Let’s say you walk into a store and you have two shelves.

On each shelf is merchandise. And the merchandise on both shelves is exactly the same.

No difference whatsoever – except price.

On one shelf the merchandise is 10% lower than the other shelf (we’ll call it the “clearance” shelf).

So which merchandise do you buy?

[ad#Google Adsense 336×280-IA]You buy the cheaper of the two, of course.

That’s intuitive.

Nobody likes to knowingly spend more money than they have to.

Conversely, everyone loves to pay less than they otherwise would have.

Money is hard to come by. And so it makes sense to avoid wasting it wherever possible.

This concept is exactly why I look for undervalued stocks.

Specifically, I attempt to hunt down high-quality dividend growth stocks that are undervalued, stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish’s list includes more than 700 US-listed stocks, all of which have increased their dividends for at least the last five consecutive years.

First off, I won’t invest in a company if it’s not willing to share its profit with shareholders in the form of a dividend. Just like if I were to own a business outright, I expect a regular cut of the profit.

Another words, don’t tell me how profitable you are; show me.

But dividend growth stocks kick it up a notch because we’re talking about companies that not only pay dividends, they routinely and regularly increase those dividends, paid out of the increasing cash flow the businesses generate.

So you first have that penchant… that willingness to share profit.

But then you have the actual ability to not only do that, but you have the financial wherewithal to give more and more year after year.

I’ve built up a six-figure portfolio over the last five or so years, chock-full of dividend growth stocks. And this portfolio will soon generate enough dividend income for me to live off of, all before my 40th birthday.

But I don’t just pick out random stocks on Mr. Fish’s list and pull the trigger.

That would be silly.

One has to first analyze a company’s quantitative and qualitative aspects to make sure the company is “up to snuff”. If you don’t have the high-quality fundamentals and competitive advantages in place for an investment to make sense, then you should probably move on.

But perhaps just as important, one also has to make sure they’re not overpaying.

Just like with the example above, you don’t want to buy the same exact stock for more money than you should.

You want to buy a stock when it’s marked down, on the “clearance shelf”.

But how do you know when it’s marked down?

How do you know if a stock is cheap or expensive?

Well, that’s where valuing stocks comes into play.

There are many ways to go about valuing a business, and I’ll explore some of those below. But one such system, discussed by fellow contributor, Dave Van Knapp, is pretty simple to use and very approachable, even for novice investors. And best of all, it’s specifically designed for dividend growth stocks.

Obviously, paying less for a stock means you’re saving money. Paying $50 for something instead of $60 means you save $10. That’s a concept anyone can relate to.

But it’s all exacerbated when talking about stocks.

See, buying a stock “on sale” means you’re reducing your risk (by very virtue of paying less) while simultaneously increasing your yield and potential long-term total return.

All else equal (assuming no change in the dividend), a stock’s yield is higher when its price is lower.

So when you buy that same stock on the “clearance shelf”, you’re not just saving money upfront. You’re also generating more income, potentially for the rest of your life (or, at least, as long as you’re invested in that company).

That’s because you’re collecting that higher yield right off the bat.

But in addition, those dividend raises (we are talking about dividend growth stocks here) compound at a higher rate off of a larger base (a higher yield).

So more money now and even more money later!

Now, that’s assuming the company continues to pay and grow its dividend, but that’s why we’re only looking at high-quality companies that should remain profitable and competitive over the long run.

Stocks go up and down every single day, sometimes for seemingly no reason at all. Up 5%. Down 10%. Round and round we go.

But sometimes a stock can be marked down dramatically, even while the underlying business is still solid from a long-term perspective. It’s essentially on that “clearance shelf”, perhaps marked down more than it should be due to short-term issues.

And that’s just what we seem to have with one big player in the tech space….

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.

Before we jump into the numbers, let’s consider a few things here.

IBM has been absolutely lambasted lately by the investor community, especially the media, over its continuing restructuring as it shifts away from legacy hardware businesses and toward newer technology plays in cloud, security, data analytics, and the Internet of Things.

What’s been happening here is that IBM’s revenue has declined for 14 straight quarters now, which has spooked a lot of investors.

