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Doing Some Back-Of-Envelope Analysis: IBM

Back-of-envelope analysis on IBM (IBM)

IBM's trailing twelve months Earning Per Share is currently $14.09, while the current share price is hovering around $185. This short article is an attempt to do a back of envelope calculation of how the market is pricing IBM share price.

How would you price the IBM Shares if the EPS were to suddenly stop growing and stay at $14.09 forever ?

Well, one finance formula would be EPS / WACC

where WACC = weighted average cost of capital. Several finance websites put the range between 8.1% - 9.6%

As a rule of thumb, I usually use 9% for Dow Components, 12% for large caps, 15% for Internet Companies. IBM is a Dow Component, however for consistency with past calculations, I use a more conservative number WACC of 10.5%.

So with WACC of 10.5% and EPS of 14.09, if IBM EPS were to stay stagnant forever, the share price would be 14.09/10.5% or $134.19 per share.

To fine-tune it further, we could assume some sort of long-term growth, according to the CIA World Factbook, the real World GDP growth for the last ten years shows a low of -0.7 in 2009, a high of 5.3% in 2006 and an estimated growth of 3.3% in 2012. I would tag a more conservative 3% long term growth for IBM, more than half of its revenue comes from outside of the US.

So assuming a long term growth of 3%, IBM is value at EPS/(WACC - growth) or 14.09 / (10.5% - 3%) = $187.86 per share

IBM current share price is $185 (approx.). This tells me that the market isn't optimistic that IBM can grow faster than 3% a year over the long term.

Perhaps investors have concerns with the new CEO, or they are not convinced that IBM can grow meaningfully with an annual sales 102 billion, or perhaps investors simply prefer other fast growing companies engaged in Cloud Computing.

Let's look at IBM Earnings Per share over the last 10 years:

























Click to enlarge

Over period of 2012/2011, IBM EPS grew 10%
Over three years, it grow 12.8% annually
Over five years, 14.9% annually and over last 10 years, 16.7% annually

So the question is, is it reasonable that IBM EPS can grow at least 10% a year over the next 10 years ? I think the answer is quite positive, especially given that they have shrunk the number of shares outstanding with buybacks over the similar ten year period, 1756 million shares outstanding in 2003, and around 1130 million shares recently.

So, let's revisit the scenario again, let's assume IBM EPS would grow 10% a year for five years and then drop to 5% a year for the next five years, and finally a 3% long term World GDP growth.

Using a simple two-stage DCF calculator, the share price works out to $275.29. This is a premium of almost 50% to the most recent share price. If I were to assume ten years of 10% EPS growth, the number is even more impressive.

In conclusion, I think the market is mispricing IBM shares, it is pessimistic that IBM can grow, while its track record shows that IBM has grown its EPS quite impressively in the last ten years. I believe IBM is worth at least $275 based on conservative growth rates, this is a premium of nearly 50% and a margin of safety over today's price of $185.


ps. I didn't get into any analysis on IBM's products, business or marketing plans. These would be the important next steps if I were to seriously consider investing in IBM as these factors would determine whether IBM can grow the EPS or not. What I am merely doing in this article is just a back-of-envelope calculation of how the market is pricing IBM.

pps. Any DCF analysis is fraught with issues. And my calculation is no exception, it can be problematic because of a number of assumption I used, eg. EPS as a proxy for Free Cash Flow, use of trailing twelve months results versus forward numbers, use of world GDP growth rates as a proxy for company long term growth rates etc. However the key is to be consistent in the calculation, and err on the side of being conservative. It is better to be roughly right than be precisely wrong.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Stocks: IBM