“In the short run, the market is a voting machine, but in the long run it is a weighing machine.” — Benjamin Graham, The Intelligent Investor

That

is the best analysis we can find about the current market. We believe there is an intrinsic value for shares and our analysis attempts to calculate this. But in the short-term market sentiment is a key factor and at the moment the votes are primarily negative. But there are some positives appearing. This week it was IBM ($IBM). $IBM announced better than expected fourth quarter results. At Valuecruncher we have previously looked at $IBM. Our 2008 projections in our previous analysis were not far out – we projected 2008 revenues of US$105.0 billion against actuals of US$103.6. We decided to update our valuation of $IBM.

Valuecruncher valuation model of $IBM with interactive assumptions

Valuecruncher produces a valuation of US$128.62 for $IBM. This is a current valuation (an estimate of intrinsic value using a discounted cash flow model) not a target price. This valuation is 42.8% above the current share price of US$90.07.

Assumptions

• Revenue: Reuters aggregates 15 analysts covering $IBM and these analysts have a mean estimate of 2009 revenues of US$103.2 billion. For our analysis we have used US$105.0 billion in 2009, US$107.0 billion in 2010 and US$110.0 billion in 2011.
• Profitability: We have used an EBITDA margin of 20% flat to 2010. Reuters had $IBM‘s EBITD margin at 20.26% in 2007 but is waiting for detailed profitability results for 2008 (including at the EBITDA line) which have not yet been released by the company.
• Capital Expenditure: We have assumed capital expenditures of US$4.5 billion in 2009 and 2010 rising to US$5.0 billion in 2011 and beyond.
• Discount Rate: 10.5%.
• Terminal Growth Rate: 3.0%.

Our analysis incorporates the cash and debt the $IBM balance sheet – Valuecruncher calculates a net debt number.

Our analysis has considerable range for downside:

• Increasing the discount rate to 11.5% drops our valuation to US$116.20.
• Lowering the terminal growth rate to 2% drops our valuation to US$117.41.
• Lowering our 2009-11 revenues to US$100.0 billion drops our valuation to US$116.43.
• Lowering our EBITDA margin to 17.5% from 2009 drops our valuation US$111.00.
• Combining all of these sensitivities results in a valuation of US$84.74 – 5.9% below the current share price.

Comparator Analysis

Comparator analysis (sometimes called comparison company analysis) is a relative valuation approach. For $IBM we looked at four peer companies – Accenture ($ACN), HP ($HPQ), Microsoft ($MSFT) and Oracle ($ORCL). We calculated enterprise values – market capitalisation plus net debt (long-term borrowings less cash). Then we measured a range of metrics against the enterprise value for $IBM and the peer set.

We have used the last financial year (LFY) as the base set of metrics. $IBM has not yet released the 2008 LFY profitability (EBIT and EBITDA) and free cash flow results. For this analysis we have used the 2008 revenue numbers with the 2007 profitability and free cash flow margins. The highlighted column links our DCF valuation to the current market valuation.

$IBM is currently trading in the middle to the upper-end of the valuation metrics of the peer group. Our DCF valuation places a value on $IBM well above where the market is currently valuing the company and the peer group. Reviewing our assumptions we remain comfortable with our valuation. Using the DCF valuation approach we believe that $IBM is trading at a discount to intrinsic value. The market is definitely voting negative – but in the long-run we believe $IBM represents value at current prices.

Play with our assumptions – what does your analysis say?

Disclosure: None

Microsoft ($MSFT) continues to trade under US$20 a share. We have previously looked at $MSFT and felt it was undervalued in the US$20-25 ra

nge. We decided it was time to revisit our valuation.

Valuecruncher valuation model of $MSFT with interactive assumptions

Valuecruncher produces a valuation of US$25.34 for $MSFT. This is a current valuation (an estimate of intrinsic value using a discounted cash flow model) not a target price. This valuation is 33.6% above the current share price of US$18.96.

Assumptions

• Revenue: Reuters aggregates 30 analysts covering $MSFT and the mean estimate of 2009 revenues is US$67.3 billion. For our analysis we have used US$64.0 billion in 2009, US$68.5 billion in 2010 and US$72.5 billion in 2011. Between 2004 and 2008 $MSFT grew revenues at a compound annual growth rate of 13.2% – revenues of US$36.8 billion in 2004 to US$60.4 billion in 2008.
• Profitability: We have used an EBITDA margin of 40.0% to 2011. Reuters has $MSFT‘s EBITD margin at 39.25% last year and an average of 37.0% over the last five-years.
• Capital Expenditure: We have assumed capital expenditures of US$3.75 billion per annum moving forward.
• Discount Rate: 11.0%.
• Terminal Growth Rate: 3.0%. In our assumptions we have 2010/11 revenue growth at 5.8% – we have assumed that growth eventually slows to a 3.0% long-term stable growth rate. We have used 3.0% as our terminal growth rate.

Our analysis incorporates the cash on the $MSFT balance sheet – Valuecruncher calculates a net debt number.

Comparator Analysis

Comparator analysis (sometimes called comparison company analysis) is a relative valuation approach. For $MSFT we looked at four peer companies – IBM ($IBM), Apple ($AAPL), HP ($HPQ) and Google ($GOOG). We calculated enterprise values – market capitalisation plus net debt (long-term borrowings less cash). Then we measured a range of metrics against the enterprise value for $MSFT and the peer set.

We have used the last financial year (LFY) as the base set of metrics. $MSFT is currently priced at the bottom of the peer group for the EV/EBITDA and EV/EBIT metrics and in the middle for the EV/FCF metric. The market is currently valuing the profits (EBIT and EBITDA) and free cash flow produced by $MSFT at less than half that of the comparable numbers for $GOOG. This reflects the perceived different future growth prospects of the two businesses. The comparator numbers show $MSFT is comparably priced against the peer group – even with the strengths of their business model (39.8% EBITDA margins vs 18.9% for $IBM and 11.7% for $HPQ). $MSFT’s growth is slowing – but it is still a very good business. Should $MSFT’s profits (at the EBITDA and EBIT levels) really be valued less than $IBM and $HPQ?

Play with our assumptions – what does your analysis say? We think that $MSFT looks undervalued. Our model is interactive – you can change any of our assumptions.

Disclosure: None

Hewlett-Packard (HPQ) has traded between US$39.99 and US$53.48 over the last 52-weeks. We decided to run the numbers on HPQ using the Valuecruncher interactive valuation tool to form a view on the current US$44.46 share price.

HPQ Valuation

HPQ grew revenues from US$79.9 billion in 2004 to US$104.3 billion in 2007 – a 9.0% compound annual growth rate. Our assumptions of revenues for the next three years are US$115.0 billion in 2008 growing to US$135.0 billion in 2010 – a 9.3% compound annual growth rate. We have projected EBITDA margins to grow from 12.5% in 2008 to 13.0% in 2010. We have used a terminal growth rate of 3.5%. We used a terminal capital expenditure number of US$4.0 billion. We have used a WACC (discount rate) of 10%.

Key assumptions as we see them are:

HPQ terminal growth rate of 3.5%. We believe this long-term growth rate could be anywhere between 3% and 4-4.5%. We have taken 3.5% as a mid-point terminal growth rate.

HPQ WACC of 10%. We believe that HPQ’s WACC (discount rate) is in the 9-11% range. Again we have taken a mid-point.

Valuecruncher valuation model of HPQ with interactive assumptions

Our analysis incorporates the cash and debt on the HPQ balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$55.38 which is 24.6% above the current share price of US$44.46.

Based on our analysis, HPQ shares look cheap. Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.