But there is far more to that story.

First is the extremely strong dollar.

IBM, like every other major multinational company based in the US, has been hurt by the strong dollar since it does business in almost every country out there, but then reports those results back in the dollar.

IBM’s aforementioned restructuring is really at the heart of this, however.

The company continues to shed non-core businesses that are no longer integral for the company moving forward, as it continues to focus on and invest in businesses that offer much higher margins for the firm, businesses that offer tremendous growth opportunities moving forward.

IBM is essentially becoming less a hardware company and more a software and services company. But this takes time.

So comparing the most recent quarter to last year’s quarter, for instance, would mean your comparing an IBM that generated revenue from a large x86 server business to one that does not (IBM sold that business in January).

The bigger picture is really about higher-growth businesses and margin. And we can see that play out with the numbers.

Operating margin has increased from 40% to 50% over the last decade. Net margin is up from under 9% to almost 13%.

Meanwhile, cloud revenue was up more than 45% YOY for the most recent quarter. Analytics was up 9% YOY. And the services backlog was up 1% (adjusting for currency) to $118 billion.

So if you look at the bigger picture, one would naturally want a smaller IBM with bigger margins.

It’s like choosing between a business that does $5 billion in revenue with 10% margin that focuses on slow-growth businesses or one with $5 billion in revenue with 15% margin that focuses on high-growth businesses.

The company isn’t really “not growing” so much as focusing on doing much more with the revenue they generate. And this is important since it’s tough to move the needle when you’re generating about $100 billion a year in revenue.

As much as pundits claim that IBM is dying off, consider that the company has been around since 1910. They’ve undergone similar large-scale restructuring in the past (moving from tabulating equipment to personal computers to mainframes to now software/services) over its 100-year history. I see no reason why “this time is different”.

Keep in mind as well that I’m not the only one who believes this: Warren Buffett has an investment worth more than $10 billion in IBM, which makes it the one of the “Big Four” investments for the Berkshire Hathaway Inc. (BRK.B) common stock portfolio.

And I think he sees what I do: IBM is a cash cow. They generated more than $12 billion in free cash flow last fiscal year. And this is for a company with a market cap of ~$130 billion.

Compare that to The Coca-Cola Co. (KO), traditionally a more vaunted investment, and one of Berkshire’s other “Big Four” investments. It has a market cap of more than $180 billion, but only generated a little over $8 billion in FCF last fiscal year.

Technically apples and oranges here, but you can see what kind of cash cow we’re talking about here.

And IBM returns a ton of it to shareholders both in the form of buybacks and dividends.

First, those dividends…

The company has increased its dividend for the past 20 consecutive years, which is almost unheard of for information technology companies, speaking to IBM’s ability to remain consistent and adapt.

Not just a serial dividend raiser, the company grows its dividend at a rather phenomenal rate: The 10-year dividend growth rate stands at 19.8%.

And if you thought that was the “old” IBM, you’d be wrong. The most recent dividend increase, announced earlier this year, was just over 18%.

CaptureNow, some of that dividend growth has been fueled by an expanding payout ratio.

So that could portend lower dividend growth in the future, depending on what kind of growth the company is able to manage moving forward.

However, the payout ratio is still low, at just 35.7%. So there’s still plenty of room for future dividend raises.

On top of all that, you get a yield of 3.91% on the stock right now. That yield, by the way, is more than twice as high as the five-year average yield for this stock (1.9%).

Just a lot to like there as far as the dividend goes. Huge yield, great track record, and a low payout ratio.

But that dividend doesn’t grow if IBM isn’t able to move its underlying results forward.

The good news, though, is that the company is, overall, moving in the right direction.

Revenue for the firm is, as mentioned earlier, roughly flat over the last decade, increasing just very slightly from $91.134 billion to $92.793 billion from fiscal years 2005 to 2014.

However, IBM’s earnings per share is up from $4.87 to $11.90 over this period, which is a CAGR of 10.40%.

There’s a pretty big spread there between top-line and bottom-line growth, but there’s good reasons for that.

First, there’s that margin expansion I touched on earlier.

