Is IBM's Stock Cheap or Expensive?

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Numbers can lie -- yet they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:

  • The current price multiples.
  • The consistency of past earnings and cash flow.
  • How much growth we can expect.

Let's see what those numbers can tell us about how expensive or cheap IBM (NYS: IBM) might be.

The current price multiples
First, we'll look at most investors' favorite metric: the P/E ratio. It divides the company's share price by its earnings per share (EPS) -- the lower, the better.

Then we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow. This divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). Like the P/E, the lower this number is, the better.

Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.

IBM has a P/E ratio of 14.5 and an EV/FCF ratio of 15.7 over the trailing 12 months. If we stretch and compare current valuations with the five-year averages for earnings and free cash flow, we see that  IBM has a P/E ratio of 17.6 and a five-year EV/FCF ratio of 16.4.

A positive one-year ratio of less than 10 for both metrics is ideal. For a five-year metric, less than 20 is ideal.

IBM has a mixed performance in hitting the ideal targets, but let's see how it stacks up against some of its competitors and industry mates.  

Company

1-Year P/E

1-Year EV/FCF

5-Year P/E

5-Year EV/FCF

IBM14.515.717.616.4
Accenture (NYS: ACN) 16.210.421.611.7
Hewlett-Packard (NYS: HPQ) 5.56.96.36.9
Dell (NAS: DELL) 8.34.611.76.8

Source: S&P Capital IQ; NM = not meaningful.

Numerically, we've seen how IBM's valuation rates on both an absolute and relative basis. Next, let's examine ...

The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash-flow generation.

In the past five years, IBM's net income margin has ranged from 10.4% to 14.7%. In that same time frame, unlevered free cash flow margin has ranged from 12.2% to 16.8%.

How do those figures compare with those of the company's peers? See for yourself:

anImage

Source: S&P Capital IQ; margin ranges are combined.

Source: S&P Capital IQ; margin ranges are combined.

In addition, over the past five years, IBM has tallied up five years of positive earnings and five years of positive free cash flow.

Next, let's figure out ...

How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you willoverpay for stocks. But even though you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared with similar numbers from a company's closest rivals.

Let's start by seeing what this company's done over the past five years. In that time period, IBM has put up past EPS growth rates of 18.3%. Meanwhile, Wall Street's analysts expect future growth rates of 12.1%.

Here's how IBM compares with its peers for trailing-five-year growth:

anImage

Source: S&P Capital IQ; EPS growth shown.

Source: S&P Capital IQ; EPS growth shown.

And here's how it measures up with regard to the growth analysts expect over the next five years:

anImage

Source: S&P Capital IQ; estimates for EPS growth.

Source: S&P Capital IQ; estimates for EPS growth.

The bottom line
The pile of numbers we've plowed through has shown us the price multiples that shares of IBM are trading at, the volatility of its operational performance, and what kind of growth profile it has -- both on an absolute and a relative basis.

The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a 14.5 P/E ratio, and IBM shows strong past growth, good future expectations, and nice, consistent margins. Looking at its price multiples, we see that IBM looks reasonable-to-cheap on an absolute basis. However, IBM's price multiples are the highest of the bunch versus its competitors. That said, versus HP and Dell, the premium seems justified. If you find IBM's numbers or story compelling, don't stop here. Continue your due-diligence process until you're confident one way or the other. And be sure to check out IBM's earnings release on October 17. For now, add it to My Watchlist to find all of our Foolish analysis.

You can also the stocks that I've researched beyond the initial numbers and bought in my public real-money portfolio.

At the time this article was published Anand Chokkaveluowns shares of Accenture.The Motley Fool owns shares of IBM.Motley Fool newsletter serviceshave recommended buying shares of Dell and Accenture. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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