AAPL

Last week we highlighted The Applied Finance Group’s (AFG’s) Wealth Creation Report for Apple Inc. (NASDAQ:AAPL) which gave some insight on how companies are rewarded when management does the right things to create wealth for its shareholders. Today we have another example of a company following a wealth-creating strategy (growth + strong economic performance = solid returns) Aeropostale Inc. and how the market has rewarded this company for growing its asset base while maintaining economic profitability.

In the Wealth Creation chart provided below you will see Apple Inc.’s cyclical economic performance and sluggish growth from 1996 to 2003 and the mediocre subsequent returns during that time period. After 2001, Apple Inc. improved its product offerings with amazing innovations such as the iPod and iTunes and began to drastically improve their economic performance when the iPod sales took off in 2004 while they gained 70% of the digital music player market. Apple followed a Wealth Creating Strategy perfectly from 2004 to present day continuing to improve their already profitable economic performance while at the same time growing their business. Apple is the perfect example of the market rewarding a company with a management team following a Wealth Creation Strategy as you can see by their excellent returns from 2004 to today.

In a recent Wall Street Journal feature on the alleged threat of deflation, authors Sudeep Reddy and Dana Mattioli proclaimed that "Deflation is a destructive force, in part because it causes consumers to stop spending as they anticipate prices to fall even further going forward." Allowing for the certain truth that deflation is destructive, what the authors presume to be deflation quite simply isn't. The answer for why is very basic. If prices of certain goods are falling, far from a deflationary event as they presume, the aforementioned decline in the cost of certain products merely expands the range of other goods available to the consumer, thus driving up their cost. If the price of a product drops, unless there's a monetary event whereby the currency in which it's priced rises substantially in value, there's no deflationary event to speak of.

The Wall Street Journal reported Monday that Apple Inc. (NASDAQ:AAPL) is expected to develop two new versions of its iPhone, one to be released this summer on AT&T’s (NYSE:T) network - consistent with years past - and one that is said to be compatible with the CDMA network currently used by Verizon Wireless (NYSE:VZ) and Sprint Nextel Corp (NYSE:S). Rumors about the iPhone finally making its way to Verizon Wireless have been swirling for nearly a couple years now. Given AT&T customers’ dissatisfaction with dropped calls and data functions on that network, Verizon Wireless may be poised to make immediate inroads, especially in heavily populated areas such as San Francisco and New York where the AT&T network is particularly strained. The investment community has held the belief for some time now that it is not a matter of “if” but “when” the iPhone will become available to Verizon Wireless customers. A significant road block towards any sort of agreement has been that Verizon Wireless’ CDMA network was not the same network that the vast majority of carriers worldwide used (GSM). Apple wanted to keep its development process simple, and therefore chose to make a phone only compatible with the most widely used type of network. However, the U.S. market is so big, and with Verizon Wireless recently overtaking AT&T as the largest network in the U.S. with over 90 million customers, it is a vast unexplored market that Apple could penetrate. Not to mention Sprint Nextel, which uses the same type of CDMA network, currently has over 48 million customers as well.

The Applied Finance Group’s (AFG’s) suite of investment tools and research is designed to help investors make more informed investment decisions by helping them understand the performance a company must deliver to justify its current stock price in addition to calculating the firm's intrinsic value. By understanding the embedded expectations a company must deliver to justify its current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are too rich or too low. Last week, AFG released its monthly stock market review which discussed the embedded expectations of the entire S&P 500 using the Value Expectations Interface. we concuded that the overall index is slightly undervalued, but trading pretty close to fairly valued. Using AFG’s Value Expectations Interface and Intrinsic Value Chart, we will provide a company example of each of the following scenarios: A) a company with an unattractive default intrinsic value and high expectations for sales growth B) a company with an attractive default intrinsic value and low expectations for sales growth.

Using The Applied Finance Group's (AFG's) Value Expectations interface we have provided an analysis of the expectations embedded in the stock prices of some of the top performers in the S&P 500 year to date (excluding financials) to see which companies have the lowest expectations for sales growth (VE Sales Growth) relative to what the company has been able to deliver historically (5 Year Median Sales Growth).

AFG’s Value Expectations interface provides clients a platform to better understand economic profitability, and at the same time understand the performance a company must deliver to justify its current stock price. By understanding the embedded expectations a company must deliver to justify their current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low. Take, for example, the typical company during the tech bubble: the expectations that were priced into the average tech stock far exceeded what it could realistically deliver. For this reason, AFG identified the technology sector as overvalued, as well as potential torpedoes such as Cisco, whose expectations were unrealistically high.

By gaining a better understanding of the embedded expectations built in to security prices, relative to what a company has delivered historically, can provide insight into the Sales Growth, EBITDA Margin, and Asset Turnover a company must deliver in the future to justify its current trading price. In many circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued.

