- IBM has a current valuation that is well below its Fair Value.
- The dividend growth has been exceptional in the past and should continue.
- Expectations are so depressed for IBM that even if it only manages low single-digit revenue growth, the stock is worth a buy.
International Business Machines (NYSE:IBM) has been in the doldrums lately. Now the stock is awfully cheap. It is time to see if it deserves its low valuation or if at its current price it is a screaming buy.
IBM's stock valuation is rather similar to Deere & Company (NYSE:DE), which I recently wrote about. Both companies are in the midst of negative revenue growth and transitional times. Both are doing a good job of keeping earnings fairly strong despite their growth challenges. Both stocks are valued similarly. And both companies have been in existence for a very long time.
In the case of DE, we can be pretty sure that demand will eventually pick up. IBM's case may be trickier to forecast.
Discounted Cash Flow [DCF] Valuation
The average estimate, as shown on Yahoo Finance, for IBM's next five years' EPS growth is 8.68%. Using that figure for five years, followed by 5% for the next 20 years, and plugging in a discount rate of 10% gives us a Fair Value price of $250.93.
I feel that the five years' growth of 8.68% may be optimistic given IBM's current woes, so I'll run another calculation based on 7.5% in the next five years (all other inputs are the same). Re-running the calculation results in my conservative Fair Value of $239.13.
The DCF Fair Value calculation is only as accurate as its inputs, so it is important to weigh the odds of IBM living up to the growth rates that I have assumed. With the conservative five-year estimate of 7.5%, I feel comfortable that IBM can reach that EPS growth. The figure is well under IBM's historical growth and 1% less than the average analyst estimate.
Dividend Discount Model [DDM] Valuation
The DDM method is a variation of the DCF method. The DDM was the brainchild of John Burr Williams in the 1930s, who thought that a stock's worth should be calculated as the present value of all the dividends to ever be paid on it.
IBM Dividend data by YCharts
(The shaded area is the Great Recession period)
In the last 10 years, IBM's dividend has gone from $0.18 to $1.10. That is certainly the type of growth that a dividend investor likes to see. IBM has averaged a very impressive 18% annual dividend hike for the past 10 years.
For the DDM calculation, I am using IBM's current dividend of $4.40 (annualized), which corresponds to a current payout ratio of 24.6% (using estimated fiscal 2014 earnings). I will assume 14% dividend growth for five years, followed by a terminal dividend growth of 5%, and an assumption of a terminal payout ratio of 70%.
Using those inputs gives a Fair Value for the stock of $282.16. The DDM valuation is a conservative method of valuing a stock, and almost always comes in below the DCF calculation. In IBM's case, the figure comes out higher due to its excellent dividend growth prospects.
I will now show comparisons between IBM, ACN, and HPQ in several key categories over the last five years. The revenue graph is normalized to facilitate analogous measurement.
IBM Revenue (TTM) data by YCharts
IBM's growth woes are certainly on full display with this graph. While it is no surprise, it is rather striking nonetheless. Note that HPQ has had its own revenue growth problems recently and a five-year graph actually shows IBM above HPQ.
One of the most important metrics to judge a company by -particularly when comparing it to peers - is the ROE. However, when one looks at IBM's ROE, you don't really get a good idea of how profitable its actual business is. What you see instead is IBM's remarkable leverage used to fund share buybacks (which increases ROE). So for this comparison, I will use ROA:
IBM Return on Assets (TTM) data by YCharts
All three companies have good ROA numbers. IBM and ACN are rather exceptional.
I alluded to share buybacks above, so let's look at the history of it:
IBM Average Diluted Shares Outstanding (Quarterly) data by YCharts
All three companies have been aggressive at buying back stock, with IBM leading the charge in this area. Warren Buffett had the following to say about IBM's buybacks in a letter to his shareholders on February 25, 2012 (and noting why he doesn't mind if the shares languish for a while):
Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.
Now that I have looked at some financial comparisons, it is time for one last graph that will illustrate a valuation comparison.
IBM P/E Ratio (Forward) data by YCharts
Not surprisingly, ACN has a much higher forward P/E than the other two companies. ACN really is the "best of breed" here and it is priced accordingly.
For comparison to IBM's five-year growth, ACN is expected to grow EPS at a 11.5% clip and HPQ is expected to grow EPS at 4.57%. (Source: Yahoo Finance)
IBM has the best PEG of the three companies.
IBM's dividend is currently yielding 2.4% and it has a very strong dividend growth record; the stock is a great pick for a dividend investor. The payout ratio is only 24.6% despite the large hikes, so it looks safe to say that the dividend growth will continue to be impressive.
The average of my conservative DCF ($239.13) and my DDM ($282.16) calculations give a Fair Value of $260 per share. While that may sound high for a company that needs to transition some of its business and faces hurdles to future growth, the fact is that IBM stock is just so cheap that it trades at a sizable discount to its Fair Value.
IBM is a dividend machine - It buys back lots of shares, and its financial ratios are excellent. I expect its revenues will only grow slowly in the future, but frankly that is all it needs to do for the stock to do well.