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IBMValuation Paper
Jacob Willrich and Josh Smith
14
Table of Contents
Summary and Conclusion…………………………………………………….………3
Capsule Description of Company…………………………………..……….3
Major Recent Developments………………………………………….………3
Earnings Projections…………………………………………………………..4
Valuation Summary…………………………………………………………….4
Investment Action………………………………………………………………5
Business Summary…………………………………………………………………….5
Company Description to the Divisional Level……………………………..5
Industry Analysis………………………………………………….…………….9
Competitive Analysis……………………………………………..…….……..14
Risks……………………………………………………………………………….……..24
IBM SWOT analysis 2013……………………………………………….…….24
Negative Company Developments……………………………………....….29
Negative Industry Developments……………………………………..….…30
Valuation………………………………………………………………………….……..32
CAPM………………………………………………………………………........32
WACC……………………………………………………………………..……..33
Dividend Discount Model……………………………………………….……34
Free Cash Flow…………………………………………………………..…….41
Residual Income Model ………………………………………………..…….47
Multiples Valuation……………………………………………….…….…..…56
Statement of Conclusions……………………………………….…….…….67
Summary and Conclusion
Capsule Description of the Company
International Business Machines (IBM) has been around for 103 years and has
taken the information technology sector and ramped it up over the past century. They
are one of the leading information technology firms in the world and is trying to gain
market share in cloud computing which is their main focus for clients. Their vision is to
be dedicated to every one of their clients and make the world a better place. IBM’s
main slogan is “Think Different” and that is exactly what they aim to do.
Major recent developments
Recently IBM has made drastic moves in the sectors they current deal in. They
sold off many of their server based applications and hardware’s to Lenovo who has
purchased many of their products in the past which means that IBM wants to get away
from the hardware server based services. IBM has also been acquiring smaller cloud
based companies to increase their market share in that segment, as this is their primary
focus for the future. There is a lot of money to be made in cloud computing as it can
make things way easier and efficient for businesses to work and communicate with
each other.
Earnings Projections
The projected earnings of IBM do not seem to be too high, as they have just
been slowly increasing revenue by roughly 2% each year. Over the next few years they
are projected to grow a little bit quicker than 2%, we assumed a 6% growth because of
how they are altering their services for a more customer-based perspective. Luckily
IBM sees that they have not been growing at a quick enough pace like their competitors
so they are changing up their products and services to gain more revenue. Cloud
based computing is more profitable as it requires less capital and costly upkeep.
Valuation Summary
IBM was valued using 4 different valuation methods, Discounted Dividend, Free
Cash Flow, Residual Income, and Market Based valuation. Based on these models we
would assume the most weight on the Free Cash Flow valuation because it most
accurately represents IBM as a whole and it was the least altered due to significant
factors in the other models. By weighting the models this would give us a more
accurate value that takes all into consideration but does not leave just one sole model to
value the company. The weights are as followed: Free Cash Flow 30%, Dividend
Discount 15%, Residual Income 25%, Market Based Valuation 30%. The dividend
discount model does not suit IBM very well because of their odd investor relationship
strategy, the fact that they constantly buy back shares, and the fact that they don’t have
a constant growth of dividends which throws off that valuation. The multiples model
however was one of the best valuation models because it took so many factors into
consideration, which showed that it is worth the price against their competitors.
Investment Action
The final value that we achieved is $196.39 and the current stock price of IBM is
actually $191.73 we would consider IBM to be undervalued. Considering that the firm is
undervalued it would be to our best knowledge to hold or even buy the stock as in the
future it will increase due to expanding markets of big data and analytics, cloud
computing and their mobile, social and securities portfolios. IBM is in a restructuring
and investment phase, and are about to take over these markets in the years ahead.
Business Summary
Company Description to the Divisional Level
International Business Machines Corporation (IBM) is an information
technology (IT) company. IBM was first incorporated on June 16, 1911 under the name
CTR or Computing-Tabulating-Recording Company. It wasn’t until February 14, 1924,
CTR was changed to IBM, International Business Machines Corporation due mainly to
the incredible growth of technology and the loss of purpose of CTRs activities. By then,
the company had expanded significantly both geographically and functionally, including
the completion of three manufacturing facilities in Europe. Currently, IBM has 434,246
employees working in 170 different countries. The IBM headquarters is located in
Armonk, New York and is included as one of the Dow Jones 30 companies in the New
York stock exchange, selling at $191.73/share as of 4/23/14.
IBM operates in five segments: Global Technology Services (GTS), Global
Business Services (GBS), Software, Systems and Technology and Global Financing.
GTS primarily provides IT infrastructure services and business process services. GBS
provides professional services and application management services. Software
consists primarily of middleware and operating systems software. Systems and
Technology provides clients with business solutions requiring advanced computing
power and storage capabilities. Global Financing invests in financing assets, leverages
with debt and manages the associated risks. (OneSource)
Total Divisional Revenue
IBMs mission and vision have been the same since 1911. But in 2003, more
than 319,000 global IBM employees participated in a 72-hour “Values Jam,” which
redefined the values which guide IBM in the development and delivery of its technology
and business products and services. The Values that all of the employees agreed on
were:
Dedication to every client's success
Innovation that matters, for our company and for the world
Trust and personal responsibility in all relationships
Key Executives
Virginia M. Rometty - Chairman, President and Chief Executive Officer
Virginia Rometty is Chairman, President and Chief Executive
Officer of IBM. Mrs. Rometty was appointed President and CEO
on January 1, 2012. She became Chairman of the Board of
Directors on October 1, 2012. Before she became CEO and Chairman, Mrs. Rometty
served as Senior Vice President of IBM Global Business Services, where she led the
successful integration of PricewaterhouseCoopers Consulting. This acquisition was the
largest in professional services history, creating a global team of more than 100,000
business consultants and services experts. Mrs. Rometty was awarded with the Carl
Sloane Award 2006, which recognizes the excellence of her leadership role in the
professional services industry.
Rodney C. Adkins - Senior Vice President, Corporate Strategy
In his over 30-year career with IBM, Rod Adkins has held a number of
management roles, including general manager positions for the PC
Company, UNIX Systems and Pervasive Computing. Since 2013, Mr.
Adkins has become IBM’s senior vice president of Corporate Strategy. He has helped
in leading continuous transformation across IBM and developing strategies for a new
era of computing, new markets and new clients.
Erich Clementi - Senior Vice President, IBM Global Technology Services
Erich Clementi is the Senior Vice President for IBM Global
Technology Services. In this role, Erich has worldwide responsibility
for cloud computing services, IT and business process outsourcing,
project-based services, and technical support services. Prior to this position, he ran
IBM’s strategy function responsible for identifying and executing on major growth
opportunities including cloud computing. He joined IBM in Milan in 1984.
Something that I found interesting is the amount of compensation awarded to
the top 5 key executives. The increases in compensation from 2009 – 2011 seems
pretty normal but then the spike in 2012 was due to the replacement of the former CEO
Samuel Palmisano. Samuel Palmisano also left the board of directors in October of
2012, being replaced by Virginia Rometty. The 57.04% drop in compensation from
88.22 million to 37.9 million is in no way reflecting the stock price or any financial
decrease, but actually the appointment of the new CEO Virginia Rometty. (OneSource)
2009 2010 2011 2012 20130
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Total Executive Compensation
Total Executive Compensation
Industry Analysis
Products
The amount of IT products available in this industry are expanding and becoming
more and more efficient every day. The IT industry is very competitive in that new
technologies are being developed, and new patents are making competition increase
dramatically. IBM being the leader in the industry has been executing an excellent
corporate strategy. Their main focus for IBM every year has been the Research and
Development department. IBM putting tens of billions of dollars every year into
research and development has helped them continue to stay a leader and become
more and more competitive within the industry. With IBM having acquired more than
170 companies their range of product are very well diversified in every segment of the
IT industry.
The information technology market is the main manufacturer of systems that
allow companies to run smoothly and quickly without any problems. Various products
are servers, operating systems, communication devices, and information sharing
devices. IBM has generally sold to large corporations but that doesn’t mean they don’t
sell to smaller companies. The average consumer is not who is targeted in this market.
Corporations seek companies like IBM to improve their computer systems by integrating
all departments together which in turn will improve their efficiency of their production
process.
Current Clients
IBM being the IT giant that it is has thousands of customers throughout 170
different countries. IBMs target market is big businesses that require a lot of IT help to
collect, store, and manage tons of client, and business data. IBM also helps
businesses run as smooth and quickly as possible, keeping their business strategies up
to date with the latest technologies and continuing to have that advantage over their
competitors. Here are a few quotes of business professionals expressing how IBM
helps take their business strategies to the next level:
"The key is taking that Big Data and turning it into the true voice of the
consumer and that is our unique proposition at Telerx and we used that to take that Big
Data and get it into actionable insights for our client." -Deana Sabatino, Senior Vice-
President, Marketing,Telerx
"We are completely satisfied by the way that IBM delivered this project. The
quality of work was exceptionally high, and the analytical models and tools that the team
developed have been instrumental in guiding us through the changes to the market and
to our role in it over the last few years. The processes and tools that IBM Global
Business Services have put in place allow us to make much better strategic decisions."
