A Deep Dive in Relative Valuation for Big Blue -- Is IBM Trading at a Bargain?

Two camps traditionally exist when it comes to stock valuation: intrinsic vs. relative. Intrinsic valuation involves cash flow projections, estimated growth rates, and present value discounting. Relative valuation takes a different approach, determining the price of an asset by comparing it to the price of similar assets -- similar to the way a house is appraised.

In the words of valuation guru and New York University Professor of Finance Aswath Damodaran:

Typically, collaboration does not take place between the two valuation methods as investors tend to stick to their preferred methodology. But at the crossroads of these two models stands opportunity in the form of corroborating, value evidence.

For IBM stock, now trading at six year lows, let's dive into the relative valuation model to determine if this company is indeed undervalued.

Relative valuation ratiosThe typical toolbox of relative valuation for stocks includes these ratios:

Price-to-earnings (P/E)
Price-to-book value (P/B)
Price-to-sales (P/S)
Price-to-cash flow (P/CF)

The appeal of these ratios lies in their simplicity, as one can simply compare the ratio value of a company to historical levels, the industry, or an overall market average. IBM,for example, has a trailing 12 month P/E ratio of 8.3 compared to an industry average of 13.7 and an S&P 500 average of 18.1. Simplistically, it appears that IBM is undervalued, but as Damodaran warns us, these ratios come with caveats.

A skewed P/EFor the market average P/E ratio, if a disproportionate number of them are either higher or lower, then the average P/E ratio will be skewed in either direction. For example, the trailing P/E for the S&P 500 is 18.1 and the median is 14.6.This is a fairly significant spread, precipitated by the higher valuations that skew the average. It is advisable to use the midpoint or median value for comparison purposes in order to eliminate some of the noise in the average.

The dangers of historical P/ETypically, a historic P/E is used as a point of reference to judge whether the market or an individual stock is properly valued. IBM has a trailing P/E of 8.3 and a historic 10-year average of 12.7.According to Damodaran, using a historic P/E average can be "fraught with danger" as interest rates can be higher or lower than historical norms, which prevents an apples-to-apples comparison. If interest rates were higher in a previous period, they served as an ankle weight to corporate performance and subsequent earnings (and vice versa). Instead, Damodaran suggests coupling relative valuation ratios with companion variables in order to determine value.

A relative solutionThe following table captures this methodology for tying relative valuation ratios to a companion variable in order to uncover indicators of undervaluation.

Valuation mismatches

Multiple	Companion Variable	Mismatch Indicator for Undervalued Company
Trailing P/E ratio	Expected growth next 3 to 5 years	Low P/E ratio with high expected growth rate in earnings
P/BV ratio	ROE (10-year average)	Low P/BV with high ROE
Trailing P/S ratio	Net margin	Low P/S ratio with high net profit margin

Multiple

Companion Variable

Mismatch Indicator for Undervalued Company

Trailing P/E ratio

Expected growth next 3 to 5 years

Low P/E ratio with high expected growth rate in earnings

P/BV ratio

ROE (10-year average)

Low P/BV with high ROE

Trailing P/S ratio

Net margin

Low P/S ratio with high net profit margin

Source: The Little Book of Valuation by Aswath Damodaran

For IBM, the trailing P/E ratio of 8.3 pairs with an expected five-year growth rate of 7.25%.We have already determined that this P/E ratio appears "low" -- now, we must determine whether a 7.25% earnings growth rate is "high". By historical standards, IBM grew earnings by a 9.2% average over the last 10 years,and the median earnings growth rate for the S&P 500 for the past 25 years is 12%.Thus, the earnings growth rate for IBM does not appear high, and the company fails this first test.

The P/BV ratio for IBM is 8.8,and the company has averaged a 59.8% return on equity over the last 10 years.The median P/BV of the S&P 500 over the last 15 years has averaged 2.7, and the company itself has a five-year median of 9. Although IBM has a stratospheric ROE, the company fails this test based on its price-to-book value, which appears high compared to the S&P median and in-line with the company's historic levels.

Last but not least, IBM trades at 1.4 times sales,and the company's most recent quarterly net margin was 20.2%.Comparatively, the median P/S for the S&P 500 over the past 14 years has been 1.4,and the company itself has a median of 1.75 over the last ten years. The median net margin for IBM over the same period has been 13.5%, and the most recent quarterly net margin for the IT services industry is 22.1%.It can be argued that IBM passes this test but just barely.

Summarily, IBM has failed two out of three of our companion variable tests and barely met the third. One would have to conclude from this analysis that IBM does not appear undervalued. Keep in mind, however, that this is merely a slice of relative valuation (a slice of a slice), and the prudent investor will develop an intrinsic valuation model in order to corroborate this takeaway.

Intrinsic value according to Buffett and WilliamsRelative valuation includes a handful of simple tools that can be used for valuation, but investors should not be lulled into their simplicity and overlook their nuances: P/E ratio averages can be skewed by uneven distributions, and historic ratios are influenced by interest rate environments. The solution is to use median values and to couple these ratios with companion variables in order to seek out undervalued companies. In completing this exercise for IBM, we do not find such indicators, but as Warren Buffett iterated in his 1992 letter to shareholders, the true intrinsic value of a productive asset was set forth by John Burr Williams over 50 years ago.

Relative valuation ratios should be used to supplement but not to supplant the true determination of value for productive assets as found in intrinsic value models.

The article A Deep Dive in Relative Valuation for Big Blue -- Is IBM Trading at a Bargain? originally appeared on Fool.com.

Adam Brownlee owns shares of International Business Machines. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.