How sensitive is our estimate of IBM's Intrinsic Value to key assumptions?
First, it useful to consider what proportion of intrinsic value is explained from our most basic simplifying assumption --- IBM grows at a normal rate of 3.5% in perpetuity.
You may be surprised to discover that this is usually one of the most important assumptions. For the case of IBM change the abnormal growth rate in stage I to 3.5%. For the current example this changes the estimate for IBM's intrinsic value to $75.20.
That is, just over 62.5% can be explained from normal growth assumptions or approximately 37.5% of IBM can be explained from abnormal growth assumptions.
Cost of equity capital. We have seen that the stage II is an important contributor to the estimate of intrinsic value. In stage 2 we made the assumption that if growth is assumed to revert to normal levels then beta is should revert to normal levels. What effect does this assumption have?
Contrast assuming CAPM (with beta equal to 1.30) versus CAPM with beta equal to 1 in stage II for IBM. You can use the drop down menu beside Stage 2 Discount rate to see this.
CAPM (beta equal to 1.66) for both stages: $96.41
CAPM (beta equal to 1.00 in stage 2, and 1.30 in stage 1): $120.14
Clearly, the Intrinsic Value is very sensitive to our assumption for beta in stage 2 when computing the cost of equity capital.
Similarly, you can test the predicted sensitivity of IBM to shifts in the long bond rate and shifts in the equity premium by changing these numbers.
Another interesting shift is the number of years assumed for stage I. For some companies 10-years may be way too high. For example, a new software start up may have an interesting product but competition may move in quickly. If they have no inherent barriers to entry then this may generate abnormal growth for 2-years and then normal thereafter. Another software company may have control of the popular operating systems which form the foundation for all applications. This control provides high barriers to entry and therefore is sufficient to protect abnormal growth for long periods of time.
For the case of IBM they have first class research and development. This generates patents that can keep them at the cutting edge for long periods of time. IBM also has demonstrated it's ability to license it's know how and generate free cash flow at the same time. As a result, some may consider 10-years to be a conservative estimate of abnormal growth and that in 10-years time IBM will still be at the cutting edge of technology and licensing "know how." In the current example if we extended 10 to 15 (keeping all other assumptions at the base case) our estimate increases from $120.14 to $129.51.
Finally, in this introduction to sensitivity analysis we may be concerned that we are using the ex post financial statements. Analysts can make pretty good guesses at what the current year's results will look like and these guesses are likely to be superior (and evidence supports this) to using last year's numbers.
So for the case of IBM the current analyst forecasts for EPS (Earnings per share) available on the Yahoo or MSN Investor sites are:
Source Yahoo Investor
These numbers can be fed back into the FCFE calculator to update forecast cash flows.
It should be noted that the above is merely a start to what type of questions should be considered.
