In this article, I'm going to show how much IBM (NYSE:IBM) stock is worth according to a Warren Buffett "owner earnings" style analysis.
I will be posting a link to the valuation model (in an excel file) that I used along with describing the assumptions that went in it. This file will contain all the cash flow data from IBM going back to 1991. (The last year in which there is EDGAR data for IBM in the SEC website.)
I will also explain why I believe IBM stock is risky and why it is difficult to predict this company going forward.
I built an excel file with a valuation model using Buffett's measure of "owner's earnings." Warren Buffett is known for being skeptical for conventional valuation models that rely on GAAP such as price-to-earnings ratio and the like. He defined one of his methods in the 1986 Letter to Shareholders:
These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges...less (C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume....Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include plus - but do not subtract.
In order to make it consistent with a conservative approach, I will be using safe assumptions in order to make sure a buy or sell rating in the stock is not based on predictions that are difficult to make. Please note that this article is not a suggestion that Buffett would value the stock exactly like suggested or that he would agree with the article. I'm simply using a model that is similar to how he described his valuation method.
The assumptions that went into the DCF-like model were:
-I defined owner earnings as Operating Cash flow minus Capex minus Software Capex minus "M&A" plus asset sales (when there is any). Why subtract M&A? M&A is a major way in which shareholder value gets destroyed (think Autonomy), the whole idea of a Buffett style valuation is to make a valuation that is based on safe assumptions.
I don't want to have to assess how much the buyouts are worth because that is difficult to predict, especially in the tech sector (years later any buyout could be worth several times the purchase price or be completely worthless). Now, this is extremely conservative because it essentially considers M&A almost like an expense that just burns cash and only sometimes comes back through asset sales. Why add back asset sales? They represent a recovery from old capex and M&A, so in a way, it's old operating cash flow coming back home. I will present both the valuation subtracting M&A and without subtracting it.
-I assume that IBM will have another 10 years of above average owner earnings growth of 6% then normalize to 3%. The average rate of growth in owner earnings for IBM over the last 6 years is 21.80% (60.18% since 91 but with extreme volatility, so it's hard to rely on these numbers), the compounded rate of growth over the last 6 years is 2.59% (5.33% since 92), the average growth rate in operating cash flows since 1991 is 6.33%. I believe 6% is a more appropriate number.
-IBM required return is 12% (the rate at which the future cash flows are discounted back to the present). I'm assigning a higher discount rate than CAPM would suggest due the risks of the technology sector and its volatility. I don't think the market has been very good at predicting the pace in which technological changes impact corporations in that sector, so 1 year beta is understated, in my view.
-Long-term normalized growth is 3%. This is even lower of what World Nominal GDP is likely to be going forward. Earnings growth tends to be quite similar to Nominal GDP growth over long periods of time.
-As a margin of safety at the start of the valuation, I took IBM owner's earnings and decreased by 15%. This 15% decrease takes into account cash liabilities that are unexpected like lawsuits, government fines, patent violations, dumb M&A and other unexpected charges. This adds a margin of safety in estimating future cash flows and is consistent with Buffett's skepticism of not subtracting enough from cash flow figures.
Plugging all these in the spreadsheet, projecting the owner cash flows and discounting it back to the present at the chosen discount rate yields a fair value price of $139 (the fair value without subtracting M&A from owner earnings is $170 but I'd argue that without subtracting the company needs a higher discount rate). With the stock currently trading at $191 or so, I would call the stock overvalued.
What troubles me about IBM is how much of their operating cash is going to M&A, since 1991 they used 12.5% of their operating cash in M&A, in the last 10 years they used 17% of their cash. Maybe they are just running out of ideas on how to stay relevant in an ever changing corporate and technological world and are trying to buy their way out of the problem? Could be, but to buy the stock right now is to believe that their M&A will compensate for the valuation gap and that their M&A capex binge will work out at the end. This is not a bet I'm prepared to make as it amounts essentially to a gamble being done with shareholders money. It could or it could not work out, but I believe that there are easier plays out there.
According to a safe set of assumptions and a Buffett like valuation model, IBM stock is currently overvalued. I wouldn't be personally buying the stock right now as I believe there are better opportunities out there currently. I'm quite concerned with the amount of M&A that is going on there, the company spent more than $3.7B in M&A in 2012; it's hard to predict how the M&A binge will turn out at the end. They are buying all kinds software and hardware companies and it's a risky proposition to believe that the management won't make big mistakes along the way. If you find any errors in my valuation, let me know.
Additional disclosure: I am not a registered investment advisor and do not provide specific investment advice. The information contained herein is for informational purposes only and I can't guarantee the accuracy of all the information presented in this article. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion. It is up to investors to make the correct decision after necessary research. Investing and trading includes risks, including loss of principal.