The top performers of the S&P 500 listed below are ranked based on valuation attractiveness using The Applied Finance Group’s valuation model. You would like to look for companies with attractive valuations and modest expectations for revenue growth relative to what the company has been able to achieve over the past five years when looking for potential investment opportunities as these types of companies have proven through time to outperform firms with the opposite characteristics.

If you would like to view some of the favorite long and short investment ideas provided by professional investors click here to view the results for AFG's Market Forecast Project.

Sales Growth Expectations of S&P 500 Top Performers of 2009

Ticker Name Sector Valuation Attractiveness 5 Year Median Sales Growth VE Sales Growth (NYSE:WDC)  WESTERN DIGITAL CORP Technology Attractive 19.43% 12.00% (NYSE:FCX) FREEPORT-MCMORAN C & G Basic Material Attractive 5.06% -6.13% (NASDAQ:CTSH) COGNIZANT TECH SOL CP A Technology Attractive 50.98% 18.34% (NYSE:FTI) FMC TECHNOLOGIES INC Capital Goods Attractive 17.48% 11.56% (NYSE:PXD)  PIONEER NATURAL RESCS CO Energy and Extraction Attractive 20.90% -0.39% (NYSE:IP) INTERNATIONAL PAPER CO Basic Material Fair -5.68% 14.49% (NYSE:WYN) WYNDHAM WORLDWIDE CORP Consumer Services Fair 13.48% 8.58% (NYSE:MWV) MEADWESTVACO CORP Basic Material Fair 5.76% 47.66% (NYSE:AMD)  ADVANCED MICRO DEVICES Technology Fair 6.44% 7.36% (NASDAQ:AAPL)  APPLE INC Technology Fair 35.30% 20.62% (NYSE:MEE)  MASSEY ENERGY CO Energy and Extraction Unattractive 15.08% 35.02% (NYSE:JWN)  NORDSTROM INC Consumer Services Unattractive 8.29% 16.02% (NASDAQ:JAVA)  SUN MICROSYSTEMS INC Technology Unattractive 0.05% 26.04% (NASDAQ:SBUX) STARBUCKS CORP Consumer Services Unattractive 20.86% 14.43% (NYSE:HAR)  HARMAN INTERNAT IND INC Consumer Durable Unattractive 9.34% 4.45% (NASDAQ:WFMI)  WHOLE FOODS MARKET INC Consumer Services Unattractive 20.66% 12.62% (NASDAQ:NTAP)  NETAPP INC Technology Unattractive 29.31% 28.26% (NASDAQ:AMZN)  AMAZON.COM INC Consumer Services Unattractive 29.19% 30.00% (NYSE:ODP)  OFFICE DEPOT INC Consumer Services Unattractive 5.13% 1.24% (NASDAQ:ISRG) INTUITIVE SURGICAL INC Health Unattractive 61.20% 37.96%

Source: EconomicMargin.com

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.

 

To stay updated on how other professional investor's currently view the market join our Market Forecast Project survey and be among the first to receive the results.

The list of most actively traded stocks in the S&P 500 seems to attract the most attention amongst the investment community and always create a good amount of “Buzz”. We decided to take the list of the most actively traded stocks over the last 50 trading days (excluding financials) and run them through The Applied Finance Group’s (AFG’s) meat grinder to see which are worthy of the hype and are attractive investment opportunities and which you should probably stay away from.

AFG uses a set of criteria in its stock selection process that has proven successful at identifying winners and losers in the market including its proprietary measure of corporate performance (Economic Margin), valuation, management quality and earnings quality among other criteria. Of the companies listed that are heavily traded, AFG believes the companies with expected improvement in Economic Margins, attractive valuations, and a wealth creating management team are the companies that will be the most likely to outperform the market and their sector peers. (register now to receive exclusive buy ideas- it's fast and free!)

