International Business Machines Corporation (IBM, Financial) has raised its quarterly dividend to $1.40 per share or $5.60 on an annual basis from its previous $1.30 per share or $5.20 per year. The company has a great history of returning value to its shareholders, and we can state that because the firm has increased its dividend every year over the last 21 years.
Last year the dividend payout was supported by $13.42 diluted EPS. Earnings were growing at a compound annual growth rate of 9%, while dividends grew at a rate of 18%. However, this situation of dividends growing faster than earnings can continue in the future as the current payout ratio is 0.39. During the past 13 years, the highest dividend payout ratio was 0.62, the lowest was 0.09 and the median was 0.19.
Moreover, IBM has good free cash flow to finance the dividend payments. The stock is trading at 11 times trailing earnings, which is below its own five-year average and the industry median of 23.6x. Let´s try to find the intrinsic value of the stock.
Intrinsic value
The Yahoo! Finance consensus price target is $144.05, representing a downside move from today’s level. To estimate the fair value, I will use the Dividend Discount Model (DDM). In stock valuation models, DDM defines cash flow as the dividends to be received by the shareholders. The model requires forecasting dividends for many periods, so we can use some growth models like Gordon (constant) growth model, the two or three-stage growth model or the H-Model, which is a special case of a two-stage model.
Once we have selected the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts, and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.
Let´s estimate the inputs for modeling.
First, we need to calculate the different discount rates, i.e. the cost of equity (from CAPM). The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium.
Risk-free rate: Rate of return on LT Government Debt: RF = 3.03%[1]. I think this is a very low rate. Since 1900, yields have ranged from a little less than 2% to 15%, with an average rate of 4.9%. I believe it is more appropriate to use this rate.
Gordon Growth Model Equity Risk Premium = (one-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[2]
Beta: From Yahoo Finance we obtain a β = 0.8097.
The result given by the CAPM is a cost of equity of: rIBM = RF + βIBM [GGM ERP] = 4.9% + 0.8097 [11.43%] = 14.16%.
Dividend growth rate (g)
The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely, assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´t issue new equity.
g = b x ROE
b = retention rate
ROE = (Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
The “PRAT” Model:
g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
Collecting the financial information for the last three years, each ratio was calculated, and to have a better approximation, I proceeded to find the three-year average:
| Retention rate | 0,68 |
| Profit margin | 0,15 |
| Asset turnover | 0,77 |
| Financial leverage | 7,10 |
Now it is easy to find the g = Retention rate Ă— Profit margin Ă— Asset turnover Ă— Financial leverage = 56.44%.
Because for most companies the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage until it reverts to the long-run rate. In other words, a smoother transition to the mature phase growth rate that is more realistic.
Dividend growth rate (g) implied by Gordon growth model (long-run rate)
With the GGM formula and simple math:
g = (P0.r - D0)/(P0+D0)
= ($149.97 × 14.16% – $5.60) ÷ ($149.97 + $5.6) = 10.05%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 56,44% |
| 2 | g(2) | 44,84% |
| 3 | g(3) | 33,24% |
| 4 | g(4) | 21,65% |
| 5 | g(5) | 10,05% |
G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).
Now that we have all the inputs, let´s discount the cash flows to find the intrinsic value:
| Year | Value | Cash Flow | Present value |
| 0 | Div 0 | 5,60 | |
| 1 | Div 1 | 8,76 | 7,674 |
| 2 | Div 2 | 12,69 | 9,738 |
| 3 | Div 3 | 16,91 | 11,366 |
| 4 | Div 4 | 20,57 | 12,112 |
| 5 | Div 5 | 22,63 | 11,676 |
| 5 | Terminal Value | 606,16 | 312,683 |
| Intrinsic value | 365,25 | ||
| Current share price | 149,97 | ||
| Upside Potential | 144% |
Final comment
Intrinsic value is above the trading price by 144%, so according to the model and assumptions, the stock is undervalued. Considering a margin of safety (usually 20%), we could say that the stock is good to buy. While Mr. Market catches up with the valuation, investors can collect the dividends.
However, we must keep in mind that the model is a valuation method and investors should not rely on it alone in order to determine a fair value for a potential investment.
Gurus like Arnold Van Den Berg (Trades, Portfolio), Kahn Brothers (Trades, Portfolio) and Mario Gabelli (Trades, Portfolio) have upped their stakes in the first quarter of 2016.
Disclosure: As of this writing, Omar Venerio did not hold a position in any of the aforementioned stocks.
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[1] This value was obtained from the U.S. Department of the Treasury
[2] These values were obtained from Blommberg´s CRP function.
