International Business Machines Corporation (NYSE:IBM)’s intrinsic value is potentially 45% higher than its stock price
The projected fair value for International Business Machines is $182 based on 2-step free cash flow to equity
Based on the current stock price of $125, International Business Machines is estimated to be undervalued by 31%
Analysts’ price target of $145 for IBM is 21% below our fair value estimate
Does International Business Machines Corporation’s (NYSE:IBM) March Stock Price Reflect What It’s Really Worth? Today we’re going to estimate the intrinsic value of the stock by taking the expected future cash flows and discounting them to today’s value. We will use the discounted cash flow (DCF) model on this occasion. Before you think you can’t get it, just keep reading! It’s actually a lot less complex than you might imagine.
However, remember that there are many ways to estimate the value of a business and a DCF is just one method. If you want to learn more about discounted cash flow, you can read the rationale for this calculation in detail in the Simply Wall St analysis model.
Check out our latest analysis for International Business Machines
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first phase is generally a higher growth phase that levels off towards the terminal value captured in the second phase of ‘steady growth’. First, we need to get estimates of cash flows for the next ten years. Where possible we use analyst estimates, but when these are not available we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We expect companies with declining free cash flow to slow their rate of contraction and companies with growing free cash flow to slow their growth rate over this period. We do this to take into account that growth tends to slow down more in the early years than in later years.
A DCF is all about the idea that a dollar in the future is worth less than a dollar today, so let’s discount the value of those future cash flows to their estimated value in today’s dollars:
The story goes on
10-year free cash flow (FCF) estimate.
Leveraged FCF ($, million)
Source of growth rate estimate
Estimated @ 6.62%
Estimated @ 5.26%
Estimated at 4.30%
Estimated @ 3.63%
Estimated @ 3.16%
Estimated at 2.84%
Estimated @ 2.61%
Estimated at 2.45%
Present value ($, million) Discounted at 10.0%
(“Est” = FCF growth rate estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = $84 billion
We now need to calculate the terminal value, which takes into account all future cash flows after that ten-year period. The Gordon growth formula is used to calculate terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 2.1%. We discount the final cash flows to today’s value using a cost of equity rate of 10.0%.
Final value (TV) = FCF2032 × (1 + g) ÷ (r – g) = $16 billion × (1 + 2.1%) ÷ (10.0% – 2.1%) = $211 billion
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = $211 billion ÷ (1 + 10.0%)10 = $82 billion
The total value is the sum of the cash flows for the next ten years plus the discounted future value, giving the total equity value, which in this case is $165 billion. The final step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of $125, the company appears fairly undervalued at a discount of 31% to the current share price. The assumptions in each calculation have a big impact on the score, so it’s better to take this as a rough estimate, not accurate to the last penny.
We would like to point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You do not have to agree with these inputs, I recommend repeating and playing with the calculations yourself. The DCF also does not take into account the potential cyclicality of an industry or a company’s future capital needs, so it does not provide a complete picture of a company’s potential performance. Because we view International Business Machines as a potential shareholder, the discount rate used is the cost of equity rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we used 10.0% which is based on a leveraged beta of 1.329. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the industry average of global peers, with an imposed limit of between 0.8 and 2.0, which is a reasonable range for a stable business.
SWOT Analysis for International Business Machines
Valuation is only one side of the coin when it comes to building your investment thesis, and it shouldn’t be the only metric you consider when researching a company. It is not possible to get a foolproof rating with a DCF model. Instead, the best use for a DCF model is to test certain assumptions and theories to determine whether they would understate or overstate the company. If a company is growing at a different rate, or if its cost of equity or risk-free rate changes significantly, the outcome can be very different. Why is the intrinsic value higher than the current share price? For international business machines, there are three other points to evaluate:
Risks: As an example, we have discovered 5 warning signs of international business machines that you should know.
Management: Have insiders been adding to their shares to capitalize on market sentiment for IBM’s future prospects? Check out our management and board analysis for insights into CEO pay and governance factors.
More high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of quality stocks to get an idea of what else you might be missing!
hp Simply Wall St updates its DCF calculation for each American stock daily. So if you want to find the intrinsic value of another stock, just search here.
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This Simply Wall St article is of a general nature. We provide comments based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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