But the bigger story here is that IBM has bought back a stunningly large number of shares over the last decade, reducing its outstanding share count by 38%. For perspective, the company repurchased over 600 million shares over the last 10 fiscal years. That’s rather incredible.

So you have a cash cow that’s basically just a dividend and buyback machine, while also attempting to adapt to modern technology. It’s a lot to ask, but I think they’re doing fairly well, all in all.

S&P Capital IQ believes IBM will grow its EPS by a compound annual rate of 2% over the next three years due to continued competitive pressure, the strong dollar, and execution issues in terms of its large-scale transition.

However, that does diverge quite significantly from recent trends, so that appears to be a pretty conservative prediction.

Further adding to the reasons one should consider IBM is their really solid balance sheet.

Although the long-term debt/equity ratio is quite high, at 2.96, IBM simply has low common equity on the balance sheet. And the common equity is even less now than it was last five years ago as the firm continues to move toward services and software. The interest coverage ratio, meanwhile, which tells you how many times over earnings before interest and taxes can cover interest expenses, is over 42.

The only issue I really have here is the fact that IBM has put on some debt over the last five years, causing some deterioration to the balance sheet. IBM, like a lot of other major multinational companies, have gorged a bit on cheap debt. Not particularly problematic because their interest coverage ratio is extremely high, but I’d like to see this improve some.

Profitability, as telegraphed earlier, is strong.

Over the last five years, IBM has averaged net margin of 15.81% and return on equity of 78.70%.

ROE is awfully high due to usage of debt, but the net margin, as already mentioned, has improved dramatically over the last decade.

Overall, IBM has a lot to like. I can’t think of any technology company that has the staying power and/or ability to adapt, and the company has, thus far, not indicated any reason why they can’t turn the corner this time as well.

You have a cash cow that’s yielding twice its recent historical average, and you also have Warren Buffett on your side on a big way.

However, one newer risk that’s become known is that IBM announced an investigation into the company by the SEC regarding revenue reporting. Anything regarding this is speculation, but I can’t truly imagine that there’s anything nefarious at play. Time will tell, though.

So there’s a lot to like here, but is the valuation compelling? Is this stock on the “clearance rack”?

The stock trades hands for a P/E ratio of 9.13. Not only is that cheap in absolute terms, but it’s also significantly lower than the P/E ratio of 13.4 the stock has averaged over the last five years. That’s also notably about half the broader market. The way I see it, IBM is basically priced for no growth ever again, which is very unlikely.

Definitely in value territory, but what’s the stock worth? What’s a reasonable estimate of intrinsic value?

I valued shares using a dividend discount model analysis with a 10% discount rate and a long-term dividend growth rate of 7.5%. This is, admittedly, on the higher end of what I normally allow for, but IBM’s prodigious cash flow generation should allow for significant EPS and dividend growth by very virtue of buybacks, so any additional top-line growth (when turnaround plans start to kick into high gear) is just extra potential. The DDM analysis gives me a fair value of $223.60.

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.

In my view, this is one of the most undervalued blue-chip stocks available right now. Perhaps that’s why Buffett continues to remain so enthusiastic about it. But let’s check in with some professional analysts for some additional perspective.

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.

Morningstar rates IBM as a 4-star stock, with a fair value estimate of $174.00.

S&P Capital IQ 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 4-star “buy”, with a fair value calculation of $190.70.

I came in at the high end, but even the lowest estimate of IBM’s value is still substantially higher than the stock’s price right now. But I like to average out the three numbers so as to smooth out the variation. That average is $196.10, which would indicate the stock is potentially 47% undervalued.

ibmBottom line: International Businesses Machines Corp. (IBM) is a blue-chip stock with a track record for adapting that is unrivaled in its industry. Warren Buffett believes in this stock in a big way, and I agree with him. The turnaround plans aren’t meant for quick change, but you’re getting a very attractive dividend in the meanwhile. The SEC investigation adds additional uncertainty, but the valuation is such that there’s a very sizable margin of safety present, indicating 47% possible upside. I’d strongly consider this stock right now.

— Jason Fieber, Dividend Mantra