Introduction
Report’s aim
Comprehensive analysis of a company is crucial for decision making regarding its inclusion in a portfolio. That requires forecasting a company’s performance to estimate the expected value of the stock and comparing it with the current market price so as to decide whether it is overvalued or undervalued. In that view, this analysis seeks to analyze the IMB Company with application of the Discounted Cash Flows method as well as WACC. With the values calculated, the value per share is compared with the current market price to make recommendations whether the stock is a buy, hold or sell depending on evaluation. To begin with, the report presents an overview of the company and the methodology applied followed by a forecast of five years cash flows. Then the repot resents the calculation of the company’s cost of capital and the resulting equity value. Finally the equity value is used to calculate the value per share that is compared with the current market price providing recommendation whether the stock is undervalued or overvalued and the recommending the suitable investment action regarding whether to buy, old or sell.
Company profile
Overview:
IBM, is a US based Corporation that deals with computer, technology as well as IT consulting with New York its headquarters. It is the largest technology company in the world and the second in terms of global brand. The company sells and manufactures computer software and hardware as well as offering key infrastructure, consulting and hosting services ranging in areas from the mainframe computer through to nanotechnology.
Origin: United States
Geographical presence: Globally (The Guardian, 2010).
Spotlight: Smarter Cities, CSR Project
In partnership with leaders for the New York City, Brookings Institution as well as other private, voluntary and public sectors, the IBM was able to convene 550 executives from 25 countries and from over 185 cities. Over 60 breakout leaders and speakers presented 28 of the case studies that were on a number of aspects on how the world economy was shaping itself as competition between world cities, in spite of their location, investment, for talent, as well as influence. In that respect, the company plans on continuing with these discussions in the year 2010, together with another regional forum for Smarter Cities in Shanghai which would be held along with the city’s Expo.
Industry overview
Companies operating in the industry offer services like software support, facility management of data processing, and system design of computers. Majority of the companies include Xerox, Computer Sciences Corporation, as well as technology consulting branches of Hewlett-Packard and IBM (based in US), Cap Gemini (France), NEC (Japan), Tata Consultancy (India), and Fujitsu (Japan).
Competitive Landscape
IT services demand is being driven by the rapid advance in technology, but the spending is dependent on health of US economy. Profitability of these companies is dependent on the technical expertise, effective marketing and innovative services. Companies that are large enjoy advantages in offering of broad service as well as global reach, giving them ability to offer to big corporate clients outsourcing services. Small companies also can compete with these big companies effectively through specializing in specific markets or services, or through partnering with big companies, which want to widen their services mix. FINALLY, the market in US is fragmented as 50 of the companies that are largest account for almost 40% of the market revenues.
Operations, products & Technology
Computer systems development, design, and the integration services account for almost 35% of revenues in the industry; development services and application design, 25%; technical support, 10%. On the other hand, companies in IT services help their clients in using the computers, communication systems, and software more efficiently besides providing giving advice on using the computer systems, frequently they recommend software and hardware systems to the customers. A variety of other associated services are provided by these firms including data warehousing, systems planning, outsourcing of business functions, planning of enterprise resource and training (Hoovers, 2016).
Competition
The following table summarizes the comparison between IBM and its key industry peer on various operational and financial aspects.
Source: (Yahoo finance, 2016c).
In view of the above table summary, it is clear that the industry is marked by relatively same size peers with reference to the market capitalization, number of workers and revenues. That provides for varying competitiveness where various companies lead the others in different aspects. In that respect, IBM is the largest in terms of employees while Microsoft is the largest in terms of market capitalization. With that, although the companies offer differentiated products, their competing services are likely to be subject to fierce competition. Finally, the performance aspects indicate that IBM is third in ranking in terms of revenues and second in gross margin while being the best in net income margin. That could be an indication of better profitability that the competitors.
Methodology– DCF
In the analysis of the IBM as a potential investment, this evaluation applies the discounted cash flows methodology. The method has two key prepositions summarized as follows
Preposition One: For asset to have value, expected flow of cash should be positive a number of times over the asset’s life.
