Going into 2014, I'm betting big on Apple (NASDAQ: AAPL ) stock. In fact, it's my largest holding. My bet on the stock has nothing to do with the catalyst of a new product category (although this is certainly possible, and maybe even probable). It doesn't even have to do with big expectations from the China Mobile deal. The basis for my reasoning is simple: The stock continues to trade below a conservative fair value estimate.
One of the most Foolish tools in an investor's toolkit is the simple action of zooming out. A 10,000-foot view of Apple reveals a solid business with an irrational price tag.
At just 14 times earnings, and 11.5 times forward earnings estimates, the market doesn't expect much out of Apple. In fact, all Apple needs to do is continue to grow earnings each year at a rate in the low single digits to live up to its valuation.
A discounted cash flow valuation, assuming Apple continues to grow EPS by 3% annually over the long haul, suggests that the fair value of Apple shares is $729 (using a 10% discount rate on future cash flows).
As it turns out, however, this projection for 3% annualized growth to Apple's bottom line is very conservative. The average analyst estimate at Yahoo! Finance for Apple's annualized EPS growth over the next five years is 14.3%. At this rate of growth, Apple's total annualized EPS would nearly double in just five years. For Apple's annualized EPS to reach those same levels while growing at just 3%, it would take 22 years. Case in point, my estimate for 3% annualized EPS growth over the long haul is extremely conservative.
Too much cash
But it gets better. While analyst estimates for double-digit growth in EPS undoubtedly take into consideration Apple's massive $60 billion share repurchase program, these projections don't consider the implications this could have on Apple's dividend.
Today, Apple pays out $12.20 per share in annualized dividends. Trading at $567 per share, this gives investors a 2.2% dividend yield. Assuming Apple continues to boost its dividend by 15% annually (as it did in April this year), Apple would double its dividend in five years. This would give investors about a 4.2% yield five years from now on the cost of shares bought today -- not bad.
But could Apple continue to boost its dividend by 15% annually over the next five years? Easily. Today, Apple is only paying out about 29% of its annual earnings in dividends. And we shouldn't forget about the $149 billion on Apple's balance sheet either.
The other factors
A conservative discounted cash flow estimate suggests Apple is trading at about a 22% discount to fair value today. This is a meaningful discount for a market leader, enough to convince me to keep holding onto the stock.
But, chances are, the scenario may be far too conservative. The China Mobile deal alone could add meaningful incremental value to Apple's bottom line. And the rumor mill is abuzz with potential new product categories Apple may enter in 2014; if these new categories turn out to be the disruptors like Apple's iPhone and iPad were, they could be big catalysts.
Here's a peek at my second-largest holding.
Over the long haul, a dividend strategy works wonderfully
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