My calculation of intrinsic value for Apple Inc.

On my 17th Oct post I calculated Apple Inc's intrinsic value was about $343,37 per share base on my old calculation method. It was trading at $306.73 base on 19th Nov US market closing price.

Now I want to apply Morningstar's calculation method to work out the intrinsic value and make a comparison here.

AAPL

Current year (2010) FCF: 16,590M
Estimated next 10 yrs FCF growth rate: 10%
Perpetuity growth rate (g): 7%
Discount rate (R): 15%

Step 1: Forecast FCF for the next 10 years

2011	2012	2013	2014	2015	2016	2017	2018	2019	2020
18,249	20,074	22,081	24,289	26,718	29,390	32,329	35,562	39,118	43,030

Step 2: Discount these FCFs to reflect the present value

2011	2012	2013	2014	2015	2016	2017	2018	2019	2020
18,249	20,074	22,081	24,289	26,718	29,390	32,329	35,562	39,118	43,030
1.15	1.32	1.52	1.75	2.01	2.31	2.66	3.06	3.52	4.05
15,869	15,736	15,325	14,925	14,536	14,157	13,788	13,428	13,078	12,736

10 yrs discounted FCFs = 143,578

Step 3: Calculate the perpetuity value and discount to the present value

Perpetuity value = (43,030 x 1.10) / (0.15 - 0.07) = 591,663
Discounted to PV = 591,663 / 1.15^10 = 146,089

Step 4: Calculate total equity value = 10 yrs FCFs + Perpetuity value

Total equity value = 143,578 + 146,089 = 289,667

Step 5: Calculate per share value = Total Equity Value / Total share outstanding

Share outstanding: 917.31M
Per share value = 289,667 / 917.31 = $315.78

It seems Morningstar's calculation method was much closer to the current stock price, but please take of the main differences here. For both calculation I used discount rate as 15% that was fine, but in old method we estimated next 10 yrs EPS growth rate @ 23.61% per year. Here we only used 10% for next 10 yrs FCF growth rate and then used 7% for perpetuity FCF growth rate.

The basic idea here is the assumption for the growth rate play a very important role to determine the intrinsic value calculation result. The key is we should take into consideration of the size of the company, industrial cyclicality, economic moat, management team, and the complexity of the business to pick a comfortable estimated growth rate - assigning estimated growth rate is an inexact science - there are no "right" answers for any stock analysis.

The Five Rules for Successful Stock Investing

Recently I read a book named The Five Rules for Successful Stock Investing which was written by Morningstar's Director of Stock Analysis, Pat Dorsey; it covering a wide range of stock research and investment strategies. This comprehensive guide can helping any serious investors on their right track to pick the right stocks, find great companies without paying too much for their investment. I summarized some important topics and investment strategies here:

Five rules recommend by Morningstar:
1. Do your homework
2. Find economic moats
3. Have a margin of safety
4. Hold for the long haul
5. Know when to sell

4 steps to analyze a company's economic moat:
1. Evaluate the firm's historical profitability.
2. If the firm has solid return on capital and consistent profitability, assess the source of the firm's profit.
3. Estimate how long a firm will be able to hold off competitors, which is the company's competitive advantage period.
4. Analyze the industry's competitive structure.

5 ways that an individual firm can build sustainable competitive advantages:
1. Creating real product differentiation through superior technology or features.
2. Creating perceived product differentiation through a trusted brand or reputation.
3. Driving cost down and offering a similar product or service at a lower price.
4. Locking in customer by creating high switching costs.
5. Locking out competitors by creating high barriers to entry of high barriers to success.

The 4 sources of growth:
1. Selling more goods or services
2. Raising prices
3. Selling new goods or services
4. Buying another company

Some Red Flags and Pitfalls to watch out for:
1. Decline cash flow
2. Serial chargers - be wary of firms that take frequent one-time charges and write-downs.
3. Earning growth outstrips sales growth over a long period, this might be a sign of manufactured growth.
4. The CFO or Auditors leave the company.
5.A/R are increasing much faster than sales growth.
6. Gains from investments
7. Overstuffed warehouse - inventories rise faster than sales.
8 Change is bad - for example like depreciation expenses.
9. To Expense or Not to Expenses - costs such as marketing and some kind of development can be treated either way.

5 Steps to calculate a firm's intrinsic value:
Step 1: Forecast free cash flow (FCF) for the next 10 years
Step 2: Discount these FCFs to reflect the present value
Step 3: Calculate the perpetuity value and discount to the present value
Step 4: Calculate total equity value = 10 yrs FCFs + Perpetuity value
Step 5: Calculate per share value = Total Equity Value / Total share outstanding

A random stock screening exercise shared!

Today I decided to do a random stock screening process to pick some strong fundamental medium to small cap stocks (market cap less than 5b) with relative low P/E ratio (<= 20) in order to test my stock picking methodology:

Here are my screening criteria via Yahoo finance stock screener:

(1) Market cap <= 5b  - to filter out large cap stocks

(2) Forward P/E <= 20 - to filter out high P/E ratio stocks
(3) Return on Equity >= 15% - to identify strong growth stock
(4) Earning growth past 5 years >= 10% - to identify strong growth stock
(5) Quick Ratio >= 1 - to find out financial sound companies
(6) Total Debt / Equity <= 0.5 - to find out financial sound companies

Below are the screening results total 12 stocks which can fulfil above criteria:

AAON , AAON, Inc. , 24.55

CGA , China Green Agric , 7.35  Stock price less than $10.00
CNU , Continucare Corp. , 4.5    Stock price less than $10.00
DORM , Dorman Products,  , 36.49
FSIN , Fushi Copperweld, , 9.32   Stock price less than $10.00
HANS , Hansen Natural Co , 51.21
IDCC , InterDigital, Inc , 33.57
KEI , Keithley Instrume , 21.58
LANC , Lancaster Colony  , 49.92
MMS , Maximus, Inc. Com , 60.63
OMPI , Obagi Medical Pro , 11.41
PTI , Patni Computer Sy , 20.9

Three of them current price less than $10.00 per share I will not take them into consideration, I prefer to trade stocks within $10.00 - $100.00 range.

