Apple (AAPL) Is A Long-Term Buy

Apple reports earnings after the close today and just about everyone is expecting blowout numbers.  An onslaught of positive developments from Apple has served as a major catalyst for the stock price over the past few months: from iPad mania to a revamped Macbook Pro line to recent announcements around iPhone OS 4.0 and coming hardware updates to the iPhone 3GS.  That being said, when compared to a basket of “peers,” Apple’s stock price still looks very reasonably valued (see analysis below).

Apple (AAPL)currently has a PE of 20x expected 2010 earnings (based on an average of 40 analysts).  That’s a PEG Ratio (PE to Growth) of 1.1x, compared to the average PEG Ratio of 1.4x on a basket of Apple peers consisting of Google (GOOG), Amazon (AMZN), Cisco (CSCO), HP (HPQ), and Microsoft (MSFT). Among these peers, only Google has a lower (very slightly) PEG Ratio at 1.0x.

We also think there is a very strong halo effect occurring in which long-term Windows supporters are (will be) switching to Macs based on their extremely positive relationship with other Apple products (iPods, iPhones, and now, iPads). This, coupled with the fact that Apple is currently armed with $25 billion of cash (no debt) and delivers a superb 32% Return on Equity (17% Return on Assets), makes the stock a compelling long-term investment at its current valuation.

Buy Apple Stock, Get a Call Option on the iPad for Free

A quick look at some numbers seems to indicate that the potential value of the Apple iPad is not reflected in the current price of Apple stock (AAPL).   At its current price of $196, Apple is trading at around 17x the average analyst estimate for 2010 earnings of $11.51 per share.  Comparing Apple’s P/E of 17x to its 5-year projected growth rate of 18.2% gives Apple a PEG ratio of 0.9.

By way of comparison, Apple traded at 18x earnings with a PEG of 0.9 in the middle of the financial market meltdown in December 2008, and around 30x earnings with a PEG of roughly 1.4 prior to the onset of the recession/financial market collapse.

Of course, we don’t yet know if the iPad will prove to be a complete flop (Apple Newton), a middling success (Apple TV) or Apple’s next blockbuster product (iPod).  But that’s where option valuation comes in.   It’s the high volatility around the potential success (or failure) of the iPad, coupled with the “time value*” of the iPad that makes a call on the iPad valuable.

* If the evolution of the iPod is any indicator, then versions 2.0, 3.0, of the iPad are likely to be dramatically improved/enhanced when compared with the version demoed by Jobs on January 27th