-David Macartney, Commercial Manager of Power NI
“Working with IBM enabled us to take an innovative approach. Instead of
following the long processes of other governments or even the private sector, we were
able to get things up and running quickly.” -Gordon J. Bruce, director and CIO of the
Department of Information Technology,City and County of Honolulu
"With completion of Phase1 of the IBM ECM solution deployment, the time
spent retrieving case history documents has gone from minutes to seconds, improving
both caseworker productivity and service to our clients." -Doug Kasamis, chief
information officer, Illinois Department of Human Services (IBM)
Emerging Markets
With IBM continuing to acquire companies, they have built relationships with
businesses, and communities all over the world. This has helped IBM grow vastly
overseas and is constantly expanding and getting involved with emerging markets all
over the world. Here are a few examples of emerging markets that IBM has been
involved in:
Smarter City Operations
The Philippines city of Davao’s 1.5 million citizens will be the first in Asia to
benefit from an Intelligent Operations Center. It ties together data and operations of four
agencies—crime prevention; emergency response; threat prevention and response; and
traffic management. Geolocation mapping, in combination with GPS-equipped task
forces on the ground, will allow officials to analyze building, street and infrastructure
data to substantially reduce response times. A new early warning system will monitor
key risk indicators so agencies can take quick action before situations escalate.
Smarter Stock Exchange
To compete with exchanges in places like London and New York, the Santiago
Stock Exchange needed to handle the growing volume of high-frequency and
algorithmic trading activity—and do so from the ground up. Working with IBM, it built a
trade processing solution that increased capacity tenfold, cut latency to microseconds
and enabled real-time fraud surveillance. The Exchange’s transaction volume is up 50
percent in the first year.
Smarter Cancer Treatment
Memorial Sloan-Kettering Cancer Center is working with IBM to use the cognitive
computing capabilities found in IBM’s Watson to help doctors develop personalized,
evidence-based cancer treatment options. The system uses insights gleaned from the
deep experience of Memorial Sloan-Kettering’s world-renowned oncologists to provide
individualized treatment options based on a patient’s medical information, the synthesis
of a vast array of updated and vetted treatment guidelines, and published research.
The result: a decision support system for physicians that will offer individualized,
confidence-weighted treatment options for their patients.
Smarter Wind Energy
Vestas, the world’s largest windmill manufacturer, is tapping into the power of an
IBM supercomputer and Big Data analytics software to model past, present and future
wind patterns—a process that involves huge amounts of data—to optimize the location
and design of sites its customers are developing. Vestas’s system is on track to digest
and analyze 20 petabytes (163,840 Terabyes) of information in hours instead of
months. The result: fewer customer power disruptions and more predictable revenues
for utilities.
Smarter Customer Retention
Pakistani telephone provider Ufone faced a challenge common to start-ups in
emerging markets. After a period of rapid growth, reaching 24 million subscribers in less
than a decade, it had to retain those customers in an increasingly competitive market.
IBM analytics enabled it to scan call detail records in near-real time, flagging customers
who fit the profile for a particular promotion. Today, by issuing offers customized to a
user’s unique usage patterns, Ufone has doubled its campaign response rates. (IBM)
Competitive Analysis
IBM has many well know competitors like Microsoft, Oracle, and Cisco. But then
there are also some competitors that not many people have ever heard of like
Symantec Corporation and Computer Sciences Corporation. These competitors, like
IBM, are all in the information technology (IT) market. The information technology
market has increased dramatically over the last 20 years sense the internet boom. IBM
has been able to stay competitive by putting vast amounts of money into their R&D
departments and by acquiring up and coming companies that may bring something new
to the industry. This market is very influential in everyday life as they supply the
majority off all computers to the world. IBM has been able to stay competitive not only
because of their R&D departments but by maintaining and increasing their brand image.
They have been able to expand and increase their brand image all over the world by
building relationship through all of the acquisitions it makes. Having this brand image
that is recognized all over the world is something that is priceless and what makes IBM
have such a high competitive advantage over its peers.
Porter’s Five Forces Model
Industry Rival: Medium
The rivals from within the industry exert a medium force on IBM because
computers are consistently increasing in power and features so they must continue to
advance along with everyone that they are competing with. Patents play a large part in
this market, which makes it hard for competitors to have similar products.
New Entrants: Low
New entrants into the IT market are not seen very much with it being very hard to
enter. This force is very low and almost not a factor for IBM. Initial capital and sunk
costs are so great that no one can possibly compete with the works of IBM and Apple in
volume of products made. Patents play another part in this force as they protect current
company’s products and ideas from being used and being done cheaper for some time.
The technologies that these companies possess are far past anything consumers have
seen and it is very hard to get a hold of that kind of technology. All of these are forces
to keep out new entrants as well as strong brand recognition in the industry. Apple has
by far the highest brand retention among the competitors.
Substitutes: Low
The substitutes that are present in the market are very low because they do not
have as good as performance as the name brand ones. Also piracy has been
increasing in the past few years but this is also low because the majority of the products
that IBM sells is not easily pirated software and will not work if pirated. Software does
make a profit and the piracy is not affecting this as greatly as people believed. It is also
very costly to switch from one company to the other if an entire company purchases
from one. That would be too costly and would not be as effective.
Supplier Power: Low
Supplier power is fairly low because the parts that are included in the products
can be found in other areas. They are not depending on one supplier to get them their
parts. High volume procurement also makes it so that the suppliers can’t price their
products too high because everything is bought in bulk.
Buyer Power: Low
The buying power of consumers, which are generally large companies when it
comes to IBM, is fairly low because there are many customers that need these products
so they do not have a large bargaining base. The product they are buying is important
to the customer and will be beneficial to them if they get the best they can for the best
price so they will pay good money for a good quality product. Customers also have
special requirements for IBM, whether it is number of computers or special IT software
needed with the computers that allow them to not be able to barter as well because they
won’t be able to get it anywhere else.
Corporate Strategy
IBM has possessed a differentiation strategy for the past few years once it got rid
of its computer segment. IBM now focuses on quality products for all types of
businesses at premium prices because they are different than what anyone else can
offer. The products that IBM offers range from small businesses to large corporations
and are far superior to the competitors. They have such a vast amount of products and
services, that businesses would rather seek IBM for all of their IT needs. They can
choose hardware, software, servers, and cloud computing all from different companies
that specialize in them or choose IBM, who can handle everything you need. With the
internet expanding and business interacting with customers more and more online, the
amount of data that is generated is growing exponentially. “By 2015, there will be 1
trillion connected objects and devices generating data. Currently there are 2.5 billion
gigabytes of data generated every day. 80 % of the world’s data is unstructured. Audio,
video, sensor data, blogs, tweets. All represent new areas to mine for incites.” –IBM.
IBM is investing billions and has created the broadest and deepest portfolio in Big Data
and Analytics. Making it easier than ever to collect, store, and analyze the vast
amounts of data each business is generating. With all this data being generated
businesses technology infrastructure has been moving cloud computing, that is the
delivery of IT and business processes as digital services. Just like the portfolio of IBMs
big data and analytics, the cloud computing portfolio is a world leader as well. With
over $7 billion invested in cloud computing, IBM has over 1500 cloud patents, and has
acquired 15 cloud computing companies, including SoftLayer, for its advanced cloud
infrastructure. 80% of the Fortune 500 companies use IBMs cloud capabilities. IBMs
public cloud is generating 5.5 million cloud client transactions every day. With cloud
computing on the rise IBMs strategy to invest $1.2 billion to open up 15 more cloud
hubs and network centers in markets all over the world by the end of 2014. With this
expansion IBM will have 40 cloud hubs and network centers across 5 continents.
In 2013, IBMs cloud revenue increased by 69%, and doubled the cloud revenue
“as a service” from 2012 to 2013. It is clear with the billions in acquisitions, $1.2 billion
in expansions of cloud hubs and network service centers around the world, and the
increase in revenue that has been generated in just the past year, why it is one of IBMs
main focuses and is beginning to take over the cloud computing industry.
With the big data and cloud computing taking over the IT industry, there is
another market that is growing rapidly and it’s why it is another part of IBMs corporate
strategy. The mobile industry has been expanding for a few years now, but with the
introduction to apps, businesses can now communicate with clients and customers with
their mobile devices. This is causing business to gather vast amounts of data and
security issues. IBM has developed a portfolio of products and services, that’s enables
businesses and communities to engage customers, employees and citizens securely.
IBM has hit some milestones that make it one of the most desirable companies if not the
most desirable to solve these mobile and security problems for businesses. “6,000
security experts, 3,000 mobile experts, 2,800 social business experts. 4,300 patents in
mobile, social and security technologies. # 1 market leader for enterprise social
software; #1 market leader in security and vulnerability management. 7 of 10 top banks
in the US, 9 of the top 10 in the UK and 2 of the top 4 in Australia use IBM Security
Solutions. 8 companies acquired for mobile capabilities like mobile messaging for
marketers and secure mobile app delivery. 12 companies acquired for security
technologies like web fraud detection, sophisticated malware, and device management.
25 security labs globally, 10 security operations centers globally. 15 billion security
events monitored daily in 130 countries.”(IBM) Since IBM has started to focus more on
the social, mobile, and securities market, this portfolio has generated double digit
revenue increase in each of the three sectors in 2013. With the most being a 69%
growth in mobile, 45% growth in social business, and a 19% growth in securities.
Generating Higher Value
IBM continues to generate and maintain a high value for themselves, by
changing their business strategy to accommodate the business demands of high value
products and services, and more profitable markets and opportunities all over the world.
With businesses becoming more and more involved with cloud computing, IBM has
started to shift away from their hardware segments and focus more on their software
and services segments.
