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Buy Apple Inc. (AAPL) Before It Rises 50%

One thing that is certain when it comes to investing in technology stocks is that what is loved today will soon be hated and share prices of hated businesses will be beaten down to absurdly low valuations. That appears to be the case today with shares of Apple Inc. (NASDAQ:AAPL). One of the great technology brands of our time is selling at a bargain-basement price compared to other tech giants.

A bad Apple or a victim?

Apple Inc. (NASDAQ:AAPL)

Just a year ago, Apple Inc. (NASDAQ:AAPL) was one of the tech darlings of Wall Street. The analysts covering the stock viewed it as a must have for virtually every portfolio, and their predictions for the performance of the stock price were astronomical.

But after missing analysts’ earnings estimates in three of the last four quarters, the company has seen its share price decimated, falling from a high of $705.07 to a recent low of $385.10. As of June 28, 2013, the shares were trading hands at $396.04, representing a decline of 43.8% from the September 2012 high.

What could have transpired so quickly to change such a beloved investment into a pariah? Analysts have changed their short-term view of this business. They now project that current-year earnings will come in about 11% lower year over year. Investors never like to see earnings fall, but does this projected drop justify a 44% decline in the share price?

Apple’s valuation compared to other tech giants

Since different industries carry vastly differing valuations based upon perceived long term prospects, it’s always wise to use companies involved in the same industry when attempting to locate accurate comparisons for establishing fair values.

Going forward, analysts covering Apple Inc. (NASDAQ:AAPL) are projecting earnings to grow at an annual rate of 15% for the next five years. However, the stock currently changes hands at a multiple of only 10 times the projected earnings for the year ended June 30. That gives the stock room to rise 50%, just to end up trading at an earnings multiple equal to its growth rate.

Other tech giants such as Microsoft Corporation (NASDAQ:MSFT) and Google Inc (NASDAQ:GOOG) trade at price-to-earnings-to-growth rate multiples of 1.34 and 1.46 respectively. Apple would have to double in price from its current PEG ratio of 0.67 to be valued at the same ratio as Microsoft or Google.

Apple could buy itself with free cash flow

Price-to-cash flow is another excellent valuation metric to determine whether any business is expensive or cheap. This ratio is simply a measure of how many years it would take a business to generate enough free cash to buy all of the outstanding shares at the current market price.

With the rapid pace of innovation in the technology sector, price-to-cash flow ratios under 10 provide the most favorable opportunities as the timeframe required to cover the value of the business with free earnings is compressed to the shortest time.

Of these three businesses, Apple Inc. (NASDAQ:AAPL) is, once again, by far the lowest valuation at only 6.8 times cash flow. That’s without discounting its massive cash hoard, estimated at $130 billion.

With Microsoft Corporation (NASDAQ:MSFT) currently valued at 9.58 times cash flow and Google Inc (NASDAQ:GOOG) carrying a multiple of 17.24, Apple could once again see a share price increase of 50% to 100% just to wind up valued on an equal plane with Microsoft and Google — even though both rivals are projected to grow earnings at a pace equal to or less than Apple Inc. (NASDAQ:AAPL) over the next five years.

With this much free cash flow, Apple could borrow enough money at 10% interest to buy all of its outstanding shares, and still have an additional 5% left over for profit as a private company. Considering Apple can sell bonds for well below 5% interest right now, its current valuation based on cash flow is ridiculous.

Does the management team handle money well?

A seldom asked but critical question when considering any investment opportunity is whether the management team in place is better at producing high returns on capital than the individual investor. Return on equity and return on capital are two excellent measures of the effectiveness with which company management teams allocate the money entrusted to them by investors.

Return on equity is simply a percentage that indicates how much the value of the business owned by investors in increasing on an annual basis. Over the past five years, Microsoft Corporation (NASDAQ:MSFT), Google Inc (NASDAQ:GOOG) and Apple Inc. (NASDAQ:AAPL) have provided annualized returns on equity of 41.4%, 18.6%, and 35.7% respectively. These rates of return are nothing short of spectacular for businesses of this size, and they clearly display the expertise of these management teams. They also further indicate that Apple should be priced in line with both Microsoft and Google in regards to other valuation metrics in establishing fair value.

Return on capital is a measure of the percentage return on investment for the capital the company has reinvested into the business. Again, the respective values for return on capital for Microsoft Corporation (NASDAQ:MSFT), Google Inc (NASDAQ:GOOG) and Apple at 36.9%, 17.6%, and 35.7% for the last five years prove the effectiveness of these management teams when it comes to reinvesting in these companies. Once again, the numbers indicate that Apple Inc. (NASDAQ:AAPL) should be valued in line with Microsoft and Google when metrics for determining fair value are applied.

Final thoughts

While all three of these businesses are currently priced at quite attractive levels for dominant global brands, Apple could rise 50% from its current level and still be valued equally with Microsoft and Google Inc (NASDAQ:GOOG). Investors who fail to take this opportunity to buy Apple Inc. (NASDAQ:AAPL) shares at this price will regret it for years to come.

Ken McGaha owns shares of Microsoft Corporation (NASDAQ:MSFT) and Apple. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple Inc. (NASDAQ:AAPL), Google Inc (NASDAQ:GOOG), and Microsoft Corporation (NASDAQ:MSFT).

The article Buy This Tech Giant Before It Rises 50% originally appeared on Fool.com.

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

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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