Editor's note: Nimish Garg and his team recently won a stock-picking contest against other high school students. One of the prizes was getting to publish an article on Fool.com. Here it is with light edits.
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Investor favorite Apple (NASDAQ: AAPL) once seemed to be an unstoppable hurricane. But over the past year, it has faced headwinds that pushed the company's shares down by as much as 17%. Nevertheless, Apple stock looks promising for three reasons: investor expectations, fundamentals, and future prospects.
Expectations were once a weakness. After Tim Cook assumed the role as Apple's CEO, no matter how well Apple performed, people always expected more. People wanted something revolutionary, both in Apple's products and Apple's financials, as Steve Jobs had done in the past. Releasing groundbreaking projects used to define Apple and separate it from its competition. However, when Apple's newest products started to feature less changes, people were disappointed.
Even if quarterly reports had a single negative indicator, Apple's stock would drop. This can be seen in July 2015's report, in which almost all components of the company were doing well; only the iPhone's results were mixed. Apple sold 47.5 million units, which was less than expectations. This was a minor drawback as Apple beat revenue and earning expectations and even reported that iPhone sales were up 35% year-over-year. But Apple ended up losing 18% of its share price over the next month.
However, what was once Apple's bane is now Apple's boon. Because of myriad factors such as China's dismal financials and Apple's overall slowing growth, investors have realized that they cannot hold such high expectations for Apple. In fact, EPS expectations from TheStreet for the June 2016 quarter were only $1.39, while they were $1.80 for the June 2015. This is a stark contrast, a 22.8% difference, signifying a lack of investor confidence.
Apple easily beat this low mark and its shares jumped 6.5% the next day. Even after this beat, investors still have low expectations.The iPhone 7 has such depressing rumors. For the October 2016 quarter, earning estimates are only at $1.64, while they were over 15% higher for the October 2015 quarter. Now is the time to capitalize on this bearish sentiment.
Fundamentally, Apple is one of the most sound companies that exist on this planet. It is highly profitable as it has a 38.02% gross margin, uses investors' money well with its 37.92% ROE, and it generated plenty of free cash flow over the past four quarters, $50.01 billion. Even if Apple were to deliver a lackluster product or quarter, the company faces minimal risk as it can invest in new businesses or continue to reward its shareholders via buybacks and increased dividend to keep them happy and keep its share price high.
Even though Apple is making such a large margin, it looks undervalued. Its P/E ratio is only 12.49, as compared to an industry average of 17.10, and its price to free cash flow is 11.98, as compared to an industry average of 14.29. This is due to the bearish sentiment behind Apple's stock, which should vanish in Apple's coming years.
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Unlike what many people believe, Apple's time in the spotlight is far from over. Apple has many places to expand, notably in developing countries such as India, and with the introduction of the cheaper iPhone SE, citizens of these countries can afford to purchase Apple products. Apple can also expand its services business. Last quarter, Apple had services revenue of $5.99 billion, beating analyst estimates of $5.78 billion. Services are now the second-largest source of revenue of Apple, beating both the Mac and iPad. Apple has Apple Music, Apple Pay, iCloud, etc, and as it becomes arduous to incrementally upgrade hardware, Apple can instead develop more services to bring in more revenue.
Moreover, Apple has potential to diversify its products even further and become a market leader in emerging fields. Apple has been making the right moves, and since 2015, it has made at least 17 acquisitions in fields ranging from healthcare to even the alluring, scarcely touched field of virtual reality. Even though Apple hasn't always been the pioneer of the fields and technology it specializes in today, and its changes to existing fields have often been controversial, it always manages to come out on top. Because of its out-of-the-box thinking, it has evolved to now become the leader in smartphones, tablets, and smartwatches. With all the assets Apple has, there's no reason why Apple can't do the same again.
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At the time of writing, Nimish Garg had no position in Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. 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.