This week in Model Vs. Market we’re taking a look at International Business Machines (IBM) to compare the company’s intrinsic value, as calculated by our discounted cash flow model, with the company’s current share price.
“The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”
– Warren Buffett
If a company’s current share price is lower than your estimate of its intrinsic value you should consider buying it. Every model using the discounted cash flow approach is based on assumptions and, like pizza, the quality of the results are only as good as the quality of the ingredients.
Here is some background on the company:
International Business Machines Corporation or IBM is a leading provider of integrated computer technology, hardware, software and services. Its business is divided into five business segments: Global Technology Services (strategic outsourcing, global process services, integrated technology services, cloud and technology support services), Global Business Services (applicatrion management, consulting and systems integration), Software (middleware and operating systems), Systems and Technology (infrastructure technologies) and Global Financing (enterprise financing solutions).
IBM has a global presence, reaching over 175 countries located in the US, UK and Europe and in key growth areas like China, India and countries in Southeast Asia, Eastern Europe, Middle East, Latin America and Africa. The company was incorporated in 1911 and its headquarters are located in Armonk, New York.
What is IBM worth?
The DCF valuation model is indicating that shares of IBM are worth $95 which is 43% less than its current share price of $169. Here are the key assumptions used to arrive at this value:
- Revenue Growth – Over the last 5 years revenue has decreased at an average rate of 1.8% annually. The model assumes this same growth (decline) rate for the next 4 years and in the terminal year. If the company is able to turn around its declining revenue and achieve just 2.5% growth the intrinsic value increased to $183 per share.
- Profitability – Over the last 5 years the company’s EBITDA margin has averaged 25%. The model assumes this same margin going forward. The EBITDA margin over the past 5 years has ranged between 24.2% and 26.1%.
- Depreciation – Depreciation in 2014 was 4.8% of revenue. The model assumes this same rate of depreciation going forward.
- Income Taxes – The average effective tax rate for the last 5 years was 22.3%. The model assumes this same effective tax rate going forward. Increasing the effective tax rate to 40% reduces the valuation to $68 per share.
- Capital Investment – Over the last 5 years the company has spent of 6.3% of its revenue on capital investments, net of dispositions. The models assumes the same rate of capital investment going forward.
- Working Capital – After netting out cash, short-term investments and short-term debt the company has operated with positive working capital. The model assumes this will continue in the projections at the same rate as revenue grows.
- Discount Rate – The assumed cost of equity is 10% and the assumed cost of debt is 3.5% over the 10-year U.S. treasury rate. The company’s net debt to enterprise value is 15%. The resulting weighted average cost of capital is 9.19%. Reducing the cost of equity to 8% increases the valuation to $119 per share.
Download this model to perform your own valuation and let us know what you think shares of IBM are worth on Twitter @tagnifi. This model was created by extrapolating the last 5 years of performance into the next 5 years of performance. Before making an investment decision you should run your own model with your own assumptions based on your own research of the company.
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