Ticker  Name Sector AFG Recommendation (NYSE:PFE)  PFIZER INC Health Attractive (NYSE:S)  SPRINT NEXTEL CORP Technology Attractive (NYSE:VZ) VERIZON COMMUNICATIONS Technology Attractive (NASDAQ:ORCL)  ORACLE CORP Technology Attractive (NASDAQ:DTV) DIRECTV GROUP INC (THE) Consumer Services Attractive (NYSE:Q)  QWEST CMMNCTNS INTL INC Technology Attractive (NYSE:DYN)  DYNEGY INC A Energy and Extraction Attractive (NASDAQ:EBAY) EBAY INC Consumer Services Attractive (NYSE:CHK) CHESAPEAKE ENERGY CORP Energy and Extraction Attractive (NYSE:WMT) WAL-MART STORES INC Consumer Services Attractive (NYSE:CVS) CVS CAREMARK CORP Consumer Services Attractive (NASDAQ:MSFT) MICROSOFT CORP Technology Attractive (NASDAQ:CSCO) CISCO SYSTEMS INC Technology Attractive (NYSE:BSX)  BOSTON SCIENTIFIC CORP Health Neutral (NYSE:TXN) TEXAS INSTRUMENTS INC Technology Neutral (NYSE:LOW) LOWE'S COMPANIES INC Consumer Services Neutral (NASDAQ:CMCSA) COMCAST CORP CL A Consumer Services Neutral (NYSE:MU)  MICRON TECHNOLOGY INC Technology Neutral (NYSE:XRX) XEROX CORP Consumer Durable Neutral (NASDAQ:DELL) DELL INC Technology Neutral (NYSE:EMC) EMC CORP Technology Neutral (NYSE:XOM) EXXON MOBIL CORP Energy and Extraction Neutral (NASDAQ:INTC) INTEL CORP Technology Neutral (NASDAQ:NVDA) NVIDIA CORP Technology Neutral (NASDAQ:YHOO) YAHOO! INC Miscellaneous Neutral (NYSE:MOT)  MOTOROLA INC Technology Neutral (NASDAQ:NWSA)  NEWS CORP A Consumer Services Neutral (NYSE:AMD)  ADVANCED MICRO DEVICES Technology Neutral (NASDAQ:AAPL) APPLE INC Technology Neutral (NYSE:MO) ALTRIA GROUP INC Consumer Non Durable Neutral (NASDAQ:QCOM) QUALCOMM INC Technology Neutral (NASDAQ:AMAT) APPLIED MATERIALS INC Technology Unattractive (NYSE:AA) ALCOA INC Basic Material Unattractive (NYSE:T) AT&T INC Technology Unattractive (NYSE:HAL) HALLIBURTON CO Capital Goods Unattractive

The rankings above were provided using AFG’s research product AFGView.com and are ranked based on AFG’s overall investment opportunity signal, valuation signal and expected changes in Economic Margins. The companies must rank as attractive or unattractive in all 3 categories or the firm is listed as neutral.

Below is a brief description of those variables with informative links.

Source: EconomicMargin.com

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.

+View our List of Value Expepectations Recommended Articles

AFG Recommendation Performance
9/1998 – 5/2009
Annualized Returns

Source: AFGView client databases from 9/1998 – 5/2009
Universe size: 4,000 to 5,500 firms

By Kai Petainen (Guest Contributor)

Jim Cramer thinks AAPL (AAPL) is worth $300 and I think AAPL is worth less than $100. To borrow Jim Cramer's line, 'Where do I get this stuff?' I'll point it back at him and ask, 'Where does he get that stuff'? Perhaps all he did was multiply two numbers? I can multiply two numbers, I have a passion for the markets and I too am opinionated. Can I have a TV show too, please? Jon Stewart, would you like to multiply two numbers? You can do it too. I'll show you how. I'll come on your show and multiply them for you if you like.

Now, just to be clear, I'm not attacking either Cramer or Stewart or their shows. I like watching Cramer, and I like watching Jon Stewart. I like the passion that Cramer has for the markets, but I don't have to agree with all of his stock picks, nor do you have to agree with mine. He'll make some stock picks that he'll get right, and he'll make some that he might get wrong. After all, I think we're doing this to 'entertain and educate'. Stewart, he too does some entertaining and educating (or so I believe). So, let me entertain and educate you just a bit. And if you make money, I'm happy for you, and if you lose money, it's not my fault... this is just entertainment. In fact, probably all of this is B.S. and so don't take anything I say seriously.

A few weeks ago, I was giving an overview of valuation techniques to a student group, and I had decided to demo a variety of valuation tools in the market. So, I'll demonstrate these tools to you as well.

Method #1: What funds own the stock?

Taking a look at the top mutual fund owners of AAPL in MSN Money, I notice that I see a bunch of funds that are called 'index', 'growth', and 'blue chip'. From that first glance, AAPL does not appear to be a 'value' stock, but more of an index, growth and information technology stock. In the top mutual funds, I don't see one fund that is called 'Value'. I'm a 'Value' investor, short AAPL.

Method #2: Some key 'Value' ratios.

Generally (but not all the time), value stocks tend to have a low PE, a low price/book and a low price/cash flow. Utilizing FactSet, I found a PE of 34, a price/book of 6.9 and a price/cash flow of 17.5 for AAPL. Now, the weighted median PE in the market is around 17, price/book is at 3 and the price/cash flow is at 11. All three ratios are higher than that of the market. From that perspective, short AAPL.