As you can see in the graph above, with IBM constantly changing its strategy to
the long term market demands, it has shifted away from hardware, and started to really
focus on the high profitable segments like, software and services. With this strategy in
place, IBM has been able to generate over 170 Billion dollars in free cash flow since the
year 2000. Allowing them to reinvest and stay highly competitive and a highly desirable
company to investors. As you can see in the chart below, IBM has continued to
repurchase shares making their stock more and more valuable over the years. The
current CEO, Virginia Rometty, wants to continue with this strategy of repurchasing
shares, and has set goal of repurchasing another 50 Billion dollars worth of shares by
the end of 2015. As you can see in the chart below, IBM has spent over 32 Billion
dollars in acquisitions. This along with the billions put into research and development
have been the driving cause for staying competitive in an industry that is so highly
innovative. Staying competitive is a big value booster for IBM and investors wanting to
get a piece of the company.
With all the cash that IBM has to spend, they have done an excellent job when it
comes to increasing the value of the company. An excellent number to look at when
valuing a company is Earnings Per Share or EPS. If you notice in the table below,
since 2002, IBM has had a consistent growth in EPS. This is due to the new corporate
strategy that took place which included the repurchasing of shares. IBM has had such
a large free cash flow, that they’ve bought back over 108 billion dollars worth of shares
since 2000, shown in the chart above. Reducing the amount of shares outstanding has
increased the value of IBM shareholders and in turn, EPS. The increase in revenue by
shifting the business strategy to focus on more valuable, faster growing segments of the
business and by investing more than 32 billion dollars worth of strategic acquisitions,
has also been a key factor in the steady increase of ESP. Another key factor to this
growth in EPS is IBMs shift to higher margin businesses, where systems integration and
processes have become more and more efficient. CEO Virginia Rometty is sticking with
this strategy of repurchasing shares, investing in strategic acquisitions and focusing on
the current high margin businesses, and projecting an EPS of $20 by 2015.
Risks
IBM SWOT analysis 2013Strengths Weaknesses
1. First mover in cloud computing solutions for enterprises
2. Market share leader – Middleware3. R&D Development4. Brand reputation5. Strong competency in acquisitions6. Global Service Model
1. Expensive service and software solutions
2. High Debt3. Reliance on Americas4. Product Recall
Opportunities Threats1. Acquisitions2. Expand services and software
divisions3. Positive outlook for Global Market4. Increasing demand of cloud based
services
1. Increasing competition in the cloud computing market
2. Expansion of Consultancy3. Rapid Technological Changes4. Slowing growth of world economy
Strengths
IBM has succeeded in gaining market share and in 2011 they held approximately
32% of the software vendor market and the closest competitor was roughly 16% behind.
Along with holding market share they also are very good at growth with a reported
approximately 12% growth in 2012 which was much greater than the industry average.
In 2012, IBM generated $20 billion in revenue and middleware software accounted for
65% of its total software revenue.
IBM has expanded greatly in the past decade and being in more than 170
countries they are growing very well. 43.6% of revenue was from the Americas,
Europe/Middle East/Africa are second with 31.1%, and Asia with 25.3% in 2012. This
shows that IBM does not solely deal with just the Americas and they are a truly global
company. “A global integrated model allows IBM to focus its resources on client-
oriented work and enhance its rapid deployment capabilities to growth markets.”
IBM has one of the strongest R&D departments in their industry, spending
roughly $6 billion annually. Since 2000 the company has invested more than $70 billion
in R&D to become the best in the industry. The R&D department is focused on
developing brand new products that have not been even imagined yet and services that
the clients need. IBM was awarded 6,478 patents, which makes it the company with
the most patents awarded in a single year, with over 47,000 in the last 20 years. IBM
R&D in intellectual property actually gives them an income of approximately $1 billion a
year. R&D is one of the most important departments in a technology firm due to the
ever-increasing innovations we see year to year.
Weaknesses
IBM is a highly debt allocated company with roughly $33 billion in debt in 2012,
up $2 billion from 2011. Such high debt is affecting the cash flows adversely. It limits
IBM ability to pursue strategic opportunities and could leave IBM very vulnerable to
economic and industry conditions.
IBM has almost half of all its revenue generated from the Americas (43.6%).
Although they do make 56.4% outside the Americas that does not have enough of a
diverse effect as you may think. They need to diversify more in the other developing
countries of the world. The economy in the Americas is very volatile in the past few
years, which means that, you cannot solely rely on the single geographic area. If the
economic conditions worsen then IBM can see a drop in revenue.
Product recalls have affected IBM quite drastically in the past and it is also a very
serious problem. In July 2012, the company had to recall 100,000 AC adaptors from
power speakers. The cords were not properly attached to the plastic enclosures and
sometimes led to shock, which can potentially harm people. Also in March of 2012 IBM
also had to recall nearly 50,500 Lenovo ThinkCentre Desktops for unknown reasons.
These recalls are very drastic and can cause companies to lose customer satisfaction.
Opportunities
IBM has had some very good acquisitions in the past few years and just recently
signed off on a new one. In March 2013 they acquired Star Analytics, Inc. which is a
business analytics company to benefit their analytics department greatly. Other
acquisitions helped benefit their: information economics, client’s social business
capabilities, system and technology segment, quality analytics software, smarter
analytics across line of business operations, mobile application development, and cloud
based analytics software. The newly acquired but not yet fully finished is Cloudant,
which is a company offering an online database service meant for storing massive
amounts of information. This acquisition marks a competitive angle into the industry like
Amazon and Google with cloud storage.
IBM has been trying to get into the cloud market for the past few years and it is a
very profitable segment to engage in. With the recently acquired companies as stated
before it could be one of the strongest cloud data managers in the likes of Amazon and
Google. Cloud Computing is forecasted to grow by about 80 billion in the next few
years and that is why IBM is trying to get a foot in the door and get ahead of the game.
Worldwide the cloud computing industry is forecasted to grow at an even greater rate
and is approximately going to account for 10% of total IT expenditure worldwide by
2015. Cloud computing is the future and IBM is heading in the right direction.
Growing the global market is a great opportunity for IBM and they have the
chance to increase their revenue greatly by growing in the other markets of the world.
IBM’s business process outsourcing is expected to reach double-digit growth. All of the
outsourcing global markets are expected to reach record highs in the next few years.
IBM needs to take advantage of these markets to make the most out of their market
share in the emerging markets and other markets that they control over their
competitors.
IBM needs to expand on their services instead of getting rid of some of their
products and services like they are planning on doing. The more diverse they are in the
products and services side the more profitable they will be. The servers that they
dropped recently were not profitable and that was a good move however they need to
expand on other services like cloud based data management and corporate computer
distribution, which are some of their most profitable segments.
Threats
The cloud based industry that is an emerging market has a very intensive
competitive edge right now. The cloud industry is new to start and everyone is trying to
get the largest market share because it will be very profitable in the future. Competitors
such as, Fujitsu, Hewlett-Packard, Accenture, and Infosys are all in the market and are
expanding their cloud database storage segments. Other segments are the servers
that Dell and EMC have that are strong competitors in the field. In the general field of
information technology they face intense competition with the likes of Microsoft, Oracle,
and EMC. IBM faces strong competitors in every aspect of their business.
Information consultancy companies in India are becoming a major threat to big
corporations in the United States because they can offer a low cost alternative with
massive amounts of knowledge. Outsourcing this aspect of the company is a great
money saver for a company and many corporations like Dow and Microsoft use
agencies in India to handle their information services departments. These companies
take away business from the major companies like IBM and make it harder for them to
offer an all in one service.
Technology is an ever-increasing industry with every company coming out with
new products weekly. With that, IBM must stay at the top of their game to compete with
its competitors. Technology is the fastest growing industry in the world. Just 10 years
ago the products we have now were just dreams in the minds of young children. Rapid
technological changes must be at the top of IBM’s watch list to maintain a competitive
advantage over all of their competitors and new entrants in the market, and to continue
with their patents year to year. (OneSource)
Negative Company Developments
Layoffs
The CEO of IBM just recently announced that it would be laying off roughly 25%
of their hardware decision to focus more on other high priority areas. These areas
include the cloud, analytics, and cognitive computing. This layoff coincides with the
recently acquired company Cloudant. This single layoff sets a pace for IBM in the
future that it may as well layoff more of its divisions because they are getting away from
the hardware division in the industry and focusing more on the software divisions.
(MorningStar)
Labor Disputes
With the newly appointed president in the IBM Japan division, Martin Jetter has
started to make workers accountable for their performance. Within months he fired
workers due to underperforming. This is a common type of restructuring in the western
countries, but in Japan it is rare because the most sought after jobs come with a
promise of lifetime employment. IBM Japan is now being sued for wrongful termination.
This has developed into a huge legal test facing Prime Minister Shinzo Abe, who has to
decide whether to make it easier for companies operating in Japan to fire workers.
These labor disputes are common with the unions of IBM due to the many acquisitions
that happen year round. (CNBC)
Negative Industry Developments
Consumer Preferences
IBM faces numerous competitors with a large consumer basis. Companies
chose whom their IT provider is based on preferences of their employees. The simplest
of things can make a large corporation chose IBM over another one of their competitors
like Oracle. The way to combat this consumer preference risk is to keep up good public
relations with the current customers and the public. Consumer preference is a major
risk for many technology firms because it’s the main priority for consumers when it
comes to practicality. The easier one technology is to use the more people will buy it.
