Warren Buffett may like IBM (NYSE:IBM), but I see it more as a low-risk investment vehicle than anything else. IBM provides 35% less volatility than the broader market and consistent growth, but it doesn't have a meaningful discount to intrinsic value when factoring in future grown. Consensus expects 2012 EPS being $16.60 and then growing 11% thereafter to hit $25.20 by 2016. At a 13x multiple, this growth translates to a $328.25 future stock value. Discounting backwards by an 8% discount rate of 8% yields a price target of $223.40. This is roughly a 10% margin of safety - approximately 1,000 basis points below what is required for "value investments".
Accordingly, I find it bizarre that the legendary value investor would open a long position in IT and business service provider. IBM may have a great brand, but growth and earnings power is not enough to drive strong returns. Moreover, I find the 11% EPS growth projections for IBM to be overly bullish given the "large of law numbers" will likely limit expansion for a $225.9B dollar company. The firm is currently rated a "hold" on the Street according to FINVIZ.com and has a consensus price target that is around the current valuation.
Buffett has stated in the past how his large fortune denies him the ability to drastically outperform broader indices like he did in the fast. This makes sense, because he has to spread his net worth over more investments. In this respect, IBM works as a glorified mattress for storing money.
By contrast, Microsoft (NASDAQ:MSFT) and Oracle (NYSE:ORCL) have significant discounts to intrinsic value. Buffett has stated that Microsoft is undervalued but that he would never invest in the company given regulatory concerns over whether his friend Bill Gates would slip him a secret or insinuate through behavior. This is unfortunate, because Microsoft and Oracle have a meaningful margin of safety with big upside.
Microsoft trades at only a respective 11.1x and 9.9x past and forward earnings on top of a 2.6% dividend yield. 2012 EPS is expected to be $3.09 and then grow 9.8% thereafter. This means 2016 EPS of around $4.49, which, at a 14x multiple, translates to a $62.86 future stock value - more than double the current market price! Moreover, at a 10% discount rate, this upside has more than a 30% margin of safety.
Of course, Microsoft is a great company with a great brand and thus merits a lower discount rate of around 8%. That would put the price target at $42.78, which is at a more than 40% premium to the current market price. Adding a 2.6% dividend yield into the equation, and Microsoft has very compelling risk/reward. Double-digit ROA and ROI in the 30% range further reinforce a bullish thesis.
It is unfortunate then that Microsoft has lost much of its luster due to the Apple (NASDAQ:AAPL) craze. The software producer is a virtual monopoly in its field and has probably the best chance of penetrating tech markets. Its sector has few barriers to entry, and Microsoft has $7.09 per share to grow R&D and re-excite the market. Microsoft 8 is a step in the right direction, but more integration needs to be done through cloud computing. Skype, Facebook (NASDAQ:FB), and the Windows Phone are additional platforms that Microsoft can leverage to close its discount.
Similarly, Oracle has the unfortunate reality of shareholder fatigue despite great value. The free cash flow machine trades at a just 10.2x forward earnings and remains heavily invested in growth projects. ROA, ROE, and ROI are lower than at Microsoft, but analysts expect the company growing earnings more over the next three years. 2012 EPS is forecasted at $2.92 and 12.2% growth thereafter. This means 2016 EPS of around $4.63, which, at a 14x multiple, translates to a future stock value of $64.79 - again, more than double the current valuation. A discount rate of 10% yields a more than 30% margin of safety.
In order to make any sense of how realistic consensus earnings projections are, investors should consider the derivative of growth: acceleration / deceleration. The 12.2% 5-year EPS growth projection for Oracle is 700 bps below EPS growth over the past 5 years. This compares to 785 bps and 560 bps, respectively, below the past 5 years for Microsoft and IBM. Put differently, even under the assumption that IBM's EPS growth declines less on absolute scale than it does for Microsoft and Oracle, its discount to intrinsic value is still less. Accordingly, I find Microsoft and Oracle substantially more undervalued than IBM. It is an investment that Buffett would make if only he could.