While we remain bullish on IBM’s long term prospects, we feel that its valuation could come under pressure in the short term.
IBM’s price to book value ratio is close to one and five year highs.
It is also at a substantial premium to a sector peer and this could indicate short term weakness.
IBM's Price To Book Value
As the chart below shows, IBM's (NYSE:IBM) price to book ratio has risen during the course of the last year. Indeed, one year ago it was at a similar level to where it is today, at around 12.3, before declining significantly during the course of the year. It reached a low of 8.2 in February of this year before quickly increasing to its current level, where it has treaded water for the last few months.
Clearly, IBM's price to book ratio has been relatively volatile over the last year, but what we're slightly concerned about is the fact that the ratio is close to one year highs. Although we feel that the ratio could push higher and even surpass its one year high of 12.3, we note that the ratio is currently just 4.9% from that level. This indicates that IBM's valuation could come under pressure in the short run, as market participants realize that the company's price does not offer such great value at the moment.
Our viewpoint is backed up by the five-year chart of IBM's price to book value, which is shown below. Sure, IBM's price to book value ratio has been as high as 12.8 in the early part of 2013, but it remains just 8.6% below this level right now. For us, this indicates that there could be short-term price pressures on IBM, as the market responds to a relatively high valuation.
In terms of relative value, IBM's price to book ratio trades at a significant premium to that of sector peer, Accenture (NYSE:ACN). Although not a perfect match, Accenture does operate in the same sector as IBM and, as the chart shows, its price to book ratio has been fairly constant over the last year. Indeed, one year ago, IBM's price to book ratio was at a 29.5% premium to that of Accenture, before it fell heavily to its one year low of 8.2. At this point, it was at a 21.9% discount to Accenture's price to book ratio. Today, IBM's price to book ratio is at a 25.8% premium to Accenture and we believe that this shows it may have become slightly overheated - in the short term at least. Sure, there could be some scope for small increases, but we feel that these are limited in the short term at least.
Despite our concerns surrounding IBM's short term valuation, we remain long-term bulls. That's partly because of the superb visibility offered in IBM's earnings and its relative bottom-line stability. For example, IBM's key Services division has $136 billion of contracts outstanding. This means that revenue for the short to medium term is very predictable and this allows investors to place a lower margin of safety on the share price, because the risk of a lack of orders is reduced.
Furthermore, although top-line growth is fairly sluggish at IBM right now, we feel that the company's strategy of moving away from its traditional reliance on hardware and towards more cloud based services is a sound one. IBM is also focusing more resources on the software division, which as recent quarterly numbers have shown, continues to offer a mix of impressive margins (37% at the pre-tax level) and top-line growth (1% in the most recent quarterly results, year-on-year). A greater focus on this segment could help to bolster IBM's profitability going forward through it focusing sales on higher margin divisions.
Therefore, even though we're slightly concerned about short term valuation pressures as discussed above, we remain optimistic about the company's long-term prospects. We feel that a mixture of high earnings visibility, a strategy that is concentrating on higher growth areas, as well as the potential for overall margin expansion through focusing sales in higher margin segments mean that shares in IBM could perform well over the longer term.
What do you think of IBM? Would you buy, sell or hold right now? Please comment below!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.