When it comes to competitors in the information technology systems substitutes
is a very prominent thing. Companies are always looking to cut costs somewhere along
the lines and if it is with their servers and software systems they most likely will if it
doesn’t affect the business aspects too greatly.
Input costs do not greatly affect information technology companies because a
majority of their business is done on the software side, which does not have physical
compartments. The input costs would be considered labor so that means that labor is
very highly regarded and the best workers are highly wanted. Employees have a very
high force on the company because they are needed if the company wants to profit.
Regular maintenance on the software is needed and that means lots of labor hours.
Substitutes
With the ever expanding capabilities of cloud computing, it makes computing
capacity available on demand and could greatly decrease profits from IBMs high-end
hardware business. IBM's custom, best-of-breed approach to meeting customers'
needs is being challenged by Oracle's potentially cheaper integrated solutions that aim
to meet 80% of customers' requirements without expensive customization. The firm's
limited application software portfolio places it at a competitive disadvantage, relative to
Oracle, in delivering integrated business solutions. (Morning Star)
Valuation
CAPM
Capital Asset Pricing Model, or CAPM for short, is a model that describes what
the expected return of a firm or security should be based off of the beta and expected
market return that it is most like. CAPM is in general the time value of money and risk,
where the riskier the investment should equate to the more money earned over time,
but could also mean more money lost over time. This risk is calculated by the beta of a
stock, which determines how well the stock has kept up with the market and how much
the stock varied in price over the last decade or longer.
The expected return calculated is the prime value in determining the values in all
of the other models. This equation is very important, as it is the base for basically
everything you need to value a company. If this value is off then the entire valuation will
be incorrect.
Risk Free Rate 3.33%
Beta 0.75
Expected Market Return
4.33%
Expected Return (ra) 6.58%
There are a few assumptions you have to make this expected return work. Since
the 2008-2009 recession was a large factor on the markets we had to go back further to
get a larger market return. We decided to go back 20 years, giving us a more
reasonable expected market return.
WACC
The weighted average cost of capital, or WACC for short, is the calculation of a
firms cost of capital in which each category is weighted. An increase of WACC also
indicates a decrease in valuation and a higher risk in the stock. IBM for example is
highly weighted in debt with roughly 62% being debt and the rest being equity. By
taking this weight average of the equity and debt we can see how much in interest the
company has to pay on every dollar it finances.
The WACC has been adjusted for interest rates and an assumed 2.5% interest
charge was added to the WACC at the end to make the models work more fluently.
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Dividend Discount Model
The dividend discount model valuation, or the Gordon Growth Model, is one that
predicts the price of a stock by using the predicted dividends and discounting them back
to the present value. If the calculated stock price is higher than what the actual price is,
then the stock is undervalued.
This model cannot be used for companies that don’t payout dividends for various
reasons, the main one being that it is a dividend based model. There are variations of
this model that can be used if a company will experience supernormal growth in the
future. This supernormal growth is when a company experiences a high growth and
then followed by a lower more constant growth.
To calculate the current stock price in this model you use the following equation:
Re 6.58%Rd = 2.15%E 22,800,000,000D 39,700,000,000Tc 15%V 62,500,000,000
WACC 3.56%Adjusted WACC
6.06%
Variables: P = stock price; D1 = value of next year’s dividends; r = cost of equity;
g= growth rate
The dividend Discount Valuation for IBM has assumed constant growth rate
because that is how they have grown in the past decade. The dividend growth rate that
is assumed for IBM is 4.5%. In the past they have declined the growth rate year after
year but kept the whole value constant, which made it difficult to assume a constant
growth rate or any type of growth rate for that matter. For the sake of the valuation a
constant growth rate is needed and therefore 4.5% made the most sense with the
growth rate of the company’s revenue.
Taking the 4.5% growth rate that we assumed we could now calculate the
forecasted dividend payouts for the next 10 years. For year 2013 the payout has
already occurred so that is a real number. From then on we just added a 4.5% growth
to each year with the company eventually reaching near their 0.40 cents per year
growth rate in year 2023. This is however a drastic change in their dividend growth
strategy but an assumption had to be made for this model to work and this was the best
one that would work.
Year Annual Dividend
2013 3.7
2014 3.87
2015 4.04
2016 4.22
2017 4.41
2018 4.61
2019 4.82
2020 5.04
2021 5.26
2022 5.50
2023 5.75
The Net Present Value calculated for year 2014 was a value of $185.89. To
calculate this value we took the expected dividend for 2014 and divide it by expected
return minus the assumed dividend growth rate.
P= 3 .87(1.0658−1.045)
=$185 .89
The calculated value is slightly lower than the current trading price also hinting
that the firm is overvalued. This value is most likely skewed because IBM has a very
odd dividend growth rate because they increase by just a flat 0.40 cents a year, which
in turns makes the growth rate decrease year after year. As well as the flat dividend
increase the shares outstanding also decrease year after year which also affects the
value calculated.
The discount rate in the Dividend Discount Model is also the calculated expected
rate of return that was found in the Capital Asset Pricing Model. This value was
calculated to be 6.58%. The value must be larger than the dividend growth rate for the
valuation to be able and correct. This value has a major effect on calculated values of
price for the future years because if this is off by a whole percent than the entire
valuation is way off.
Pros:
Some positives of the dividend discount model are that is does not take into
consideration any earning of the company or the free cash flows; it only takes the
dividends that the company pays out into consideration. The model only uses the
dividends to calculate the value of the company so there is usually little error because
there are so few factors involved in the equations. Another advantage of this model is
its one of the easier valuations used to value a firm or security. Since only three inputs
are required that it is very easy for anyone to do. The values are easily attainable for
anyone to determine or forecast.
The advantages in the dividend discount model are also very closely related to
the disadvantages. One of the disadvantages is that it is selective when it comes to the
companies that it can be completed on. Only companies who pay out a regular
dividend and which is expected to grow at a constant rate in the future. The severely
limits the model to stable companies and not every company can be valued this way.
The model is also sensitive to the numbers that are used just like any valuation used.
Just like any models the numbers you put into the equations must be correct if you want
to get the correct answers. Also the model should use a margin of safety projections
because there are always assumptions that can be incorrect so the value of the
company could always be off by a few percent.
To use this model for IBM you must assume that IBM will have a constant
dividend growth rate in the future. They have not used a constant growth rate in the
past as stated before they just increase by a flat 0.40 cents per year, which makes this
valuation method not completely accurate. It is hard to assume a constant growth rate
when they have continuously decreased their growth rate over the past decade 40% to
11%. To use this model as a sole valuation of IBM would not be rationale because it
does not accurately describe the future of the company, as they do not increase their
dividend payout regularly.
The following table shows the calculated stock prices and which year they
coincide with. The price calculated for year 2013 was $186.11, which is actually slightly
under the actual stock price of roughly $190.00, which means that the company is
overvalued.
The main problem with this model and why it is not greatly recommended for use
is because the growth rate calculated is highly sensitive and if this value is incorrect
then the entire model is incorrect. This model is also highly affected by the expected
rate or return needed for the firm that you are valuating.
As an investor who would be looking to invest with IBM I would not take into
consideration this model valuation alone. I would however use it alongside the other
2013 186.11
2014 194.49
2015 203.24
2016 212.39
2017 221.94
2018 231.93
2019 242.37
2020 253.27
2021 264.67
2022 276.58
valuations to see if a company is over or undervalued. The dividends and shares
outstanding of IBM do not follow a steady concrete pattern and that greatly affects the
model, which skews it. However the calculated value of $185.89 does show that the
company is overvalued as well as the other valuation concur with this value, varying by
only a few dollars. I do think that the company will not increase in price dramatically
until something serious happens in their company so with this model I would consider
holding onto the company.
This model does not however fit well with IBM because of the very odd dividend
growth rate they have seen in the past. As an investor I would not solely use this model
to calculate the value of the firm because the assumption are too varied and can be
assumed way differently. So you must take this model with caution, as it should not be
the only one looked at for IBM.
Free Cash Flow
The free cash flow valuation model is one that measures the financial
performance of the firm by taking operating cash flow minus the capital expenditures.
The free cash flow is the amount of cash the company is able to use after all money
required is spent. The money required is all of the money that a firm must spend to
maintain or expand the firm. This “free cash” that the firm has is used to pursue
opportunities to enhance the company and also enhance shareholders value of the firm.
A high free cash flow is a good indication of a firm doing well above their means to
operate.
Free cash flow is also a measure investors use to see how well they are doing
compared to the firms they are competing with. A firm with a high free cash flow in a
designated market has a much higher ability to improve or even acquire other
companies to better themselves. This value should be high if an investor wants to feel
comfortable investing in the long run as the company should be using this money to
increase their revenue and profits overall.
The free cash flow equation was one of the more difficult valuations to
accomplish with IBM. First we had to calculate the growth rate for the free cash flows of
the following years. Since IBM has not seen abnormal growth rate in the past ten years
we estimated that they would have a constant growth rate for free cash flow as well.
The calculation is as follows:
g = (Total capital, fair value0 × WACC – FCFF0) ÷ (Total capital, fair value0 + FCFF0)
The growth rate that was calculated was 1.21% for the next 10 years. However
that such a low growth rate is not actually realistic as inflation is much higher than
0.74%. So to make up for this error in the growth rate we must assume and adjusted
growth rate that takes into account inflation. Our assume growth rate for the Free cash
flows was 4.21% which is just slightly higher than inflation.