Method #3: The Dividend Discount Model (DDM)

I generally do not like the DDM model, as it places an emphasis on dividends. But, I need to mention it as it is commonly used. I read a paper the other day by Richardson, Tuna and Wysocki called "Accounting Anomalies and Fundamental Analysis: A Review of Recent Research Advances", and in it, they asked practitioners, "What valuation method do you use?" and in 5th place at 26% of users, they list the DDM model. Now Bloomberg has a DDM model, and I've noticed that although most stocks that I try don't pass this test, if something passes it, then it's probably a value stock. So, I typed 'AAPL Equity DDM' and it gave me a default target price of $209.

At first glance, it looks like the model and the street are at an agreement. There is a huge problem in this argument, because valuation models depend a lot on the terminal growth rate. In this example, it assumes that AAPL will grow at 18.8% FOREVER, and that gives the target of $209. If I assume that AAPL will grow at 22.7% forever, that gives a price target of $300 (Cramer thinks it's worth $300). Personally, I'll assume that as time goes on and 'forever' occurs, I'll assume the company grows at a growth rate similar to that of the GDP, and so when I enter 5% as the terminal growth, I get a price target of $54. Short AAPL.

Method #4: The Residual Income Valuation (RIV)

Bloomberg also has a model called the RIV model in its system. To get it in Bloomberg, type 'AAPL Equity RIV' and the default price target for AAPL is listed as $94. By including the EPS for the next period, I get a target price of $114. In both cases, the stock is worth less than $300 or even $200. Short AAPL.

Method #5: The AFGView Model

My favorite quick valuation method is through The Applied Finance Group's AFGView.com. You can certainly read about it at www.economicmargin.com. From personal experience, if the stock doesn't pass this test, it's not a value stock. Mind you, sometimes I'm wrong and this is just an opinion. Anyways, if I take the default assumptions, and assume the default of a competitive advantage period of 21 years and a discount rate of 7.68%, I get a price target of $114 for AAPL. Short AAPL.

I can get a price target of $300 for AAPL, but I need to assume a discount rate of 6% and that AAPL will dominate (AAPL fans rejoice) for the next 35 years. Now, when I run models, I like to use a discount rate of 8%, and I'll assume that AAPL has a competitive advantage over its peers of 10 years. That gives me a price target of $64. Short AAPL.

DISCOUNTED CASH FLOW MODELS

Analysts spend a lot of time trying to figure out the EPS for this period and the next, but the power in the DCF model does not come from the short term, but the long term. If an analyst does a DCF model, many will focus in on the EPS estimates, but ask them these 4 key questions (and you might be surprised by their answers). If they don't have an answer, but claim to do DCF, think a bit more about their analysis.

What is the time horizon you used? Was it 5, 10, 20 years?

Personally, I like to use 10 years for consistency.

 

What is the 'discount rate' that you used? Was it 6%, 8%, 10%, 12%?

Personally, I like to use 8% for consistency. Some will argue that it should be higher/lower depending on the industry, but I'll disagree with that as I like to know over time how the valuations change, and know that they changed while I kept some value constant. When I value the discount rate for the market, almost always I get a target between 7% and 9%. So, I use 8%. With regard to AAPL, AFGview gave me a discount of 7.7%, Bloomberg's WACC default model had it at 9.7%, FactSet's WACC default model had at 9.1%, eVal uses a default of 10% and I use 8%. Which one is right? I don't know. I use 8% for consistency.

What is the terminal 'sales growth' that you used? Is it much higher than long term GDP?

Personally, I like to use 5%. Generally I see numbers between 3% and 6%. Anything higher and you better justify the number.

 

And this question can destroy some of the best valuation models / analysts:

What is the terminal ROE in your model for the company? Why is it so high? Was it historically that high?

In general, if a company is making a profit and you increase the time horizon, lower the discount rate, increase the sales growth and increase the terminal ROE, you can get a very high target price. If you do the opposite, you'll lower the target price. An analyst that wants to be optimistic about a company might actually use a short time horizon, a low discount rate and a low sales growth, but by making a model that has a high ROE they can make almost any company look good. Let me try to demonstrate.

 

Method #6: The Discounted Cash Flow Model (eVal model)

Using a product called "eVal" by Lundholm and Sloan, I entered AAPL's 10-K and did a bit of analysis. I made a model that had a 10 year forecast and taking the default assumptions that it had, I got a target price of $291 and EPS estimates of $9.35 this year and $11.89 for the next.

But that model had many flaws. Modifying the shares outstanding to reflect the number I see in Yahoo finance and lowering the discount rate to 8% from 10%, I was able to get a stock price of $527 and estimates of $9.27 this year and $11.79 the next year!

