Everybody would like to have bought IBM (NYSE:IBM) at the end of 2008. In this short article I will show why you can now buy IBM at a price that only apparently is much higher than back in 2009.
According to Warren Buffett, there is a test every investor should run before buying a stock: You should figure out whether the company creates or destroys value, i.e. whether management has been able, over longer periods of time, to transform every dollar of retained earnings into at least one dollar of market value.
Let's run this test for IBM:
Retained earnings 12/2008: $70.35 billion
Retained earnings 9/2013: $124.88 billion
Difference: $54.53 billion
Market capitalization 12/2008: stock price $82 x 1.34 billion shares outstanding = $109.88 billion
Market capitalization today: stock price $176 x 1.09 billion shares outstanding = $191.84 billion
Difference: $81.96 billion
IBM meets the requirements: its management has transformed every dollar retained into more than a dollar of market value.
But there is another conclusion to draw from this exercise:
Now we know how Mr. Market thinks about IBM's value compared to 2008. He believes the business today is worth $27.43 billion (81.96 less 54.53) more than during the peak of the market panic, which translates into $25.2 per share. At about $150 the stock would be as cheap as back then, as we would pay only the sum of the then stock price of $82 and the earnings retained since then.
That's a downside of only 15%.
We can buy IBM now at a price which is not much higher than at the very trough of the stock market panic in winter 2008. To be precise, today's price corresponds to the stock price of April 2009: at about $102.5 the market capitalization was $54.53 billion lower than today.
Just to feel a bit more sure about our results, let's now compare the Price/Earnings Ratios:
At $150 IBM would trade at a similar earnings multiple as in 2008 and we would pay only the earnings retained since back then. As Benjamin Graham said: "In the short run, the market is a voting machine but in the long run it is a weighing machine."
I hear your objections: the stock market trades the future. Retained earnings do not automatically translate into added value, hence the necessity to run this test in the first place.
Maybe IBM has squandered these retained earnings for silly acquisitions? Maybe they've done useless research and developed expensive stuff nobody needs? In this case, the company would have deserved a market capitalization rising less than accumulated retained earnings and a current PER below the 2008 PER.
I recently wrote another article on IBM to show that investors do not need to worry so much about IBM's future as almost two thirds of its earnings are annuity based and almost guaranteed for some years to come. Remember that even in the last, rather bad quarter, the services backlog was actually up. (The bad news came from the non-recurring revenue sector and management projects the annuity based revenues to grow even further in the years to come.) If the stock price languished for a longer period of time, these recurring cash flows alone would permit immense stock buybacks. To be precise, currently about $11.5 billion/year, which means (if the stock languishes) 66 million shares/year. In about 8 years IBM would have bought back half of the currently 1.09 billion shares outstanding. Assuming stable profits of only $11.5 billion, this would bring EPS to about $22. - Would the stock still languish? - If you think that it surely would, you should buy at least one share immediately. After another 8 years of buybacks at a clip of 66 million shares/year, your share would be the last one outstanding and you would own the whole company!
I think this is why Warren Buffett underscored that he likes IBM's "financial position" and that he felt "the odds" were "good", while admitting that he did not feel as sure about IBM as about BNSF or Coca-Cola. At the current stock price, the recurring revenues alone together with the still growing backlog and IBM's buyback strategy provide sufficient guarantees for excellent future returns.