The following table is the future free cash flow for the next 10 years at a constant
growth rate of 4.21%. These values are calculated to allow an investor to see how
quickly they can grow their free cash flow and if it makes sense to invest in the firm or
not. They can be taken into consideration because it shows that the firm will grow and
make a profit year after year while steadily increasing this profit.
MillionsTime FCF (millions)
0 2013 13,3451 2014 13,9072 2015 14,4933 2016 15,1034 2017 15,7395 2018 16,4026 2019 17,0937 2020 17,8138 2021 18,5639 2022 19,344
10 2023 20,159NPV:
Present ValueFirm Value (NPV)
131642
MV of Debt 39,700Equity Value 91,942V0 $82.98
The price per share (V0) that was calculated here is way off due to the fact that
IBMs free cash flow is not significantly high enough to account for the real firm value
they achieve. Calculated later on using the WACC and growth rate a more accurate
firm value is calculated which allows for the MV of Debt to be as high as it is. This net
present value approach of the price per share does not work in the case of IBM
because of how high their market value of debt is compared to everything else.
With these values calculated we now could calculate the value of the firm that we
are trying to accomplish.
The equation that would best fit IBM at a constant growth rate would be:
Firm Value = (FCFF1) / (WACC – g)
And from this equation we could calculate the equity value by subtracting the
market value of debt from the firm value.
Equity Value = Firm Value – Market Value of Debt
And finally to calculate the value per share, or the price per share, we would just
divide the equity value calculated by the number of outstanding shares.
Firm Value $259,944FCFF1 13,907WACC 6.56%g 1.21%
Equity Value $220,244Firm Value $259,944MV of Debt 39,700
Value/share $198.78
The value calculated above does indicate that the firm is undervalued slightly
because they are trading roughly around $192 a share. So if this model was the only
one taken into consideration by an investor we would suggest to buy the shares as they
will soon see a rise in their stock price and get close to $200 per share. Along with that
the market value of debt for IBM is very strange for a company of their performance and
history. They are highly based off of debt with it being 63% of their value. This makes
the valuation to be slightly off because most companies of this size are the opposite
with most of the value being in equity. IBM is most likely aligned this way to increase
their value over time and they can always pay off this debt when they feel the need to
however as they are still growing in certain markets the firm does not need to at this
moment.
Advantages
The free cash flow valuation is one of the most accurate models to produce the
closest value. The other models use relatives that compare it to others in the markets
where as this model focuses on the cash on hand that the company has to calculate
what they should be valued at. Free cash flow is a trustworthy source of information
because if a company has a lot of money on hand that means they are making a very
large profit and will use that money to better the company in the future which brings the
value up. You can also use this model as a backwards check and figure out how much
cash on hand the company would need to achieve for them to attain a given price.
Problems
Projecting the cash flows for each year can be a very difficult. There is a lot of
uncertainty when it comes to projecting cash flow increases from year to year whether it
be a constant growth or a supernormal growth. The past few years that are taken into
consideration can be outliers and not be a whole representation of the actual growth
rate of the firm. The ability to predict the operating cash flow and earnings decreases
exponentially overtime because serious factors are a role in these numbers. Since one
year’s cash flows are highly based off of last year’s a small error at the beginning of the
valuation can greatly throw off the ending numbers.
Predicting capital expenditures are also a problem that can alter the free cash
flow valuation. Capital expenditures are needed to calculate the free cash flow for each
year. Every year the predictions become harder because of the variances in the capital
expenditures year to year. They can also be largely discretionary because if the
company has a down year then they may pull back in capital expenditure plans, while
the inverse may also be true. Assumptions in this category are considered highly risky
for these reasons. During the calculation of the capital expenditures the smallest of
changes can greatly affect the outcome.
The discount rate and growth rate are also factors in the free cash flow valuation
model and can also greatly affect the outcome of the valuation. To calculate the
discount rate we used the weighted average cost of capital of the firm. Since this is a
theoretical equation it is not exactly correct because of slight variations in every firm.
There is no exact way to calculate the exact discount rate so every time it is calculated it
could be different. A constant growth rate assumption is highly theoretical and will most
likely never occur. The chances of a constant growth rate are too much to even
calculate so this is just a theoretical equation all together. Assuming a different growth
rate affects the outcome of the free cash flow valuation on many different levels and
they can highly change the answer. A true growth rate of a firm changes greatly and
can sometimes even go negative when there is a bad year or a depression, so a
constant growth rate assumption is not very logical.
This model is not meant to be used for short term investing at all. The free cash
flow valuation is meant for a long term investor to look at and see where the company
will be at in 10, 20, or even 30 years. The value calculated could not even occur in 10
years because something might come up and postpone the growth, however it is a good
indicator at when the value will be achieved. This valuation will help an investor if the
firm is already at their peak but it cannot predict the quick price ups and downs, which
are the profitable ones. Focusing too much on this model will make you miss
opportunities in the quick gains of a new emerging firm.
Application to company
This model actually one of the better fit models for IBM because they have a
steady growth in free cash flow and there are no outliers to throw off the valuation.
Unlike the other models that have very odd numbers and growth rates, which make it
harder for assumption to be made, the free cash flow model is easier to assume a
growth rate and assume what the value should be. Calculating a value of $198.78
means that the company is undervalued where as the other values are all calculated to
be overvalued so that does give the investor another side to look at. Taking this model
and weighing it more than the others will give you a fair value of IBM as a whole
because the free cash flow is the most stable of all the items on the balance sheet.
Residual Income Model
Book Value Development
The book value of a firm is the accounting value. It is the value of the assets that
shareholders would receive if a company were liquidated. By comparing the book value
to the market value you can indicate whether the stock is over or underpriced.
To start the residual income valuation we need to first calculate the book value of
IBM. The book value is the first value needed in the equation for the residual income
model. To calculate the book value of IBM we take the common stockholders’ equity
and divide it by the number of shares outstanding.
Book Value $22.57Common Stockholders’ equity
22,792
Shares outstanding 1,010*SE and shares outstanding are in millions
The book value calculated is very close to the given (21.62) so we can assume
that the value calculated is accurate and proceed with the rest of the valuation.
Description
The residual income model is the approach that accounts for the most variables
of all the models. Residual means an excess of a certain value. In the valuation model
this means the excess of costs measured relative to the book value of shareholders
equity. Residual income is therefore the income after accounting for the cost of capital.
This model is highly regarded in both investment practices and research. The model
has been used as far back as 1800 by Alfred Marshall and in 1920 General Motors used
this concept in evaluating their business segments.
EPS
The earnings per share of IBM have had a very constant growth rate of about
12% every year as they continue to buy back shares and increase their revenue. We
chose a constant growth rate of 12.72% for earnings per share, as it seems that IBM
will continue to slowly buy back shares to increase this number and get the most out of
their shares. The following table is the calculation to get the equity charge from future
earnings per share and subtracting future dividend annual payouts.
Year EPS Dividend Equity Charge
2014 15.41 3.87 11.542015 16.32 4.04 12.282016 17.27 4.22 13.052017 18.28 4.41 13.872018 19.36 4.61 14.752019 20.49 4.82 15.672020 21.69 5.04 16.652021 22.96 5.26 17.702022 24.31 5.50 18.812023 25.73 5.75 19.98
Dividend Growth Assumptions
IBM’s dividend yield has been very odd over the past decade. As the stock price
has been going up year after year the dividends have also been going up just not at the
same rate. Year after year IBM declares a dividend raise of 0.40 cents no matter what
occurs in the companies financials. Even during the recession where they saw a
decrease in revenue they still increased their dividends by 0.40 cents. Increasing by a
whole amount each time and not a percentage makes the growth rate decrease
overtime. IBM had a dividend growth rate of 40% in 2004 and they just recently had a
growth rate of 12% in 2012 which was actually more profitable than 2004. This very
rare dividend strategy made assuming a growth rate very difficult because anything that
is assumed is going to be incorrect. A 4.5% growth rate is assumed as a constant
growth rate for the next ten years for this valuation to even work. If they were to
continue the way they increase at a flat 0.40 cents then in ten years their growth rate
will actually be 4.5%. Obviously in the short run this growth rate does not seem
accurate but over time it becomes accurate.
Using the residual incomes we found for each future year we then calculated the
present value of each. The price of year 0 is the sum of all the present values of
residual incomes.
The top half of the following chart takes the calculated book value and adds in
net income and then takes out the dividends paid out to calculate the ending book. The
ending book is then carried over to the next year as the beginning book.
IBM ROE 70.98% *Net income increase by 13% annually*
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023Beginning Book
22.57
34.88 49.12 65.53 84.42 106.12 131.02 159.55 192.20 229.52 272.14
Net Income
16.02
18.10 20.45 23.11 26.12 29.51 33.35 37.68 42.58 48.12 54.37
Dividends 3.70 3.87 4.04 4.22 4.41 4.61 4.82 5.04 5.26 5.50 5.75Ending Book
34.88
49.12 65.53 84.42 106.12 131.02 159.55 192.20 229.52 272.14 320.77
Net Income
16.02
18.10 20.45 23.11 26.12 29.51 33.35 37.68 42.58 48.12 54.37
Equity Charge
1.48 2.29 3.23 4.31 5.55 6.98 8.62 10.49 12.64 15.10 17.90
Residual Income
14.53
15.81 17.22 18.80 20.56 22.53 24.73 27.19 29.94 33.02 36.47
PV 13.64
13.91 14.23 14.57 14.95 15.37 15.83 16.33 16.88 17.46 19.29
To calculate residual income it is fairly easy. The following is how we went about
calculating the Residual income for the forecasting.