Proposition Two: Assets that generate cash flow early during their life time are worth more compared to those that do the same later; but the second may on the other hand have higher flow of cash and greater growth to compensate.
In view of the method, the following formula is used
Value = [CFt / (1+r)t] where CF are the cash flows and the r the discounting rate
Thus, the equity value is obtained through expected cash flow discounting. That means the cash flow that is the residual after all expenses, principle payments and interest, and tax obligations are met, at the equity cost, i.e., required rate of return by the firm’s equity investor (Brearley Myers, 2003).
When using the dividends, the discount model is an equity valuation case that is specialized, and the stock value is the current value of future’s expected dividends.
Value of Equity = CF to Equity/ (1+ ke ) t
In that view, the firm’s value is determined by firms expected cash flows discounting. That means the cash flow residue after all the operation expenses as well as taxes, but before payment of debts at the capital’s cost weighted average, which is the different financing components used by firm cost, weighted by those components proportions of market value.
WACC = Weighted Average Cost of Capital
Thus, the Value of a Firm = CF to Firm (1+WACC)
Future cash flow projections
The first step in valuing the IBM stock is estimating its future cash flows that require forecasting of the income statement and balance sheet as follows.
The income statement forecasting is based on an expected 5.29% growth in revenue over the five years considering the 2015 revenue of $81,741,000,000 as the basis of the forecast.
The following is the forecasted balance sheet
Source: (Yahoo finance, 2016a & 2016d; Google finance, 2016; IBM, 2015).
With the above income statements and balance sheets forecast, the company’s cash flows are forecasted s follows
Source: (Yahoo finance, 2016a & 2016d; Google finance, 2016; IBM, 2015).
In view of the above forecast, it is clear that the company would have positive free cash flows for the five years. That is a suitable position given that it would have funds to invest and pay its investors.
Main developments that informed the forecasts
One of the key development informing the positive growth forecast is the IBM continued investment and commitment in being an innovative firm in the industry. Further, one of the key shareholders Buffett notes IBM as being well positioned given its leadership in the popular cloud computing as well as corporate services in addition to the level of security the company offers the clients with the products and services (Yahoo finance, 2016b).
Assumptions made in the calculation
In addition to the above observation, the following assumptions and facts are applied in the forecast
Regarding the five years revenue growth, the analysis forecast the business to grow at an average of 5.29% hence the growth rate in the revenues forecast.
In 2015, the COGs were 50 percent of the revenues hence the assumption of the trend in 2016.
For the sales and marketing expects, it was assumed that the expense would reduce by 10% given the business establishment and popularity in the market.
Some of the items in the statement are assumed to be constant including the depreciation, equity and long term debt as well as interest expense.
The corporate tax is calculated using the 35% for the US companies.
The cost of debt was taken as 3.1445% the average of the company’s long term debt calculated from the debts listed by the Morning star (Morningstar, 2016).
The long term growth rate for the company is provided as 0.65% as indicated in Nasdaq’s review of the analysts rating and valuation (Nasdaq, 2016).
Cost of capital
The method used in estimating the company’s cost of capital is the WACC. On the other hand, the capital cost is defined to be all the enterprise invested capital’s opportunity cost. The opportunity cost stands for what an enterprise sacrifice as consequence of their decision in using a resource that is scarce in a given way. All invested capital is the amount in total of the cash that is invested in a business. For n enterprise, this is the fact that it is measuring all capital sources opportunity cost which include equity and debts. The company capital’s Weighted Average Cost is calculated using a process with three steps:
Capital component cost. It starts by inferring or calculating each type of capital used by an enterprise cost’s; namely, equity and debt. Debt capital cost is equivalent with imputed or actual rate of interest on the debts of the company, adjusted for deductibility of tax of the interest expenses.
The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in %)
The equity capital is the capital that is gotten from equity shareholders and they do not require an open return on the capital. However, the equity shareholders are faced with an unspecified opportunity cost by investing in a given company, as they would invest with another company with risk profile that are similar. Thus, the equity capital’s opportunity cost is inferred. This can be done by using “Capital Asset Pricing Model" (CAPM). The model states that the equity shareholders require a minimum return equity rate for return from an investment that is risk free plus return for having extra risk. The extra risk which is often referred to as “risk premium on equity” is equivalent with risk premium in the market as whole period a multiplier referred as “beta” that is used to measure how a given security is comparative to the market total, the equity capital total = Risk - Free Rate + (Beta times Market Risk Premium).