Notice, the strength wasn't coming from the EPS assumptions, but from other factors. What was causing the difference? It was primarily the terminal ROE, as it was saying the AAPL would have a ROE of 23.5% forever! Perhaps I would accept that terminal ROE for AAPL, but look at AAPL's history and you'll see that through the years the ROE fluctuates as they innovate and stagnate, innovate and stagnate, and so I'll argue that they cannot maintain that high ROE forever. I'll change the model, so that as time goes on and more competition occurs, their COGS/Sales, R&D Sales and SG&A/Sales will increase, but they'll stay within historical levels and AAPL's ROE will approach that of the cost of capital of 8%. That model gave me a target price of $76 and EPS estimates of $8.01 and $9.36.

Next, I modified the model so that the model reflected the analyst estimates of growth, but that it also reflected the EPS estimates given by analysts. According to Cramer, he argued that analysts would increase their earnings targets as AAPL would change their revenue recognition and EPS would sky-rocket. I'll give a simpler argument... analysts should change their EPS estimates, because the consensus estimate of 30+ analysts missed AAPL by $0.37 last quarter. How 30+ analysts can miss this EPS so badly I'm not sure. Perhaps AAPL is superb? Is there an accounting anomaly? Are the analysts just missing the boat? You do realize that next quarter, if AAPL doesn't beat by $0.37, the stock could drop? According to MSN Money, I note that the highest EPS estimate for 2010 is $7.87 and the highest is $11.04. Presuming that AAPL will beat by $0.37 each quarter, I'll make a model that reflects a model with $9.35 for 2010 and 12.52 for 2011.

I get a target price of $80. Note... by changing the short term ratios, it only moved the target from $76 to $80, the strength of DCF on AAPL is at the terminal assumptions. Once again, short AAPL.

Method #7: The Discounted Cash Flow Model (FactSet template)

FactSet has a cool DCF model as well, and within it I was able to create a similar model and 'justify' a target price between $247 and $292. Again, the results relied not so much on the short term, but on high terminal revenue growth estimates. And if you look a bit closer, you would realize that the price target came from the default assumptions that AAPL would grow at 36% forever! That's not a mistake of FactSet, that's a mistake of the user or the analyst.

Adjusting the numbers, once again I got a price target < $100. Short AAPL.

Method #8: The Quant Model

There are a number of ways to run 'quant models', but to simplify the process it can look like this: Take a bunch of 'anomalies' that are illustrated in academic literature. You can go to websites like www.aaii.com or www.ssrn.com to find such anomalies. Test the anomalies, weight the anomalies, and give stocks a score on how it performs in each anomaly. For example, suppose I create a quant screen (and this is best done in FactSet), and in that quant screen I place a lot of factors relating to value, 'smart money', quality, and momentum. Stocks that appear nice on such a screen can appeal to a wide variety of investors, as I can take the stock and pitch it to a value firm, a momentum firm, a quality firm, and that in turn might lead to more 'investor recognition' which would drive up the price more. Now AAPL has some 'nice' qualities that 'help' the stock: it has low short interest, a decent 'Piotroski Score' (financial health score), earnings momentum and price momentum. AAPL also has some negative qualities that can hurt the stock, as it has a: high PE, high price/book, high accruals, some insider selling and a high fscore (read the paper called 'Predicting Material Accounting Misstatements' by Dechow, Ge, Larson and Sloan). So, there are some good qualities to AAPL, but there are also some bad qualities to it as well, and since I hate to say 'HOLD' as analysts love to do, I'll say.. AAPL... short.

Method #9: Muliply PE * EPS. Hey Jon Stewart, check it out.

Multiply PE * EPS. That's it. Forget everything I told you and multiply those numbers. I hate this method, but it's quite common. In the paper listed earlier, Richardson et al. ask practitioners, 'What valuation method do you use?', and 74% of them look at earnings multiples (59% use DCF)! Wow. It's quite common to hear something like this: "Taking the forward EPS estimates by our distinguished panel of analysts, and multiplying it by the industry PE, we get a price target of $$$". Then, for the next 20 pages, the analyst will discuss how they got the EPS estimate and spend 95% of the time marketing the product. If they don't like the stock, instead of saying 'sell', they might just drop the stock. After all, people don't like to hear about bad news. The problem is, is that analysts sometimes only focus on the EPS estimates now, and they forget to look at the future beyond. Some look at the EPS estimates now as they'll get in the news, and if their estimate matches that of the company, it sure makes the analyst look good. But, how do you do this? A few weeks ago, I was looking at Yahoo Finance and noted that the highest PE listed for AAPL was at 30.37 and the highest EPS estimate was at 8.68.

Price Target: 30.37 * 8.68 = $264.

A few days later, Cramer came on his show and gave a price target of $264. Then, just a few days ago, Cramer came on his show again and gave a target price of $300. Guess what? On the night of his show, I saw the 8.68 and this time the PE was at 34.75. 

Perhaps Cramer did some fancy math to get his target price and deep analysis like I did above with the valuation models, but I was able to get the same result by multiplying two numbers. Who knows what procedure he followed, but I was able to replicate it rather easily.

