Undervalued Dividend Growth Stock of the Week: International Business Machines (IBM)

yield-1-stockphotoYou probably won’t find a bigger fan of stocks, and more specifically dividend growth stocks, than me.

After all, it’s just plain easy to invest in world-class businesses that pay you to own them. All you have to do is open a brokerage account, pay a small fee, and – bam! – you own a piece of a public company.

The barrier to entry when it comes to investing in stocks is low. Even better, anyone can peruse a list like David Fish’s Dividend Champions, Contenders, and Challengers and find over 550 stocks that not only pay dividends, but increase them regularly.

How can you not like getting paid by a world-class business on a monthly, quarterly, semi-annual, or annual basis?

I have no idea, which is why I’m invested in 51 high-quality dividend growth stocks in my own personal portfolio.

Now, while I’m a huge cheerleader for investing in dividend growth stocks, I’m an even bigger fan of getting a good deal on these stocks.

See, stocks come with prices attached to them.

Pull up a quote on any stock ticker and you can find out exactly what a share is being sold for.

But how do we know if that’s a good deal or not?

Well, you’ll want to go through the exercises involved to properly come up with some kind of reasonable range of fair value. After all, you’ll never know if the price of something is a good deal or not if you don’t know what that respective object is worth.

You can actually find a great tutorial on valuing stocks here on the site. Written by David Van Knapp, it goes through some concepts you’ll want to be familiar with if you’re looking to discern fair value.

Just like I love getting a good deal on quality merchandise down at my local store, I love getting a great deal on high-quality stocks. Paying less than what a stock is worth is something I greatly look forward to.

As such, you can probably imagine I’m always busy looking for a good deal across the spectrum of dividend growth stocks. And I’m going to share one such value with you here today.

International Business Machines Corp. (IBM) is an information technology company, engaged in creating value and solving problems for clients. They operate in over 170 countries.

They operate in five segments: Global Technology Services (39% of fiscal year 2013 revenue); Software (26%); Global Business Services (19%); Systems and Technology (14%); and Global Financing (2%).

IBM has been around for a long time. They were founded in 1910, and technology has certainly changed quite a bit since then. Fortunately, IBM has been able to stay on top of IT trends and generally in front of changes. One major trend lately has been moving away from hardware and toward software and services that offer higher margins and more recurring revenue.

They’re one of the few major blue chip technology companies out there with a lengthy dividend history. IBM has been paying quarterly dividends since 1916 and they’ve increased their dividend for the last 19 consecutive years. Impressive, considering the sea of change in technology.

And the raises haven’t been token; over the last decade, they’ve increased the dividend by an annual rate of 19.4%. Add that kind of growth on top of the yield of 2.45% that this stock offers and you have a recipe for solid long-term returns.

statsYou can kind of see this bare itself out in the stocks’ performance, as it’s up 112% over the last 10 years – almost double that of the S&P 500 index.

I’m confident that IBM will continue increasing its dividend for the foreseeable future, and the very low payout ratio of 27.9% gives me that kind of confidence. That’s among the lowest payout ratios I can find with a yield that high.

I typically like to invest in stocks with payout ratios of 50% or less, as that allows management to continue growing the business with a healthy chunk of retained earnings, while shareholders collect the other half of profits to spend or reinvest as they wish. It’s a nice compromise. Less than 30% means IBM offers a competitive yield while still retaining a ton of profit to continue growing.

One aspect of IBM you may really enjoy is that you have Warren Buffett on your side by investing in this tech giant. Through Berkshire Hathaway’s investment portfolio, Buffett has a substantial investment in IBM – approximately 12.5% of the portfolio, or over $12.6 billion.

So let’s take a look at the rate at which IBM has been able to grow over the last decade. After all, a faster growing business will be worth more than a slower growing business because the former will be able to generate more cash flow. And when it comes to valuing businesses, it’s all about how much cash they can possibly generate (and return to shareholders). IBM’s fiscal year ends December 31.

Revenue grew from $96.293 billion in FY 2004 to $99.751 billion in FY 2013. That’s a compound annual growth rate of just 0.39%. Quite unimpressive. Obviously, one would like to see better top line growth here.

Well, what about earnings per share? I generally consider EPS growth a better indicator of a company’s growth as we want to see profits rising. EPS has increased from $4.94 to $14.94 during this time frame, which is a CAGR of 13.08%. That’s a bit more like it! IBM has a pretty substantial share buyback program authorized pretty much all the time, and has reduced the share count from a bit over 1.7 billion to just over 1.1 billion during this 10-year stretch. That 600 million reduction in share count is aggressive by any definition.

S&P Capital IQ predicts EPS will grow by an annual compound rate of 9% over the next three years, citing a competitive pricing environment. However, a 9% growth rate is still impressive.

What about debt? After all, the more interest expenses a business has, the less profit (and dividends) that’s available for shareholders.

IBM’s balance sheet might look worse than it really is. For instance, the long-term debt equity ratio is 1.49. That looks a bit hefty, but the common equity is low due to the company moving away from hardware and toward software solutions. As such, there is less physical equity to compare to debt.

However, the interest coverage ratio is very high, at 49.6. So you have a company that’s not really all that leveraged at all.

Profitability appears to be incredibly solid to me. Net margin has averaged 15.22% over the last five years, and it’s improving due to the firm’s move away from low-margin hardware and into higher-margin software and solutions. Meanwhile, return on equity has averaged 74.47% over this time frame. Return on equity is so high due to the aforementioned low common equity.

So what are we looking at here? Is IBM a good value?

Well, let’s find out!

The stock is trading hands for a price-to-earnings ratio of 11.38 right now. A good rule of thumb is that a ratio of 15 represents fair value. Now, this varies by industry, but IBM’s own five-year average is 13.2. So while IBM typically trades at a discount to the broader market’s historical average, it’s lower than even that average right now.

I further valued shares independently using a dividend discount model analysis with a 10% discount rate and a 8% long-term growth rate. That rate appears quite conservative seeing as how it’s substantially below what IBM has generated in regards to growth in earnings and the dividend. It’s also lower than the predicted earnings growth rate moving forward. The DDM analysis gives me a fair value of $237.60 on IBM shares, which is significantly above where shares trade at right now.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth. It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

Think I’m being crazy? Let’s check out what some professional stock analysis firms think.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value. These stars are meant to coincide with predicted returns, as a stock that is substantially overvalued will likely lead to subpar returns.

Morningstar rates IBM as a 4-star stock, with a fair value estimate of $212.00.

S&P Capital is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates IBM as a 3-star “hold”, with a fair value calculation of $252.40.

So it looks like I’m not crazy after all. That’s good to know, right? If you average all three of these numbers together, you get a fair value of $234.00 on shares, which is right about where I landed. That implies more than 25% upside from where shares trade at right now.

SCBottom line: International Business Machines Corp. (IBM) is a world-class IT firm that’s been around for more than 100 years and paying dividends for almost the entire time. The low payout ratio and substantial growth rate in earnings foretells future dividend raises for years to come. Meanwhile, IBM offers an attractive yield and a price that appears to be well below what the stock is worth. Consider picking up this Buffett-approved tech giant at a good value here, especially in a market that isn’t providing a ton of value everywhere else.

— Jason Fieber, Dividend Mantra

10 Worry-Free Stocks to Survive the Coming Correction [sponsor]
These ultra-safe stocks rarely take a hit from the market. And even if they do, they bounce back like a rubber ball right after the dip. If you're interested in a million-dollar retirement portfolio, you'll definitely want to read this. Click here now.