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International Business Machines: A Road Map To Reasonable Valuation

International Business Machines Corporation (IBM) likely isn't flying under anyone's radar. From its humble beginnings as the Computing-Tabulating-Recording Company in the early 20th century, this Armonk, New York based mega technology corporation has grown to a top 20 company in the world. But even without that tidbit of information, you've surely heard about the company.

Perhaps two of the most well-respected value investors - Warren Buffett and Peter Lynch - have commented specifically on this company. Warren Buffett's Berkshire Hathaway purchased 63.9 million shares or about 5.5% of the company in 2011 stating the following:

"I was late to the IBM party. I have been reading the company's annual report for more than 50 years, but it wasn't until a Saturday in March last year that my thinking crystallized."

In an interview, he went on to describe that in his early entrepreneurial days he competed against IBM products only to be told that "nobody ever got fired for going with IBM."

In Peter Lynch's book "One Up On Wall Street" he describes the a similar ideology on the ownership side:

"There's an unwritten rule on Wall Street: "You'll never lose your job losing your client's money in IBM."

So if - according to Buffett's and Lynch's experiences - you can't really go wrong with either being a customer or an owner of IBM, then it seems like a company in which one might find interest. Granted these two sentiments were separated by two decades, but each seems to be as relatively true today as it was at the time they made their remarks.

IBM operates in 5 business segments, but really it comes down to three basic components: Hardware, Services and Software. In 2000 these parts made up roughly 35%, 38% and 27% of profits respectively. (Note: Financing has been a small part of the overall business but is included with Hardware) As of the 2012 annual report these numbers have moved to 14%, 41% and 45% respectively. In other words, there has been a migration out of Hardware and into Services and Software. Notably, the company indicated that roughly half of its profits are expected to come from Software by 2015.

In addition, IBM has consistently reiterated its Road Map objective of $20 in operating earnings per share by 2015; which appears quite achievable given its revenue growth and prolific share repurchase program which has decreased outstanding shares by roughly 40% over the last 15 years.

Morningstar's Grady Burkett sums IBM up nicely indicating:

"While each of [IBM's] businesses is an industry leader in its own right, the combination of these products and services provides the firm with an unrivaled solution, creation and delivery ability that is the key to its wide economic moat."

Specifically, he goes on to indicate that while mainframes still remain as an advantage for IBM, the company has shown its ability to innovate and diversify towards more profitable business technologies. Risks include a move away from hardware, varied cloud computing substitutes and potentially cheaper alternatives from rivals like Oracle (ORCL).

Especially telling of IBM's entrenched technology and ability to continuously innovate is their enormous amount of patents. In 2012 alone the company received 6,478 patents and kept its two decade streak of most patents by any company in the world. In turn, shareholders have been continually rewarded via share buybacks and increased payouts.

15 Years of Growth

International Business Machines Corp has grown earnings (orange line) at a compound rate of 11.3% since 1999, resulting in a $209+ billion dollar market cap. In addition, IBM earnings have risen from $3.84 per share in 1999, to today's forecasted earnings per share of approximately $16.90 for 2013. Further, IBM has been particularly consistent by not only paying but also increasing its dividend (pink line) for the last 18 years. Especially noteworthy is the 16% average annual growth rate of this payout for the last decade and a half.

For a look at how the market has historically valued IBM, see the relationship between the price (black line) and earnings of the company as seen on the Earnings and Price Correlated F.A.S.T. Graph below.

IBM Corp
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Here we see that IBM's market price previously began to deviate from its justified earnings growth; starting to become overvalued in 1999 and coming back to fair value around 2002. Today, IBM appears undervalued in relation to both its historical earnings and relative valuation.

In tandem with the strong earnings growth, IBM shareholders have enjoyed a compound annual return of 5.9%; note that this does not correlate closely with the 11.3% growth rate in earnings per share due to overvaluation at the beginning of the period. Still, a hypothetical $10,000 investment in IBM on 12/31/1998 would have grown to a total value of $23,138.82, without reinvesting dividends. Said differently, IBM shareholders have enjoyed total returns that were roughly 1.4 times the value that would have been achieved by investing in the S&P 500 over the same time period.

IBM - 15 Year Performance Results
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But of course - as the saying goes - past performance does not guarantee future results. Thus while a strong operating history provides a fundamental platform for evaluating a company, it does not by itself indicate a buy or sell decision. Instead an investor must have an understanding of the past while simultaneously thinking the investment through to its logical, if not understated, conclusion.

In the opening paragraphs we alluded to a variety of potential opportunities for growth. It follows that the probabilities of these outcomes should be the guide for one's investment focus. Yet it is still useful to determine whether or not your predictions seem reasonable.

27 leading analysts reporting to S&P Capital IQ come to a consensus 5-year annual estimated return grow rate for IBM of 10.1%. In addition, IBM is currently trading at a P/E of 11.8, which is at the low end of the "value corridor" (defined by the orange lines). If the earnings materialize as forecast, IBM's valuation would be $404.90 at the end of 2018, which would be a 16.9% annualized rate of return including dividends. A graphical representation of this calculation can be seen in the Estimated Earnings and Return Calculator seen below.

Intl Business Machines Corp IBM
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Now it's paramount to remember that this is simply a calculator. Specifically, the estimated total return is a default based on the consensus of the analysts following the stock. The consensus includes the long-term growth rate along with specific earnings estimates for the next two upcoming years. Further, the dividend payout ratio is presumed to stay the same and grow with earnings. Taken collectively, this graph provides a very strong baseline for how analysts are presently viewing this company. However, a F.A.S.T. Graphs' subscriber is also able to change these estimates to fit their own thesis or scenario analysis.

Since all investments potentially compete with all other investments, it is useful to compare investing in any prospective company to that of a comparable investment in low risk treasury bonds. Comparing an investment in IBM to an equal investment in a 10 year treasury bond, illustrates that IBM's expected earnings would be 4.8 times that of the 10 Year T-Bond Interest. This comparison can be seen in the 10-year Earnings Yield Estimate table below.

IBM - 10 Year Earnings Yield Estimates
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Finally, it's important to underscore the idea that all companies derive their underlying value from the cash flows (earnings) that they are capable of generating for their owners. Therefore, it should be the expectation of a prudent investor that - in the long-run - the likely future earnings of a company justify the price you pay. Fundamentally, this means appropriately addressing these two questions: "in what should I invest?" and "at what time?" In viewing the past history and future prospects of IBM we have learned that it appears to be a strong company with solid upcoming opportunities. However, as always, we recommend that the reader conduct his or her own thorough due diligence.


Disclaimer: Long IBM, ORCL at the time of writing.


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