Here are some common questions I get about AAPL:

Do I hate AAPL?

No. I actually love I-Tunes, I-Phones and I-Pods. It's important to note that although I love the products, it doesn't mean that I have to think the stock is undervalued. I hate it when I see or read stock pitches and 95% of it sounds like a marketing commercial. I'm concerned about numbers, risk, ratios, insider transactions, and earnings. I know the company gets products for a widget, makes the widget, and sells it. If I want to hear a marketing pitch, I'll go to the store.

What about the change in revenue recognition?

As Cramer explains on his show, he mentions that AAPL should have an increase in EPS as they recognize some revenue earlier. Although perhaps true, this confirms one of my beliefs that analysts spend a lot of time on the near term EPS estimates and sometimes neglect the long term estimates. Realize that if AAPL recognizes some revenue earlier, that is revenue they would have announced later, so although it might produce a short temporary jump in EPS, at some point the upcoming EPS should be lower than expected since they won't be announcing the revenue that they would have recognized then (and instead announced it earlier). Also, some companies like to smooth earnings and although I'm unsure AAPL would do this, I don't like seeing EPS numbers that fluctuate wildly.

What about Steve Jobs?

A common argument about AAPL relates to how Steve Jobs is loved by AAPL users and so the stock should go up as he is a creative influence. Fine, I'll agree to that argument, but... if that is true, then what do you think of DIS? Why is it that when DIS announced that they were buying Marvel comics, that I don't remember hearing one interview asking Steve Jobs, "Steve, what do you think of the Punisher character and the image of him carrying a machine gun with Mickey Mouse ears"? Oh, you didn't know... I was looking at FactSet and noticed that Jobs has about $1 billion (0.6%) ownership of AAPL, but he also has about $4 BILLION (7.4%) ownership of DIS. Which company do you think I'd be concerned about if I was him? AAPL or DIS? If you like Jobs, perhaps you should buy the company he has more of, buy DIS. Analysts, next time you talk about Steve Jobs, talk about DIS, please.

Haven't I had bad luck with timing AAPL?

Yes and no. In 2007, I wrote a blog about how I thought AAPL was worth $75 and that blog went on MSN Money when it was trading around $130. The stock shot up $200 and I looked like an idiot. The stock ran down to $120 in 2008 and MSN had an article called "One Who Saw Trouble" and I felt good. Bad luck came around to me, and AAPL flew up to $190 once again, and I felt crappy. It dropped again, but it fell more than the S&P 500 and it came close to my target with a low of $78 - I felt good once again. Now, in the past year, AAPL is up at $200 and again I look dumb. So, yes, I do think AAPL is worth $80, but timing is critical with this stock. I might be wrong, I might be right, but unlike most of the 30+ analysts covering the stock with high target prices, I'll say sell/short to AAPL.

So, there you have it. Take it as entertainment. Here's an opposing view to the crowded world of analysts who love AAPL. I'm bearish on AAPL, and I think it's worth $80.

Kai Petainen
Visit His Site

Tozzi Finance Center Manager
Ross School of Business

 

Understanding the amount of accruals a company has on its books and the quality of its reported earnings is especially important during earnings season, as poor earnings quality companies are more likely to have negative earnings surprises and underperform as a result. With so many companies reporting earnings this week, we wanted to share an analysis of their earnings quality based on The Applied Finance Group’s Earnings Quality score. AFG’s Earnings Quality variable is based on the concept of accruals and is an important indicator, which helps to differentiate between companies with poor and high quality of reported earnings. Watch out for firms with poor EQ score – make sure they are not trying to pad their sales numbers through channel stuffing, for example.

 

*Source: www.afgview.com

 

Two ways to approach accruals:

1. Cash Flow Statement
•Difference between Net Income and Cash Flow

2. Balance Sheet
•Change in Net Operating Assets from Period t-1 to t
•Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)
• Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.
• We found the Balance Sheet approach is also easier to expand to international companies.
• Low Accrual companies outperform high accrual companies
 

 Here is a look at how well the Earnings Quality variable works when you split top half vs. bottom half in each sector/style universe.

Source: AFGView client databases from 9/1998 - 5/2009   Universe size: 4,000 to 5,500 firms

 

Here is a look at an example of a poor Earnings Quality company that has a negative earning surprise and thus underperforms.

Eastman Kodak

• Other Liabilities declined in Q308, leading to high accruals – change in licensing agreement required immediate recognition of deferred revenue.
• Eastman Kodak (EK) subsequently missed earnings in Q408.
• EK’s stock dropped 29% on January 28th, when Q408 earnings were announced.
• EK has underperformed the S&P500 by almost 70% since January 28th.
 

source: www.economicmargin.com

With a major week of earnings right around the corner, we thought it would be useful to our readers to provide an analysis of the companies set to report in the first half of next week. This analysis contains a breakdown of each company's default recommendation according to AFG's Buy/Sell criteria, a look at their valuation attractiveness, and a look at the direction their Economic Margin's are expected to head in the upcoming year. The three companies that look the most attractive based on these criteria are Pfizer, Advanced Micro Devices and Boston Scientific.

