Does the January share price for International Business Machines Corporation (NYSE:IBM) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF ($, Millions)
US$12.9b
US$14.1b
US$13.7b
US$16.2b
US$16.4b
US$16.6b
US$16.9b
US$17.3b
US$17.6b
US$18.1b
Growth Rate Estimate Source
Analyst x5
Analyst x4
Analyst x2
Analyst x2
Analyst x2
Est @ 1.43%
Est @ 1.79%
Est @ 2.04%
Est @ 2.21%
Est @ 2.34%
Present Value ($, Millions) Discounted @ 8.1%
US$11.9k
US$12.1k
US$10.8k
US$11.9k
US$11.1k
US$10.4k
US$9.8k
US$9.3k
US$8.8k
US$8.3k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$105b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.6%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$341b÷ ( 1 + 8.1%)10= US$157b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$262b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$225, the company appears a touch undervalued at a 21% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
The Assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at International Business Machines as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 8.1%, which is based on a levered beta of 1.319. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
SWOT Analysis for International Business Machines
Strength
Debt is well covered by earnings and cashflows.
Weakness
Earnings declined over the past year.
Dividend is low compared to the top 25% of dividend payers in the IT market.
Opportunity
Annual earnings are forecast to grow for the next 4 years.
Good value based on P/E ratio and estimated fair value.
Threat
Dividends are not covered by earnings.
Annual earnings are forecast to grow slower than the American market.
Next Steps:
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For International Business Machines, there are three additional items you should assess:
Risks: Take risks, for example - International Business Machines has 3 warning signs we think you should be aware of.
Future Earnings: How does IBM's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.