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IBM shares were recently severely punished for disappointing earnings released last week. Shares dropped 8% in a single day, dragging the Dow down with it and are now trading much closer to their 52 week low of $182 than the highs of $216. Analysts and investors were not impressed with IBM's results, and rightly so as the quarter was terrible, but was the selloff overdone? This article will take a look at Big Blue's valuation in relation to its prospects and determine whether or not shares deserve your capital.

To determine a fair value for IBM shares, we'll use a DCF-type analysis that requires some assumptions: 1) book value and analyst growth rates from Yahoo! Finance 2) perpetual growth rate of 4% (my estimate) 3) dividend growth rate of 10% per annum (my estimate) and finally 4) discount rate of 10% (my estimate). Of course, you may disagree with some or all of my estimates but I used what I believe to be reasonable approximations for IBM's prospects given available information. Keep in mind that all forecasting is subject to conjecture.

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$16.77

$18.46

$20.40

$22.54

$24.91

x(1+Forecasted earnings growth)

10.10%

10.49%

10.49%

10.49%

10.49%

Forecasted earnings per share

$16.77

$18.46

$20.40

$22.54

$24.91

$27.52

Equity Book Value Forecasts

Equity book value at beginning of year

$17.14

$30.17

$44.52

$60.39

$77.96

$97.39

Earnings per share

$16.77

$18.46

$20.40

$22.54

$24.91

$27.52

-Dividends per share

$3.40

$3.74

$4.11

$4.53

$4.98

$5.48

$6.02

Equity book value at end of year

$17.14

$30.17

$44.52

$60.39

$77.96

$97.39

$118.88

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Normal earnings

$3.02

$4.45

$6.04

$7.80

$9.74

$11.89

Forecasted EPS

$16.77

$18.46

$20.40

$22.54

$24.91

$27.52

-Normal earnings

$3.02

$4.45

$6.04

$7.80

$9.74

$11.89

Abnormal earnings

$13.75

$14.01

$14.36

$14.74

$15.17

$15.63

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

Abnormal earnings disc to present

$12.50

$11.57

$10.79

$10.07

$9.42

$8.82

Abnormal earnings in year +6

$8.82

Assumed long-term growth rate

4.00%

Value of terminal year

$229.19

Estimated share price

Sum of discounted AE over horizon

$63.16

+PV of terminal year AE

$129.26

PV of all AE

$192.43

+Current equity book value

$17.14

Estimated Current share price

$209.57

Given my model's inputs, IBM has an approximate fair value of $210 today. With shares trading at $191.59 as of this writing, the stock is trading at a 9.4% discount to my fair value estimate. It is important at this point to understand what the fair value estimate means. The model's output is a price at which, given the parameters specified, shares can be bought at a "good price" today. The estimated fair value is the net present value of the company's cash flows plus its current book value. Therefore, the fair value of the business today, according to my estimates, is about 9% higher than where shares are trading.

There could be many reasons for this discrepancy. For instance, indices are near major highs, fears about IT spending in general going forward and others are all valid risks for the stock. However, with a 9% estimated cushion, some of these fears are probably priced in already. In addition, it is important to note that $209.57 is not a nominal price target; rather, it is the net present value of all the company's estimated future earnings and current book value. Given IBM's current forward PE of 10.4, if the company achieves $27.52 in earnings per share in 2018, a price of $286 is implied with no multiple expansion.

In addition, my model is forecasting that over this same period, shareholders will receive approximately $28.86 per share in cash dividends, or about 15% of the current share price. This offers a bit of downside protection in the shares and provides some current income in the process. While IBM's dividend isn't huge by any means, it is decent and has plenty of room to be raised later on.

There are risks, of course, to my estimates. First, IBM may not achieve the 10.49% earnings growth annually that analysts are forecasting. If that does not happen, there is potentially significant downside risk to my fair value. For instance, if only 4% earnings growth is achieved, the fair value decreases to just over $165, imply IBM is overvalued by a whopping 13%. In addition, IBM's high-margin model of enterprise cloud computing service is under ever-increasing assault from commoditized computing power available for virtually no cost in comparison to IBM's service. That's not to say that IBM is in dire straits but there are certainly competitive risks that Big Blue must address for my analysis to prove correct. IBM has done it before and I have no reason to think the company will just let its low cost competitors run it out of the business it has built.

Given the fact that shares are very attractively priced with a reasonable 10% discount rate and a decent amount of dividends that are due shareholders in the coming years, I believe the margin of safety is probably large enough to warrant taking the risk at this point. Also remember that this analysis assumes no share repurchases and IBM is apt to do just that and such a move could be a tailwind for EPS and shares in the future. The combination of share repurchases, dividends, earnings growth and current reasonable valuation means IBM shares have a sizable enough margin of safety to mitigate future earnings risk under most scenarios. Significant downside risk could materialize if IBM is unable to retain its high margin customers but I don't see a huge risk of that happening any time soon.

Source: IBM: Big Blue's Big Bruise Is Your Opportunity