I also filtered out another 5 stocks due to their inconsistent earnings or a relative low average ROE rate (<15%) for the past 5 years.

IDCC    KEI   OMPI - inconsistent EPSGR for the past 5 years

DORM  MMS - past 5 years average ROE less than 15%

Now only left AAON, HANS, LANC, and PTI; I will estimate their intrinsic value.

AAON
Sector	Industry	ROE (5 yrs)	GM (5 yrs)
Industrial Materials	Building Materials	24.67%	23.86%
EPS (2010)	EPSGR (5 yrs)	EPS (2015)	P/E (5 yrs)
$1.44	9.86%	$2.30	15.60
P(2015)	P(2010)	P(current)	P(52-Week )
$35.94	$17.87	$24.55	18.00-26.13
HANS
Sector	Industry	ROE (5 yrs)	GM (5 yrs)
Consumer Goods	Beverages - Soft Drinks	40.33%	52.56%
EPS (2010)	EPSGR (5 yrs)	EPS (2015)	P/E (5 yrs)
$2.21	17.40%	$4.93	15.50
P(2015)	P(2010)	P(current)	P(52-Week )
$76.42	$38.00	$51.21	24.01-52.84
LANC
Sector	Industry	ROE (5 yrs)	GM (5 yrs)
Consumer Goods	Packaged Foods	18.86%	21.01%
EPS (2010)	EPSGR (5 yrs)	EPS (2015)	P/E (5 yrs)
$4.07	22.93%	$11.42	15.50
P(2015)	P(2010)	P(current)	P(52-Week )
$177.01	$88.02	$49.92	43.28-61.60
PTI
Sector	Industry	ROE (5 yrs)	GM (5 yrs)
Software	Software - Application	17.14%	34.56%
EPS (2010)	EPSGR (5 yrs)	EPS (2015)	P/E (5 yrs)
$2.12	19.78%	$5.23	11.68
P(2015)	P(2010)	P(current)	P(52-Week )
$61.09	$30.38	$20.90	18.11-28.33

  Note:

1. 5 years average data were calculated from 2006 - 2010.
2. If 5 years average P/E higher than S&P 500 5 years average P/E, S&P 500 P/E ratio will be applied.
3. P(2015): estimated stock price in 2015 - this if stock price Future Value (FV).
4. P(2010): estimated stock price after applied annual discount rate of 15% in today's value - this is the intrinsic value or Present Value (PV) of the stock price.
5. P(52-week): 52 weeks stock price movement range range.

You can see from above table currently AAON & HANS are over-valued, I will put it under my watch list and wait for the market correction in order to get the real bargain deal.

Now let's look at LANC & PTI in deeper details:

LANC - Lancaster Colony manufactures food products, automotive accessories, glass products, and candles. The company's largest division, which produces specialty foods, markets condiments, baked goods, and pasta under brand names such as Girard's, Pfeiffer, and Marzetti. Its automotive division produces floor mats, truck splash guards, and other parts, which it sells to auto manufacturers and retail stores.

Current stock price $49.92 was within lower band of 52-week price range and also about 44% discount to it's intrinsic value price $88.02.

The intrinsic value was calculated base on past 5 years (2006 - 2010) EPS data 1.45, 1.28, 3.18, 4.07, 4.07 to work out growth rate @ 22.93% per annum.

But if we look at the EPS data from 2000 - 2005 2.49, 3.11, 2.24, 2.67, 2.48 it seems that the EPS growth was inconsistent and also without any clear trends.

If we take more conservative estimation, let's say the growth rate for next 5 years will be 15% per annum (since 5 years average ROE was about 18.86%) which worked out the intrinsic value is about $63 per share. Current stock price is about 21% lower than intrinsic stock price and we should take this opportunity to buy this stock and wait for market to recognise it's true value.

PTI - Patni Computer Systems, an offshore-centric IT service provider from India, is known for its long history of managing large client relationships and its strong domain expertise in the select industries of insurance, manufacturing, financial services, and telecommunications. However, Patni does suffer from high client concentration and a limited global presence. In our opinion, Patni is a relatively weak player in a good industry.

Current stock price $20.90 was also close to the lower band of 52-week price range and it was about 31% discount to it's intrinsic value price $30.38.

But same findings can be derived from past 10 years EPS data.

2001 - 2005: 0.48, 0.64, 0.66, 0.92, 0.96 - growth rate @ 14.87%
2006 - 2010: 0.86, 1.64, 1.50, 1.84, 2.12 - growth rate @ 19.78%

We can find that past 5 years earning growth was much faster than previous 5 years period. Since the average ROE (for past 5 years) was about 17%, we can take a conservative estimation the next 5 years EPS will be increasing about 15% per annum which work out the new intrinsic value is $24.63.

Current price $20.90 was about 15% lower than the intrinsic value. To me 15% was not a clear margin of safety I will put it under my watch-list and wait for the stock price drop to below $19.70 (80% of the intrinsic value $24.63) then start to buy it.