?  The company is now trading for a P/E of 2,705 (that is not a typo), and a forward P/E of 128.11!  Growth estimates for five years on Amazon is 35.59%, but Amazon has been missing estimates and losing money in recent quarters.  Why is the street giving Amazon a pass?  Only Mr. Market knows, but I think we will see a 50% cut in Amazon in the coming year when the music stops.  Amazon has razor thin 1% to 3% margins, compared to Apple's monstrous 40% range.

GAAP Numbers Underestimating Earnings at Apple

But wait!  My headline said Apple could hit a P/E of just 5, or maybe lower!  How can this be?  Well, in all these EPS estimates Apple uses conservative GAAP accounting methods.  They reserve 35% for US taxes on all overseas earnings.  This means for every $100 earned overseas they only report $65 of it.  The idea is that when the money comes back to the USA it will be "repatriated," and this 35% becomes tax due.  However, Apple has made clear they will never bring this money back until the repatriation tax is repealed or significantly reduced.  Someday the tax code will address this, but until then the money is all Apple's, and can remain so as long as they choose.

So with GAAP EPS underestimating Apple's true earnings power, and since most of Apple's earnings originate internationally, we know that the company's true EPS is much higher.  As they say, it's not what you make, it's what you keep. Apple is keeping a lo,t but not telling anybody who isn't willing to listen.

If you take into account all the international earnings over these past few years, we see Apple's P/E drop under 5 in 2014.  Should Apple beat 2013 and 2014 estimates with its refreshed product lineup and potential new products, the P/E falls even further.

Doug Kass Now Bullish on Apple!

It seems I'm not the only one doing this worse case scenario analysis.  While almost finished with writing this entry I was listening to Doug Kass on CNBC, who has gone from bearish to bullish using a similar worst case analysis.  He mentions that Apple can go to just 3% growth, and that Apple still is a buy now at this price when looking out just 2 to 3 years.  What a difference a 24% drop and 45 days can make.

Always Find Your Margin of Safety

Next time you are thinking of buying or selling it is useful to try and calculate what your margin of safety looks like if things go wrong or simply not as great as planned.  Even if Apple flat lines or shrinks earnings and revenues for a few years (which seems unlikely on their recent strong product launches), the stock at these prices seems to offer a sizable margin of safety for any investor with a time frame exceeding a year. 

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