A company's Economic Margin (EM) is a measurement of a their true earnings above or below their cost of capital. EM also corrects distortions caused by accounting policies to give a more accurate assessment of a company's real value. It is important to understand the direction a company's EM's are heading because, by knowing this, one can get a complete assessment of how profitable a company can be in the future. The EM Framework addresses profitability, competition, growth and cost of capital. When factoring in each of these variables, investors can fully assess a company's value. 

Below is the list of companies reporting earnings in the first half of the upcoming week along with a closer look at Boston Scientific:

 According to the chart below, BSX's intrinsic value is above its current stock price, which leads us to believe that Boston Scientific is undervalued right now. 

 According to the Wealth Creation chart below, BSX has shown a positive Economic Margin and is forecasted to improve that margin in the upcoming year.

Source: Www.EconomicMargin.com 

AFG's Buy/Sell criteria factor in Economic Margin, Management Quality, and AFG's Valuation Metric. In order to determine Management Quality, AFG scores management on their growth decisions in accordance with the company’s ability to either create or destroy wealth. AFG's Valuation Metric measures a company's Percent to Target (the deviation between a stock's current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model.

AFG's default valuation is a good place to start because it is a simple metric that gives a more accurate outlook on a company's value while correcting distortions.

 

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AFG’s Intrinsic Value Chart identifies how far a stock’s intrinsic value (target price assuming immediate decay) deviates from its trading range, which helps you recognize potentially mispriced stocks and pursue long and short opportunities.

• The blue bars represent the high and low trading range for a stock for 1 year.
• The red dotted line represents AFG’s historical Intrinsic Value through time.
• When the red line (Intrinsic Value) is above the blue bars (trading range), the company looks to be undervalued.
• When the red line (Intrinsic Value) is below the blue bars (trading range), the company looks to be overvalued.

AFG’s Intrinsic Value Chart also contains a company’s Value Score (ranked valuation attractiveness), Economic Margin Change (expected increase/decrease in economic profitability), and Accuracy score (how well AFG’s default valuation has tracked the company).

Wealth Creation Report: displays a company’s Economic Margins (what a company earns above or below its cost of capital) through time as well as a projection of their expected future levels. The second graph shows how a company has grown their assets over time and also contains a projection of how they will grow their assets next year. AFG’s view on wealth creation starts by looking for profitable companies that are also growing their assets to make the most of that profitability.

Investment Insights from your peers, Professional Investors - The Applied Finance Group would like to invite professional investors to join AFG’s Market Forecast Project so you can better understand what your peers currently think about the market and cultivate the “wisdom of Crowds” into actionable investment ideas and themes. 
Click here to learn more

 

 

 

The Applied Finance Group’s (AFG’s) Earnings Quality variable is an important indicator of companies that may be more likely to have negative earnings surprises and underperform due to high amounts of accruals. With many firms under pressure to meet sales expectations in the current environment, it is important to watch out for those firms that may be trying to pad their sales numbers, ie. Channel stuffing (sending excess inventory to stores that cannot sell their products).

The EQ score ranges from 1 to 100, 1 being the best EQ score resulting from the lowest accruals, and 100 being the worst EQ score indicating the highest accruals. Because high EQ score companies (bad Earnings Quality) are more likely to have negative earnings surprises, you may want to avoid these firms. Our back-test indicates that the EQ variable works well as an exclusionary variable coupled with AFG’s valuation model.

We screened the S&P500 to identify those firms with the worst Earnings Quality (EQ), which may be possible torpedoes. The Chart Below displays the 14 firms along with their EQ scores and our valuation analysis.

 

Earnings Quality: Accruals

•An accrual is the difference between Cash Flow and Net Income.

•Net Income = Cash Flow + Accruals

•Low Accrual companies outperform high accrual companies

Two ways to approach accruals:

1. Cash Flow Statement
•Difference between Net Income and Cash Flow

2. Balance Sheet
•Change in Net Operating Assets from Period t-1 to t
•Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

-Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

-We found the Balance Sheet approach is also easier to expand to international companies.

 14 Worst Earnings Quality Firms

 

Here is a look at how well the Earnings Quality variable works when you split top half vs. bottom half in each sector/style.

Source: AFGView client databases from 9/1998 - 5/2009   Universe size: 4,000 to 5,500 firms

 

Here is a look at an example of a poor Earnings Quality company that has a negative earning surprise and thus underperforms.