Equity Charge = Equity Capital x Cost of Equity
Residual income = Net Income - Equity Charge
To calculate the V0 we used the following equation:
V0 = B0 +(sum of PV of RI) + (r* EB10)/(1+r)10
V0 = 205.79
Variables: V0 = Price per share, B0 Beginning book time 0, r = expected return, EB10 =
ending book time 10
NPV
To calculate the “sum of PV of RI” part of the equation you must first calculate
each year’s residual income, which was found in the previous table. After you find
these values you then must discount them to make them the present value. The
calculated discount rate, or rate of return, was calculated to be 6.58%. You then use
the following equation to find the present value of each year’s residual income:
PV = Value / (1+6.58%)t
t = the year starting at 1
The residual income valuation calculated the price per share of the company to
be $205.79, which is around $10 higher than the current trading price claiming that the
company is undervalued, as did the Free Cash Flow model. This model can be
considered one of the more important models for IBM because it takes more variables
into consideration when calculating the value and does not just use one or two different
areas of the firm. We believe that this model accurately describes the firm although
there were a few alterations that needed to be made because of a few outliers that IBM
solely has over every other company. We had to make some assumptions in the model
for this to accurately describe IBM; otherwise the value would be drastically off.
IBM has an ROE that has been over 70% for the past few years making this
model much more difficult to use because to calculate the Net Income you must take
beginning book and multiple by the ROE. This being so high made the book value
exponentially grow by multiplying by such a large percentage. Instead of using this way
we ended up making an educated increase in net income at a 13% increase every year.
The value that was calculated in this model does fit IBM very well as stated that
they are currently considered undervalued slightly. I believe that with the assumptions
we had to make and with the values we came up with that this model does suit the best
out of the four. We will weigh this model much more than the others in the final
valuation of the company and can still properly determine the overall value of IBM.
The residual model is similar to the dividend discount model because you just
substitute the future residual earnings for the dividend payments. However the
Residual income model is more appropriate for a firm like IBM because they have a
very odd and unpredictable dividend payment pattern. IBM does not do a straight
percentage based increase in dividend payments they basically pick a set number and
increase by that amount which causes the percentage to decrease overtime. The
residual income approach is also less sensitive to terminal value because the value is
calculated much sooner than others.
Time frame
The time frame for this model was chosen to be to next 10 years. We have
started with 2013 as our first value to give us a base on the model. Then we forecasted
the next 10 years until 2023 to give a practical value for the valuation. This valuation is
not accurate by only using 5 years so we had to extend it to at least 10 years. After the
model was calculated we believed that the price per share was accurate and that 10-
year forecast was good enough to use as a time frame.
Advantages
There are a few advantages for the Residual Income Valuation model that makes
it better than others. The model uses easily accessible accounting data that anyone
can obtain. The model can be applied to companies that do not pay out dividends, so
you can use this over the dividend discount model, and also can be used if the company
does not a have a positive expected free cash flow. This model also can be used when
cash flows are not predictable which means that it is safer than the free cash flow
model. The residual income model also has a focus on economic profitability.
Disadvantages
There are also a few disadvantages when it comes to working with the residual
income model. The data that the model is based on can be easily manipulated by the
management of the firm, which means that not all data used could be correct. The data
used may require significant adjustments, which were seen in our valuation of IBM as
we had to adjusted the ROE, and use another method. The model also must assume
that the cost of debt capital is reflected appropriately by interest expense.
A few factors can result in problems in the residual income valuation. The
discount growth rate is needed to complete the residual income model because you
must subtract the dividend off of the beginning book value. So the dividend growth rate
must be correct for this to also be correct which could cause problems. Both of these
valuation models use the expected return calculated from the CAPM equation, which
means if that is wrong then the whole equation will be thrown off.
Multiples Valuation
P/E
The price to earnings ratio is used when the earning power of the company is
one of the primary drivers of the company. The P/E is widely used by investors
because it is a good ratio to compare companies of the same industry. A difference in
two stock prices P/E’s may be related to differences in the long-run average returns on
investments.
Some potential disadvantages to using the P/E ratio would be when the stock
has an EPS relatively close to zero the ratio does not make any sense because the
denominator would be significantly too small. The managers of the firms are the ones
who must assume these values when reporting and they could distort these values and
make them incorrect for when you calculate the P/E for the firm and it will make it harder
to compare to other companies.
The price to earnings ratio is one the allows for an investor to compare
companies in the same industry by how much they cost to invest with and how much
they are earning overall. This makes it easier to compare a massive company like IBM
with a smaller company like Computer Sciences Technology.
P/EIBM 12.90Microsoft 14.77Symantec Corp 16.33Oracle 16.71
Computer Sciences Corp
11.81
Cisco 14.93
Average 14.58
The table above shoes what the P/E ratios are for IBM and their competitors.
The average was taken of all 5 companies and listed as well. To compare the average
P/E to find the value of IBM you would just need to take this average and multiply it by
the earning that IBM has reports for 2013, which was 14.3 billion. The calculated value
using the P/E ratio for IBM was found to be $208.42. This value is much higher than
the current price because IBMs P/E ratio is much lower than everyone else’s P/E in their
industry, which means they are underperforming everyone in this section.
P/B
The price to book ratio, or the P/B for short, is the measure of a company’s book
value per share compared to the current trading price of the company. The
denominator of this ratio, the book, is a level variable unlike EPS from the previous
ratio. The book value per share attempts to measure the investment the common
stockholders have made in the company.
Some advantages to using the P/B ratio is that the book value is a cumulative
value calculated from the balance sheet and is generally positive even if the EPS is zero
or negative which makes the P/E ratio not work. Book value is indeed more stable than
EPS so it makes P/B look more meaningful in the investor’s eyes than does the P/E
ratio. Book value can also be used in valuing a company that does not expected to
continue in the future.
Some possible disadvantages to the P/B ratio are some assets that are critical to
a company are not recorded down into these balance sheets. For example a person’s
knowledge cannot be recorded into a numerical value and that may be why a company
is worth what it actually is because they have these ideas that are not numerical data
yet, which makes this ratio not technically work. P/B may be misleading when the
levels of assets used by companies under comparison differ significantly. Share
repurchases or issuances may distort the historical comparisons that you need, which is
a case in the history of IBM.
P/BIBM 8.60Microsoft 4.00Symantec Corp 2.40Oracle 4.04Computer Sciences Corp
2.42
Cisco 2.14
Average 3.93
The table above shows the P/B values calculated for IBM and their competitors
with an average of all of the values at the bottom. IBMs price to book is much higher
than the rest of the companies and it makes this value not easily used to value IBM.
However the value that was calculated using the Average P/B of the industry and the
book value of IBM, which is $22.57, was a price per share of $88.76. This value is
significantly lower than the current trading price but that is due to the fact that IBM has
consistently repurchased shares year after year making their P/B value much higher
than the rest in the industry.
P/S
The price to sales ratio, or P/S, takes the current price a stock is trading at
divided by the annual sales they achieved last year. This ratio is usually best for stocks
that are currently undervalues because sales are usually normal every year which not
many distortions in them. P/S is usually one of the most used multiples models to value
a stock because of this fact.
Some advantages to using the P/S ratio are that sales is not subject to much
distortion or alterations than other denominators like in P/E. Sales are usually always
positive because that means a company is doing well for themselves and not filing for
bankruptcy so you do not have to worry about a 0 on the denominator. P/S is generally
more stable than the other ratios because of sales being so stable year after year
unless a dramatic occurrence happens.
Some disadvantages of the P/S ratio are a business could show a high growth in
sales but however they may not profit very much because it does not take into account
for operating expenses and capital expenditures. The P/S does not reflect the
differences of cost structure between comparable companies and this could have an
effect of the comparison. However manipulation in sales is very hard to achieve there
could always be some alterations in the revenue section of the balance sheet.
P/SIBM 2.02Microsoft 4.08Symantec Corp 2.04Oracle 4.74Computer Sciences Corp
0.64
Cisco 2.48
Average 2.67
The table above shows the P/S ratio calculated for IBM and their competitors
with an average P/S of 2.67. This ratio does not work very well for valuing IBM
because all of the P/S are very far apart from each other and are also very small so the
littlest difference makes a big impact of value. The calculated value of IBM of the P/S
ratio was $244.27 which was actually significantly higher than the current trading price
of IBM which means the company is severely undervalued which contradicts many of
the other models performed. This model however does not work because the sales
structure of some of these companies is completely different from each other.
P/CF
The price to cash flows ratio, or the P/CF, is used to compare the current stock
price and the cash flows from year 1. This ratio is widely used and is said to be
approximately be the same as P/E and P/B but should be slightly higher than P/S or
dividend yield.
Some advantages of the P/CF ratio are cash flow is less subject to manipulation
from management because it is the final cash on hand that the company possesses
after everything has been paid out. Cash flow is considered more stable than earnings,
which means that the P/CF is more stable than the P/E. Comparing the P/CF of the
comparable companies can show how different companies accounting conservatism
are.