Capital structure: Then the calculation is done of the proportion contributed to entire enterprise by the equity and debt capital, using market value for total equity and debt to reflect investments by which these investors are expecting to gain return that is minimum.
The concept weighting: Finally, the cost of every type of capital by proportion that contribution by each is to the whole capital structure. This result to Weighted Average Cost of Capital (WACC), which is average cost for each dollar that is employed in a business (Armitage, 2005).
Assumptions for the inputs
In the cost of capital calculation, the one year treasury rate is used as the risk free rate. It is an index that is published by Federal Reserve Board on basis of average yield for a range of the Treasury securities, all being adjusted to an equivalent of one year maturity.
The IBM’s beta was taken to be 0.79 as provided by yahoo finance (Yahoo finance, 2016e).
The market return rate is taken as 1.4% given as the annual return of the S&P 500 index that acts as a benchmark index comprising of best 500 traded companies (YChart, 2016).
Limitations
Although the WACC is a suitable method of calculating a company’s cost, it is limited in scope of its application given its rigid assumptions that do not suit new projects. However, considering that IBM is not a new project, the method is considered suitable.
With the above assumptions and use of the CAOM model, the cost of capital is calculated as follows
Source: (IBM, 2015; Yahoo finance, 2016a & 2016b; Ychart, 2016, Bank rate, 2016, Morningstar 2016)
Value per share and sensitivity analysis
Using the above calculated cost of capital, the company’s equity value is calculated by calculating the terminal value and the value per share as follows
Source: (IBM, 2015; Yahoo finance, 2016a & 2016b; Ychart, 2016, Bank rate, 2016, Morningstar 2016)
Cost of capital
The cost of capital used is the WACC of 0.016245
Terminal value
The terminal value given the cost of capital and long term growth rate of 0.65% is calculated as $2,301,250,468.99
Value per share
Given the terminal value and the number of common shares, the value per share is calculated as $2,382.91.
Sensitivity analysis to WACC, Long term growth and Expenses
Given the above values, their sensitivity to change in WACC and long term growth is calculated as follows
WACC change
With a WACC change to 0.005, the following is the estimate of the value per share
Source: (IBM, 2015; Yahoo finance, 2016a & 2016b; Ychart, 2016, Bank rate, 2016, Morningstar 2016)
Long term growth change
With a change in the long term growth to 0.5%, the following is the calculation of the value per share
Source: (IBM, 2015; Yahoo finance, 2016a & 2016b; Ychart, 2016, Bank rate, 2016, Morningstar 2016)
In view of the above sensitivity analysis, it is clear that a change in WACC without changing the long-term growth, he change in the value is not significant as it only changes to $2,385.26. However, the change in the long term growth has a significant effect on the share value to $2076.01
Recommendations
Comparison of the value per share and the actual share price
The calculation of book value is done from balance sheet, which is the different between company’s total liability and total assets. On the other hand, market value refers to the company’s value according to stork market. The calculation of market value is done by multiplying company’s outstanding shares by their current price in the market (Arnold, 2005).
In view of the calculated value per share of $2,382.91 and the current market price of $146.74, the equity value is significantly higher than the market price hence the stock can be considered as being undervalued. That means the current market price does not fully capture the full value of the company’s potential given the expected future cash flows.
Investment recommendation – overvalued or undervalued (Holding, buying or selling)
In view of the high value of the company’s equity and the low market price, the stock which is significantly undervalued can be recommended as suitable buy for holding. That is given the fact that the stock has potential to create wealth for the investors given the long-term growth of 0.65% and the WACC of 0.016.
Conclusion
In view of the analysis, IBM has potential to create wealth for the shareholders considering the forecasted cash flows and the current expected long term growth of 0.65 as well as considering the cost of capital of 1.6% as indicated by the WACC model. With that, the stock is undervalued and is a good buy and investors can hold it o gain value through the suitable future cash flows.
Bibliography
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