IBM Shares Set to Double

 | Dec 20, 2011 | 12:13 PM EST  | Comments
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ibm

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aapl

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goog

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amzn

With the vast majority of tech analysts focused on names like Google (GOOG), Apple (AAPL) and Amazon (AMZN), IBM (IBM) is selling well below intrinsic value and may be carrying the biggest upside potential.

Whether we like or not, a business derives its value based the amount of future cash that can be taken out of that business. If I were selling you a gas station for $500,000, the only way you would be able to determine whether or not my asking price was a great deal would be to know how much cash the gas station produced after all expenditures, what those cash flows would be worth today and how much the gas station could be sold for in the future. That entire process is the basis of a discounted cash flow analysis and it should be applied when looking at buying a gas station or 100 shares of IBM.

Looking at Big Blue, net income has swelled from $9.4 billion in 2006 to what is expected to be $15.5 billion in 2011. Over the past 10 years, earnings have grown by 21% a year under the able leadership of Sam Palmisano. While IBM's mandatory retirement age means Palmisano will be stepping down at the end of the year, future prospects look bright under Virginia Rometty, who has worked closely with Palmisano for many years. Any future doubts about IBM's future prospects can be mitigated somewhat with Warren Buffett's $10 billion investment in shares of IBM this year.

With IBM's depreciation approximating capital expenditures, net income is a good proxy for free cash flow. Given the company's favorable future prospects, it's feasible that IBM can grow its net income by 20% a year over the next five years. Although the company size and scale help ensure stable cash flows, I'll apply a 10% discount rate to the cash flows. Further, I will assume that IBM could be sold for 15x cash flows at the end of 2016. The discounted cash flow, starting in 2012 and working from a net income figure of $15.5 billion in 2011, look like this:

Based on the above discounted cash flow model, IBM's intrinsic value based on future cash flows over the next five years is $426 billion. Over the past five years, shares outstanding have dropped from 1.5 billion to about 1.2 billion. While that share count is likely to decline further over the next five years, I'll assume shares outstanding remain fixed at 1.2 billion. Leaving shares fixed will help account for any cash flows that may be taken out of the business to buy back stock. Based on an intrinsic value of $426 billion against 1.2 billion shares outstanding, IBM shares are worth $355. Today they trade for $182, about 50% below intrinsic value, a satisfactory margin of safety for a blue-chip company.

In short, IBM shares appear likely to double over the next five years providing a very attractive rate of return for investors. Even if cash flow growth comes in slightly below my forecasts, the high margin of safety leaves room for plenty of upside. No wonder Buffett was secretly buying up $10 billion worth of stock.

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