The goal in value investing is to buy a stock when it trades at a significant discount to fair value in order to hold it until the price finally catches up to the intrinsic worth of the underlying business. Here are two investment ideas that have surfaced in the tech sector that could make great value investments.
It's no secret that Apple is a cheap stock. But a discounted cash flow valuation helps add a bit of perspective on exactly how cheap Apple really is.
In a discounted cash flow valuation, you simply discount future cash flows by the required rate of return that would convince you to invest in stocks to find the present value of these cash flows. I've used a discount rate of 10%, which is typical. Next, I estimated that Apple's annual free cash flow will stay at today's levels. To be conservative, I didn't add any asset value, like excess cash, to intrinsic value.
The result? Apple's shares are worth $468 per share. In other words, at $417 the stock trades 11% below its fair value.
An 11% margin of safety, of course, isn't significant enough to convince a value investor to jump in. However, I was extremely conservative in my assumptions. Consider some of these facts:
Apple's share repurchase program will effectively reduce outstanding shares by about 15%.
Apple's cash hoard of $144.7 billion is no joke, and it should be considered in any valuation.
It's easy to say Apple is doomed, but analysts don't think so. The 46 analysts covering Apple on Yahoo! Finance, on average, project EPS to increase 20.88% per annum over the next five years.
What happens to the valuation if we adjust our growth assumptions a bit higher? Estimating 3% annual growth in free cash flow for the next 10 years, and no growth beyond that, the fair value of Apple shares is $574.84. With this estimate, shares today trade at a 27% margin of safety.
If Apple's not undervalued, the company is at least reasonably priced.
Watching Baidu's operating margin contract by 1,200 basis points year over year to 37% when the company reported earnings last week wasn't fun. Even worse, a 37% operating margin is 1,500 basis points below the company's peak operating margin in 2011. But does this mean Baidu's growth story is over? Far from it.
The company boasts an impressive 70% of all paid search dollars in China, positioning itself to receive the bulk of benefits from growth in digital advertising in China over the coming years. Of the 17 analysts covering Baidu on Yahoo! Finance, the average estimate for per annum EPS growth over the next five years is 25.78%.
But I'll be far more conservative, estimating free cash flow to grow by 15% in year one and then decelerate each year thereafter for the next ten years:
Using a 10% discount rate and a 3% perpetuity rate for years beyond the 10th year, the fair value of shares with these assumptions is $110.50, meaning shares are trading at a 23% discount to fair value. Keep in mind that my estimates are far more conservative than the projections made by analysts covering the stock.
If not an outright buy, Baidu is definitely a stock to add to your watchlist.
What do you think about these investment ideas? Have they reached value territory?
Got Apple? Get smart.
There's no doubt that Apple is at the center of technology's largest revolution ever, and that longtime shareholders have been handsomely rewarded with over 1,000% gains. However, there is a debate raging as to whether Apple remains a buy. The Motley Fool's senior technology analyst and managing bureau chief, Eric Bleeker, is prepared to fill you in on both reasons to buy and reasons to sell Apple, and what opportunities are left for the company (and your portfolio) going forward. To get instant access to his latest thinking on Apple, simply click here now.
The article 2 Investment Ideas for Value Investors originally appeared on Fool.com.
Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Apple and Baidu. The Motley Fool owns shares of Apple and Baidu. 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.
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