Some disadvantages to the P/CF are if a company deals in front end loading
revenue recognition than this ratio does not take that into account and could possibly be
incorrect. The theoretical model would use free cash flow to equity as the denominator
in this ratio however FCFE is more volatile than cash flow and FCFE is more than likely
more negative than cash flow.
P/CFIBM 10.58Microsoft 15.10Symantec Corp 12.05
Oracle 12.12Computer Sciences Corp
12.74
Cisco 10.64
Average 12.21
The table above shows the P/CF ratio for IBM and their competitors as well as
the average of all of their values at the bottom, which was calculated to be 12.21. This
ratio seems to work very well because all of these companies have generally the same
values for P/CF, which makes it easier to compare the industry to each firm. The
calculated value for IBM was $213.41, which is only slightly higher than the current
trading price so they are only slightly undervalued by this model. Since the variables in
this model are much harder to manipulate on the management level we can consider
this one of the more accurate models and weigh it more than others.
Dividend Yield
The dividend yields are frequently reports to investors to indicate what the
company thinks they are actually valued at. They will release their dividend yield and
allow investors know this sort of information. Dividend yield is a good comparable
because it is a component of total return, which is very stable. Since dividends are less
risky than capital appreciation many investors use this ratio to compare like companies.
Since dividend yield is only one component of total return it does not include
everything and this could limit the valuation method. Investors may hold off on future
earnings growth to receive a higher dividend yield, which means they the dividends,
paid out just end up lower the return in the future. The safety of dividends means that
market prices reflect difference in the relative risk of the components of return.
Dividend Yield
IBM 2%Microsoft 2.80%Symantec Corp 2.90%Oracle 1.20%Computer Sciences Corp
1.30%
Cisco 3.30%
Average 2.25%
The table above shows the dividend yield for IBM and its competitors as well as
the average dividend yield in the industry of 2.25%. All of these companies payout
roughly the same dividends each year according to their prices. To calculate the value
of IBM with this ratio we would take the dividend paid out last year and divide it by the
average dividend yield found and our value would be $164.44. This value is much
lower than the current price of IBM but that is explained in part by that some of the
companies have a much lower price and much higher dividend payout, which makes
sense because IBM does payout a small dividend for their price. This method can be
considered pretty accurate however as each company in the industry still pays out a
significant portion of their earnings.
EV/EBITDA
Enterprise values are sometimes used because the enterprise values are
relatively less sensitive than the price values to the effects of financial leverage. Some
analysts like to use only one type of multiple where some prefer to leverage both
models and average them all out.
The enterprise to EBITDA is the most widely used enterprise value multiple
because EBITDA is a flow of both debt and equity and seems to be relatively normal.
Since EBITDA has both debt and equity it is more commonly used to compare
companies with different financial leverages like in the case with IBM where they are
highly debt leveraged and their competitors are the exact opposite. Since EBITDA adds
back depreciation and amortization it controls for difference in both among businesses.
EBITDA is also frequently positive when EPS is negative which allows you to use this
method instead of P/E ratio.
Some possible drawbacks to the EV/EBITDA multiple are that it will overestimate
cash flow from operations if working capital is growing. EBITDA also ignores the effects
for differences in revenue recognition policy on cash flow from operations.
EV/EBITDAIBM 9.43Microsoft 8.57Symantec Corp 6.39
Oracle 10.15Computer Sciences Corp
4.35
Cisco 6.91
Average 7.63
The table above shows the calculated EV/EBITDA values for IBM and their
competitors as well as the average for the industry, which is 7.63. The enterprise value
calculated for IBM after the average was found is $184.94 billion. After the enterprise
value is calculated you can then find the price by dividing by the outstanding shares of
IBM to get a final value of $150.36. This value is significantly lower than the current
trading price, which lets you believe that IBM is significantly overvalued. This multiple
does not have many problems with it, which makes us believe that IBM is overvalued in
this aspect because the uses of this model should fit with IBMs problems.
EV/S
Enterprise value to sales is a much better method than the P/S in the case that a
company is highly debt leveraged which is exactly what IBM does. This value
calculated is much better than the P/S value of $88.76 that was calculated. Since not
many companies are debt leveraged as IBM this allows that to be accounted for and
makes it much more even when comparing companies with different financial
structures.
EV/S
IBM 2.31Microsoft 3.27Symantec Corp 1.84Oracle 4.42Computer Sciences Corp
0.68
Cisco 1.87
Average 2.40
The table above shows the EV/S calculated for IBM and their competitors as well
as the average EV/S of 2.40. This method has much better numbers than the P/S as
mentioned before and an enterprise value of $237.21 was calculated from taking the
average and multiplying by sales of last year. We then take the enterprise value and
divide by the total outstanding shares and calculated a price of $192.85 for IBM which is
almost identical to what the firm is trading at currently. This is by far one of the best
multiples model to compare IBM with their competitors because they are so oddly debt
leveraged and everyone else is not.
Conclusion
To get a final value out of the seven total multiples models we must take a weight
average of all of them and combine them. Doing this makes it more accurate because
you can see how they stack up against the competitors in various sections of their
financials. Below you will see the values and the weights that were assigned to each
multiples model with there being an exception to the P/B and P/S because they do not
accurately portray IBM in comparison to their competitors and it would not be smart to
include those values in a valuation of the firm. Those two models are not used at all in
the final valuation of IBM.
Multiple Value Weight PriceP/E 208.42 25% 52.11P/B 88.76 0% 0.00P/S 244.27 0% 0.00P/CF 213.41 15% 32.01Div Yield 164.44 15% 24.67EV/EBITDA 150.36 10% 15.04EV/S 192.85 35% 67.50
Total: 191.32
The final valuation of IBM we calculated from the multiples model was $191.32,
which is just at about where IBM is currently trading so this suggests that IBM is valued
appropriately when it comes to these methods of valuation. We would highly take this
into consideration when investing in this company as this take a lot of information into
account and averages it all together to get a rough estimate of the company. Since so
much data is involved in this valuation method you can assume that it is near accurate
and one of the better valuation methods discussed so far.
Statement of Conclusions
The models of valuation overall show that IBM is currently at par value if not
slightly undervalued. Some models worked better for IBM because of certain issues
with their financials but with the weighted average shown below it looks like IBM is just
slightly undervalued by a few dollars because they are trading right around $192. In the
table below you can see what each model valued IBM at and what weight they were
taken at to make it more averaged out. The weights were chosen on basis of how well
the model suited IBM as a whole. The dividend discount model does not suit IBM very
well because of their odd investor relationship strategy and the fact that they constantly
buy back shares which throws off that valuation. The multiples model however was one
of the best valuation models because it took so many factors into consideration, which
showed that it is worth the price against their competitors.
We would suggest holding onto this stock as the value will stay constant for the
next few years and hope that it will eventually rise as their products start to increase and
as the establish themselves in more markets around the world. IBM has a very long
Models: Price Weight PriceResidual Income
205.79 25% $51.45
Dividend Discount
186.11 15% $27.92
Free Cash Flow 198.78 30% $59.63Multiples 191.32 30% $57.40
Total: $196.39
history and their stock price is not going to be going down anytime soon. IBM is just in
a building phase as they switch over from hardware to more software-based products.
