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Fundamentally Speaking

International Business Machines Corp. (IBM) matured some time ago and the tech firm made a decision to increase profitability and value added business lines such as software and services. IBM did this by sacrificing sales in low margin areas like hardware and this strategy has paid off.

IBM has had a low P/S ratio compared with other firms in the industry over the last five years and this makes it a very attractive investment. IBM's P/B ratio is much higher than the industry average and this is indicative of the very high expectations that investors have for the tech giant.

These common stock valuation ratios are reflective of IBM being renowned as the industry leader. Additionally, highly successful value investor Warren Buffett recently stated that he would buy more IBM stock "from time to time."

(click to enlarge)

Source: Google Finance

Since 2000, IBM has lowered its share count by a third due to the drop in revenue growth. This has seen the stock price appreciate over the last 10 years by a great deal. Additionally, the EPS has also gone up.

In the chart above, one can see the number of dividends that have been paid out over the last 10 years signified by the pointers labeled 'D'. The remarkable fact is that for each $1,000 of stock owned over the last 13 years, the quarterly dividend has added up to a whopping $2,200. This is more than double the initial investment, without taking into account the gain in the stock price.

The Dividend Discount Model

The dividend discount model [DDM] makes a very big case to buy IBM stock. The DDM is an easy to use tool for investors to quickly assess a stock as it is great at finding intrinsic stock value estimates.

The DDM is a procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

It is based on a discounted cash flow [DCF] valuation technique. Dividends are the most clear-cut measure of cash flow since these are obviously cash flows that go straight to the investor.

Intrinsic Stock Value

This is using the Dividends Per Share forecast.

Year

Value

DPSt or Terminal Value (TVt)T

Calculation

Present Value at 15.11%

0

DPS01

3.30

1

DPS1

5.29

=3.30*(1+60.44%)

4.60

2

DPS2

7.79

=5.29*(1+47.13%)

5.88

3

DPS3

10.42

=7.79*(1+33.82%)

6.83

4

DPS4

12.56

=10.42*(1+20.52%)

7.15

5

DPS5

13.57

=12.56*(1+8.04%)

6.71

5

Terminal Value (TV5)

826.87

=13.47*(1+8.04%)/(9.80%-8.04%)

409.17

Intrinsic Value of common stock (per share)

$455.63

Current share price

$203.03

1 DPS0 = Sum of last year dividends per share.

It is easy to see that IBM is undervalued from the table above and so it makes for a great investment idea. But there must be a number of questions on your mind. Specifically, what is the 'calculation' column and how are the growth rates obtained. The good thing is that I am going to show you everything so that you will be able to do a dividend discount model on any stock you wish to analyze.

Dividend growth rate [g] obtained from the PRAT model

The biggest calculation is getting the dividend growth rate [g] and this is the product of the profit margin [P], the retention rate [R], the asset turnover [A], and the financial leverage [T].

Selected Financial Data

Dec 31,2012

Dec 31, 2011

Dec 31, 2010

Dec 31, 2009

Dec 31, 2008

Dividends

3,773

3,473

3,177

2,860

2,585

Net Income

16,604

15,855

14,834

13,428

12,335

Revenue

104,507

106,916

99,871

95,759

103,630

Total assets

119,213

116,433

113,450

109,023

109,526

Total IBM stockholders' equity

18,860

20,138

23,046

22,637

13,466

USD $ in millions

Ratios

Dec 31,2012

Dec 31, 2011

Dec 31, 2010

Dec 31, 2009

Dec 31, 2008

Retention Rate

0.77

0.78

0.79

0.79

0.79

Profit margin

15.89%

14.83%

14.85%

14.02%

11.90%

Asset Turnover

0.88

0.92

0.88

0.88

0.95

Financial leverage

6.32

5.78

4.92

4.82

8.13

Now we have all the components in the PRAT model listed in the table above with their respective values. These components are calculated as follows.

Retention rate: (Net Income - Dividends) ÷ Net Income

Profit margin = 100 × Net Income ÷ Revenue

Asset turnover = Revenue ÷ Total assets

Financial leverage = Total assets ÷ Total IBM stockholders' equity

We have now obtained the PRAT model component values for 5 years and we obtain the averages which are summarized in the table below.

Averages

Retention Rate

0.78

Profit margin

14.30%

Asset Turnover

0.90

Financial leverage

6.00

We use the figures in the table above to get the dividend growth rate as implied by the PRAT model. This is the percentage used in the Year 1 row of the first table in this article that gives the intrinsic stock value according to the dividend discount model. The calculation is shown below for your convenience.

Retention rate × Profit margin × Asset turnover × Financial leverage

= 0.78 × 14.30% × 0.90 × 6.00 = 60.44%

Dividend growth rate [g] implied by Gordon growth model

This is an integral part of finding the intrinsic stock value. We start by estimating the required rate of return (RF). To do this, we start by obtaining the average of bid yields on the total amount of outstanding fixed-coupon U.S. Treasury bonds. These Treasury bonds should not be due or callable for another 10 years and the average will be an unweighted one. This value of 2.6% will act as a proxy for the risk-free rate of return.

The estimated rate of return on a market portfolio (RM) is widely estimated to be 13.19%. The systematic risk (β) for IBM is 0.68. The required rate of return on IBM (rIBM) is calculated as follows:

rIBM = RF + βIBM [E(RM) - RF]

= 2.60% + 0.68 [13.19% - 2.60%]

= 9.80%

Once this is found, we insert the values into the Gordon growth model equation.

g = 100 × (P0 × rIBM - D0) ÷ (P0 + D0)

= 100 × ($203.03 × 9.80% - $3.30) ÷ ($203.03 + $3.30) = 8.04%

where:

P0 = IBM stock price

D0 = Sum of last year dividends per share

Dividend growth rate [g] Forecast

Year

Value

gt

1

g1 (implied by PRAT model)

60.44%

2

g2

47.13%

3

g3

33.82%

4

g4

20.52%

5 and thereafter

g5 (implied by Gordon growth model)

8.04%

Conclusion: IBM has tremendous potential

I have always been a firm believer in innovation. IBM is the most innovative business around as indicated by the fact that it has gotten the most patents since the year 2000.

The DDM shows that IBM is a great investment idea as the current stock price of $203.03 is much lower than the calculated intrinsic value of $455.63. This is a much bigger difference than what we saw in the case of SAP AG (SAP) which had an intrinsic value of $83.56.

IBM is definitely good value for the money and past performance shows that it keeps returning that value to investors through dividend increases and buybacks, in addition to stock price appreciation.

Lately, the stock price has risen above the 100-day moving average [MA] and it is slightly below the 50-day MA. This is a perfect entry point to buy more IBM shares.

Source: IBM: Excellent Value For Money

Additional disclosure: Valuation is based on standard assumptions. There may exist particular things pertinent to stock value that are not analyzed here. In this case, the actual stock value may differ greatly from what has been estimated here. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for a specific situation.