This year’s Q3 results have been perhaps this year’s most happening quarter. Giants and honchos have nosedived and hit grounds and surprise companies have reached new highs. The whole quarter has been marked with mergers and acquisitions and companies have not just launched new products and brands but have also made forays into new realms. Among the companies, one whose Q3 results have been discussed and debated a lot is perhaps the tech giant International Business Machines (IBM, Financial).
After making a lot of forays into the niche sectors like Big Data and Cloud computing, this company cut a rather sorry picture for its investors in the Q3 results; while many Street analysts see this as the start of a new downtrend for the tech major and have criticized a lot of its management moves and strategies on the other, quite a few analysts like us still recommend holding and increasing positions in the company. Amid all such discussions, let us see what could pan out for the tech honcho in the near future.
Fail safe levels – IBM
After the disastrous show in the Q3, the shares of the company took a heavy beating in the market and currently stand at $163.86 per share. So is this the time to press the panic button on IBM. Going by the definition of Benjamin Graham, the father of value investing, in his book, "The Intelligent Investor," he defines the margin of safety as "the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments."
In other words margin of safety would mean the earnings minus the bond interest and dividend payout should act as a hedge against any future bad news.
How do we define the fail safe level for IBM?
In order to define the fail safe levels for IBM, we need to take into consideration four data sets as the following:
1. Going by Graham’s methodology he always maintained a conservative line of analysis and would use multiple years of EPS as a defense mechanism against any outliers. Following the experts' methodology, let us consider the EPS of 2012, 2013 and the Q3 EPS of 2014 also taking into account IBM’s management guidance of a further decline in EPS by 2-4% from last year’s EPS of $16.64 and to further ensure the worst possible we take the EPS for 2014 with a pinch of salt of 4% decline from that of 2013, that is we peg 2014 EPS at $15.97. On averaging out the EPS for the last three years the average EPS stands at $15.09.
2. Total dividend payout for 2014 stands at $4.25 per share considering all the four payouts to be made by the year end.
3. The current IBM share price at the close of trading on Monday stood at $164.36 while we were considering the levels for calculation.
4. Considering the ten Year IBM Corporate Bond Rate, IBM has a 3.625% Coupon Bond maturing Feb. 2024.
Considering all the above parameters as of 11/04/2014, the yield to maturity for IBM stands at 2.9%.
The simple steps of calculations going by the books is that in the first place we worked out the ratio between EPS and share price by dividing the average EPS by the current share price resulting in an earnings yield of 9.18%.
Next let us take a look at the dividend yield by dividing dividend payout by share price which yields a value of 2.58%
After taking away the dividend payout and the 10-year bond interest from the total earnings yield, the left over earnings of 2.9% can be reinvested for the good of the business.
Taking the ratio of the remaining earnings power to the yield to maturity of the bond generates a margin of safety of around 2:1 or approximately 100% margin of safety.
But the obvious question that pops up is if 100% safety margin or fail safe level is good enough to hedge the risk of staying invested in the company.
Going by Graham’s words in his earlier writings for a typical stock 100% safety margin is good enough for the stock to recover in the near future and taking a cue from the industry experts in the case of IBM, the margin of safety is exactly enough to be adequate to stay put and the time has yet not come to press the panic button.
Our take
As we had mentioned earlier in our article titled: ‘IBM: Hold For Long-Term Gains’ we still strongly feel that IBM is still a great bet and the current dip should be used to buy in more position in the IT bigwig. IBM is undergoing significant change. Despite the change, IBM has been rewarding investors through financial engineering. With just a quarters debacle a company of the size of IBM would not crumple down moreover the financial engineering methods adopted by IBM might not be adequate to offset future debacles however given to understand the kind of sector IBM has set foot on like Big Data and Cloud computing the future doesn’t look that bleak and things will turn around for sure and hence smart investors should hold their current holdings in the company and rather buy with the dip to en-cash them in the future.
