Module 4: simple analysis and parsimonious forecasting

1. Module 4:simple analysis and parsimonious forecasting International Business Machines Corporation Frank Huang

2. BriefintroductionofIBM • incorporated in the State of New York on June 16, 1911 • InthecomputermanufacturingandITconsultingindustries • Creates value through integrated solutions that leverage information technology and deep knowledge of business processes • IBM solutions reduces a client‘s operational costs or enablesnew capabilities that generate revenue

3. Corporate recognition and brand • In 2012, Fortune ranked IBM the • No. 2 largest U.S. firm in terms of number of employees, • the No. 4 largest in terms ofmarket capitalization, • the No. 9 most profitableand • the No. 19 largest firm in terms of revenue. Globally, the company was ranked the No. 31 largest firm in terms of revenue by Forbes for 2011.

4. Major operation components • The company's major operations consists of five business segments: • Global Technology Services and Global Business Services, which the company collectively calls Global Services, • Software, • Systems and Technology, • Global Financing

5. Return on Enterprise Operations

6. Enterpriseprofitmarginrevealshowmuchoperatingprofitthefirmearnsfromeachsalesdollar.Enterpriseprofitmarginrevealshowmuchoperatingprofitthefirmearnsfromeachsalesdollar.

7. Forecast revenues via forecasts of sales growthrates

8. Forecast EPAT via forecasts of EPM ForeachdollarofIBMsalesduring2010to2012,thefirmearnedroughly12.9centsprofitafterallenterpriseexpensesandtaxes.

9. Forecast EPAT via forecasts of “EPMfromsales” • Excludetheimpairmentcharge,discontinuedoperations,financialstatementtranslation,andgains/losesoncashflowhedges • Hopetogainsmootherresults

10. EPMIndustryAverage

11. Forecast NEA via forecasts of EATO • Enterpriseassetturnovermeasurestheproductivityofthefirm’senterpriseassets. • Revealsthelevelofsalesthefirmrealizesfromeachdollarinvestedinenterpriseassets. • Foreachdollarofenterpriseassetsemployed,IBMgeneratedanaverageof$14.11insales.

13. Assumptions for parsimonious forecasting • Sales growth rate 1.13% • Enterprise profit margin (EPM) 15.1% • Enterprise asset turnover (EATO) 14.11

14. Discounted Cash Flow Model • Assumption: growthrate:1.13% Discountrate:10.00%

15. Discounted Cash Flow Model

16. Conclusion • Improvementthatcouldbemade: • a more accurate discount rate • growthrateistheaverageofpreviousyears’growthrates • FY13 sales number not yet released

17. Module 6:Cost of capital and Valuation International Business Machines Corporation Frank Huang

18. Cost of capital and Valuation

19. Guiding formula

20. Cost of Equity Capital using CAPM Cost of capital for equity Market risk premium Risk-free rate of return, proxied by using return on 30 year T-bill Sensitivity of the asset’s market return to the overall market return

21. Cost of Equity Capital using CAPM • rrf (risk free rate of return) • Average of 52wk range=3.40% • rMKT assumed to be 11%

22. Cost of Equity Capital using CAPM Return on S&P 500 using 60 monthly observations from 2008-2014 Return on IBM 500 using 60 monthly observations from 2008-2014

23. Regression analysis for ß Yahoo number Using Return on S&P 500 as the independent variable; Using Return on IBM as the dependent variable; ß=0.6 (ß=0.7 using bloomberg’s adjustment)

24. Cost of Equity Capital using CAPM 7.96%=3.4%+0.6*(11%-3.4%)

25. Cost of Debt Capital • rD = Pretax borrowing rate for debt X (1 – Tax rate)

27. Cost of Debt Capital • utilize long-term disclosed average interest rate as pretax borrowing rate • Assume pretax borrowing rate for debt=3.5% • Tate rate=35% • rD=2.28%

28. Cost of Enterprise Capital VD =$12,747 million Veq =$188.68 billion Implied Vent = 201428.05 million R=7.60%

29. Revaluing IBM

30. Thoughts & Questions • Could have used alternative methods to calculate cost of debt to test its accuracy • Could have chosen better estimates for risk-free rate of return and market rate of return • Imperfection of CAPM • …