Appendix
Date Open Close Adj Close growth growth +1 DJIA1/2/2004 92.86 99.23 84.682/2/2004 99.15 96.5 82.48 -0.0259802 0.974019839 0.58%
3/1/2004 96.5 91.84 78.5 -0.0482541 0.951745878 -2.62%
4/1/2004 91.67 88.17 75.36 -0.04 0.96 0.92%
5/3/2004 88.13 88.59 75.88 0.00690021
1.006900212 -3.21%
6/1/2004 88 88.15 75.5 -0.0050079 0.994992093 2.79%
7/1/2004 88.28 87.07 74.57 -0.0123179 0.987682119 -2.05%
8/2/2004 86.87 84.69 72.69 -0.0252112 0.974788789 -1.18%
9/1/2004 84.05 85.74 73.59 0.01238135
1.012381345 1.71%
10/1/2004 85.95 89.75 77.03 0.04674548
1.046745482 -1.99%
11/1/2004 89.33 94.24 81.04 0.05205764
1.05205764 4.10%
12/1/2004 94.5 98.58 84.77 0.04602665
1.046026654 2.51%
1/3/2005 98.97 93.42 80.34 -0.0522591 0.947740946 -1.25%
2/1/2005 93.67 92.58 79.77 -0.0070948 0.992905153 1.75%
3/1/2005 92.64 91.38 78.73 -0.0130375 0.986962517 -0.39%
4/1/2005 91.49 76.38 65.81 -0.1641052 0.83589483 -3.73%
5/2/2005 76.88 75.55 65.27 -0.0082054 0.99179456 0.91%
6/1/2005 75.57 74.2 64.1 -0.0179255 0.98207446 1.06%
7/1/2005 74.3 83.46 72.1 0.12480499
1.124804992 0.56%
8/1/2005 83 80.62 69.81 -0.0317614 0.968238558 0.08%
9/1/2005 80.16 80.22 69.47 -0.0048704 0.995129638 -0.21%
10/3/2005 80.22 81.88 70.9 0.02058442
1.020584425 -1.98%
11/1/2005 81.85 88.9 77.17 0.08843441
1.088434415 3.59%
12/1/2005 89.15 82.2 71.35 -0.0754179 0.924582091 1.24%
1/3/2006 82.45 81.3 70.57 -0.010932 0.989067975 0.41%
2/1/2006 80.9 80.24 69.83 -0.010486 0.989513958 0.91%
3/1/2006 80.2 82.47 71.77 0.02778176
1.027781756 1.58%
4/3/2006 82.72 82.34 71.65 -0.001672 0.998327992 0.81%
5/1/2006 82.59 79.9 69.78 -0.0260991 0.973900907 0.88%
6/1/2006 79.89 76.82 67.09 -0.0385497 0.961450272 -2.96%
7/3/2006 77.54 77.41 67.61 0.00775078
1.007750783 0.31%
8/1/2006 76.65 80.97 71 0.05014051
1.050140512 2.04%
9/1/2006 81.13 81.94 71.85 0.01197183
1.011971831 2.45%
10/2/2006 81.76 92.33 80.96 0.12679193
1.126791928 3.72%
11/1/2006 92.5 91.92 80.86 -0.0012352 0.998764822 1.86%
12/1/2006 91.9 97.15 85.46 0.05688845
1.056888449 1.58%
1/3/2007 97.18 99.15 87.22 0.02059443
1.02059443 1.09%
2/1/2007 98.97 92.94 82 -0.0598487 0.940151341 0.95%
3/1/2007 90.25 94.26 83.17 0.01426829
1.014268293 -2.87%
4/2/2007 94.51 102.21 90.18 0.0842852 1.084285199 3.96%
5/1/2007 102.06 106.6 94.42 0.04701708
1.047017077 5.12%
6/1/2007 106.62 105.25 93.23 -0.0126033 0.987396738 0.54%
7/2/2007 105.39 110.65 98.01 0.05127105
1.05127105 1.47%
8/1/2007 110.39 116.69 103.73 0.05836139
1.058361392 -3.20%
9/4/2007 116.34 117.8 104.71 0.0094476 1.009447604 2.40%
10/1/2007 117.61 116.12 103.22 -0.0142298 0.985770223 2.53%
11/1/2007 115.5 105.18 93.83 -0.0909707 0.909029258 -5.04%
12/3/2007 105.55 108.1 96.43 0.02770969
1.027709688 1.56%
1/2/2008 108.99 107.11 95.55 -0.0091258 0.990874209 -6.48%
2/1/2008 107.16 113.86 101.96 0.0670853 1.067085296 -0.95%
3/3/2008 113.86 115.14 103.1 0.01118086
1.011180855 -1.82%
4/1/2008 115.2 120.7 108.08 0.04830262
1.048302619 3.79%
5/1/2008 121.06 129.43 116.37 0.07670244
1.076702443 1.23%
6/2/2008 128.49 118.53 106.57 -0.0842141 0.915785855 -5.90%
7/1/2008 117.5 127.98 115.07 0.07975978
1.079759782 -6.09%
8/1/2008 128.52 121.73 109.88 -0.045103 0.954897019 1.84%
9/2/2008 122.87 116.96 105.57 -0.0392246 0.960775391 -3.61%
10/1/2008 115.51 92.97 83.92 -0.2050772 0.7949228 -17.43%
11/3/2008 92.64 81.6 74.07 -0.1173737 0.882626311 -6.13%
12/1/2008 80.95 84.16 76.39 0.03132172
1.031321723 -0.22%
1/2/2009 83.89 91.65 83.19 0.08901689
1.089016887 -2.32%
2/2/2009 90.6 92.03 83.99 0.00961654
1.00961654 -8.40%
3/2/2009 91.17 96.89 88.42 0.05274437
1.052744374 -5.92%
4/1/2009 96.13 103.21 94.19 0.06525673
1.065256729 10.46%
5/1/2009 103.78 106.28 97.5 0.03514173
1.035141735 5.08%
6/1/2009 106.94 104.42 95.79 -0.0175385 0.982461538 2.32%
7/1/2009 105 117.93 108.19 0.12944984
1.129449838 1.01%
8/3/2009 118.88 118.05 108.8 0.00563823
1.005638229 8.01%
9/1/2009 117.67 119.61 110.24 0.01323529
1.013235294 2.77%
10/1/2009 119.39 120.61 111.16 0.00834543
1.008345428 2.31%
11/2/2009 120.77 126.35 116.97 0.052267 1.052267003 3.76%
12/1/2009 127.29 130.9 121.19 0.03607763
1.036077627 2.01%
1/4/2010 131.18 122.39 113.31 -0.0650219 0.934978134 0.36%
2/1/2010 123.23 127.16 118.25 0.04359721
1.043597211 -2.45%
3/1/2010 127.5 128.25 119.26 0.00854123
1.008541226 4.53%
4/1/2010 128.95 129 119.96 0.00586953
1.005869529 3.51%
5/3/2010 129.39 125.26 117.08 -0.024008 0.975991997 -4.99%
6/1/2010 124.69 123.48 115.42 -0.0141783 0.98582166 -3.25%
7/1/2010 123.55 128.4 120.02 0.03985444
1.039854445 0.62%
8/2/2010 129.25 123.13 115.66 -0.0363273 0.963672721 1.25%
9/1/2010 125.31 134.14 126 0.08939997
1.089399965 2.39%
10/1/2010 135.51 143.6 134.89 0.07055556
1.070555556 4.21%
11/1/2010 143.64 141.46 133.47 -0.0105271 0.989472904 1.39%
12/1/2010 143.61 146.76 138.47 0.0374616 1.037461602 2.38%
1/3/2011 147.21 162 152.85 0.10384921
1.103849209 2.94%
2/1/2011 162.11 161.88 153.34 0.00320576
1.003205757 3.28%
3/1/2011 163.15 163.07 154.47 0.00736924
1.007369245 -0.89%
4/1/2011 163.7 170.58 161.58 0.04602836
1.046028355 2.93%
5/2/2011 172.11 168.93 160.73 -0.0052606 0.994739448 1.17%
6/1/2011 168.9 171.55 163.23 0.01555403
1.015554035 -3.84%
7/1/2011 171.61 181.85 173.03 0.06003798
1.060037983 3.43%
8/1/2011 182.6 171.91 164.28 -0.0505693 0.949430735 -9.48%
9/1/2011 172.71 174.87 167.11 0.01722669
1.017226686 -1.33%
10/3/2011 174.36 184.63 176.44 0.05583149
1.055831488 3.05%
11/1/2011 181.55 188 180.38 0.02233054
1.022330537 2.50%
12/1/2011 187.01 183.88 176.43 -0.0218982 0.978101785 2.30%
1/3/2012 186.73 192.6 184.79 0.04738423
1.047384232 3.94%
2/1/2012 193.21 196.73 189.49 0.02543428
1.025434277 2.69%
3/1/2012 197.23 208.65 200.97 0.06058367
1.060583672 1.48%
4/2/2012 208.96 207.08 199.46 -0.0075136 0.992486441 -0.37%
5/1/2012 207.18 192.9 186.58 -0.0645744 0.935425649 -2.38%
6/1/2012 190.12 195.58 189.17 0.01388144
1.013881445 -1.38%
7/2/2012 196.36 195.98 189.56 0.00206164
1.002061638 2.15%
8/1/2012 196.96 194.85 189.27 -0.0015299 0.998470141 2.50%
9/4/2012 196.61 207.45 201.51 0.06466952
1.06466952 2.16%
10/1/2012 208.01 194.53 188.96 -0.0622798 0.937720212 -0.28%
11/1/2012 194.68 190.07 185.44 -0.0186283 0.981371719 -3.62%
12/3/2012 190.76 191.55 186.88 0.00776531
1.007765315 1.92%
1/2/2013 194.09 203.07 198.12 0.06014555
1.060145548 3.58%
2/1/2013 204.65 200.83 196.76 -0.0068645 0.993135473 2.59%
3/1/2013 200.65 213.3 208.97 0.0620553 1.062055296 3.23%
4/1/2013 212.8 202.54 198.43 -0.0504379 0.949562138 1.79%
5/1/2013 201.87 208.02 204.76 0.03190042
1.031900418 3.38%
6/3/2013 208.25 191.11 188.11 -0.0813147 0.91868529 -0.90%
7/1/2013 192.15 195.04 191.98 0.02057307
1.020573069 2.36%
8/1/2013 196.65 182.27 180.31 -0.0607876 0.939212418 -1.27%
9/3/2013 183.63 185.18 183.19 0.01597249
1.015972492 0.49%
10/1/2013 185.34 179.21 177.28 -0.0322616 0.967738414 0.13%
11/1/2013 179.81 179.68 178.7 0.00800993
1.008009928 3.80%
12/2/2013 179.46 187.57 186.55 0.04392837
1.043928372 1.42%
1/2/2014 187.21 176.68 175.72 -0.0580541 0.941945859 0.92%
2/3/2014 176.02 177.14 177.14 0.00808104
1.008081038
Price/month growth 0.61%
Beta 0.75
Dividends
Source
IBM. http://www . ibm . com/annualreport/2013/strategy-data . html . 2014
CNBC. As Japan PM Abe Weighs Labor Reform, IBM Emerges as Test Case. http://www . cnbc . com/id/100874742 . Tuesday, 9 Jul 2013
Morning Star. http://library . morningstar . com . librarydb . northwood . edu:2048/Stock/
analyst-report?t=IBM®ion=USA&culture=en-US. Feb 2014
One Source. http://globalbb.onesource.com/web/Reports/ReportMain.aspx?
KeyID=15771&Process=CP&FtrID=UNIFIEDSUMMARY March 2014