Eastman Kodak

If you like this article, you might be interested in stocks that fit our Buy Reccomendations: Click here to read

A brief description of some other AFG's insights:

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.
AFG's Value Universe - Companies in the AFG universe, which have MV/IC at the bottom 50% of the universe and have EPS estimates.

Today, Apple will be releasing it's newest iPhone, the 3G S, which offers improvements in speed, memory, and battery life over the previous model, and comes equipped with a new video recording feature. The 3G S also has the latest version of the iPhone’s operating system, OS 3.0, which also seems to have made some improvements over the previous version. Furthermore, Apple just recently announced it is cutting the price of the iPhone 3G by 50% to $99, as it ushers in the newer model. As investors ponder the impact of the release of the iPhone 3G S, as well as the price reduction of the iPhone 3G (we won’t even mention the questions regarding Steve Jobs’ health), we thought it would be timely to show the Value Expectations embedded into Apple’s stock price necessary to justify it's recent peak, trough, and yesterday’s closing trade. These expectations assume that Apple will maintain 3 year median levels for both EBITDA margins and Asset Turnover.

AAPL Trading Price

 

Chart A

Source(The Applied Finance Group)

In December 2007, Apple's stock price hit a high of $199.82 and along with that came some pretty big expectations to support that price. To justify that trading price now, Apple would have to grow sales by approximately 22.7% over the next five years. This translates to about $90 billion in annual sales by 2013.

Chart B

Source(The Applied Finance Group)

On January 20th 2009, Apple's stock price hit a low of $78.2 and along with that came some very low expectations to support that price. To justify that trading price now, Apple would only have to grow sales by about 1.6% over the next five years. This translates to about $35 billion in annual sales by 2013.

Chart C

Source(The Applied Finance Group)

Yesterday, Thursday, June 18, Apple closed at $135.88. To justify this price, Apple must generate annual sales growth of approximately 13.9% over the next five years. This translates to about $62 billion in annual sales by 2013.

AFG's Value Expectations interface provides you the flexiblity of building your own set of expectations for a company, and will translate those expectations into an intrinsic value for its stock price. In regards to Apple, the answer to whether you should BUY, SELL, or Hold heavily depends on your confidence in the company’s ability to generate annual sales growth of 13.9% over the next five years (as well as the EBITDA Margin and Asset Turnover expectations). If you expect the company to deliver results in line with these expectations, the company would appear to be fairly valued. In the next couple of weeks we will be issuing some new buy ideas. If you would like to be the first to recieve them via emal, click here to register with Value Expectations.

*AFG’s Value Expectations allows us to understand the Sales Growth, EBITDA Margin, and Asset Turnover a company has to deliver in the future to justify its current trading price. In theory, and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future Sales Growth of Apple assuming its EBITDA Margins and Asset Turnover stays at the 3 year median levels.

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

 

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.

 

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

 

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In March, Jim Jubak of MSN Money released a list of stocks that he believed should be stocks that you should pay attention to in the upcoming months/quarters as potentially attractive investment opportunities. ValueExpectations.com set out to answer the question, which stocks on Jim’s watch list look attractive according to AFG’s valuation model and should be on your watch list?

Provided in the table below are Jubak’s watch list companies and how they fare from a valuation perspective using The Applied Finance Group’s Value Score variable which ranks the valuation attractiveness of each company based on the discrepancy between the company’s current trading price and AFG’s target price.

 

Jubak's Watch List Companies (Ranked by Valuation Attractiveness)

 

Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers.

AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

Faisal Laljee of stocksandblogs.com came out with 2 blogs earlier this year providing companies that he believed were the top stocks to own/watch for 2009 (Part 1, Part 2). Laljee was on the money with his predictions so far through 2009. 13 of the 15 companies he recommended have positive returns and the whole portfolio of 15 companies has an average return of 21.24% compared to the S&P 500 return of 0.10% over the same time period. Valueexpectations.com thought it would be useful to analyze how these firms are positioned as possible investment opportunities going forward from AFG’s valuation standpoint. Valuation Attractiveness is determined by AFG’s proprietary valuation framework, which estimates a stock’s intrinsic value through a DCF model which incorporates a corporation’s Economic Profitability, Growth of Capital Base, Decay, and Cost of Capital. In addition, we also showed sales growth expectations embedded in each company’s latest stock price and its historical 5 year median sales growth. It is interesting but not surprising that all the Attractive stocks have low implied sales growth compared to those companies’ historical performance.

 

Stocksandblogs.com 15 Companies To Own/Watch In 2009 : Perfomance Results

 

*AFG’s Value Expectations allows us to understand the Sales Growth, EBITDA Margin, and Asset Turnover a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future Sales Growth of the list of companies assuming their EBITDA Margins and Asset Turnovers stay at the 5 year median levels.