Contents - Index

Sensitivtiy Analysis
©2009 OS Financial Trading System

To answer this question we will conduct some sensitivity analysis on IBM.  We can ask the question by how much do we need change the value of key inputs to make IBM's assessed value more consistent with the market price?  Asking this question doesn't imply that we are trying to match the market price.  Instead the issue is if we purchase at the current spot market price what are the implied assumptions relative to a FCFE valuation?  As a result, by answering the above types of questions provides important insights into whether we assess the current market price to be reasonable or not relative to the FCFE model.  
There are three main inputs into the model then sensitivity analysis should focus on the three major inputs - growth behavior, free cash flows and the cost of equity capital.
Impact of Abnormal Growth
We will work with the latter first.  Suppose we predicted zero abnormal growth for IBM.  That is, lets assume normal growth in perpetuity.  This is not realistic but it will serve as a benchmark.
Again using Parameters we can change FCFGrowth1 value to 0.045.  That is, we are assuming a growth rate equal to the economy wide growth rate for both stages.  So in summary current parameters appear as follows:


This yields the modified assessed value as:


This reduces IBM further to 227.31.  So the market is not really valuing a lot of abnormal growth for IBM.
Second in our sensitivity analysis, we can consider our FCFE estimate.
Referring back to the FTS Real Time Client we can observe what the current implied FCFE is given some very conservative numbers. 
Impact of FCFE Estimates
We next more closely examine the CAPEX assumptions.  Now we want to adopt a longer term perspective so we turn to the annual statements:


In IBM's 10-K estimate they work with $4.5billion as CAPEX.  One quick test for assessing the adequacy of CAPEX is to compare it to Depreciation Expense.  In the normal growth phase we would expect CAPEX to be approximately equal to Depreciation expense.   In the abnormal growth phase we would expect it to be higher.  From the above disclosures IBM's CAPEX and especially our adjusted CAPEX exceeds Depreciation/Depletion in each year.
Cash From Investing Activities:
Observe that the 5-year average for Cash from Investing Activities is:  7055.4
Recall:
Cash flow from Operations (TTM) = 9,128 + (18,812 - 8,452) = 19,488
New Capital Expenditure:  7055.4
New TTM Free Cash Flows = $19,488 - 7,055.4 = $12,432.60
Adjusting for Comprehensive Income:
Recall TTM FCF = (12.4326 - 6.472) = $5.9606 billion
Adjusted CAPEX
Capital Expenditure:  7,055.4 + 6,472 = 13,527.4
The Debt to Total Assets Ratio (i.e., Debt Ratio) = (20,868 + 0.0 + 8,504)/103,652 = 0.28
FCFE = FCF + Debt Ratio*Adjusted CAPEX =5,9606 + 13,527.4*0.28 = 9,748.272 billion because recall that FCFE is higher than FCF for a firm financed by both debt and equity.
FCFE per share = 9.748272/1.31 = $7.4414 per share
As a result, by still working with a complete set of conservative numbers for IBM's FCFE as above we can now adjust the FCFE per share:


Again this reduces our intrinsic value estimate but not by a large amount:


Estimated value is still $186.93
In other words by combining conservative growth assumptions with conservative FCFE estimates IBM's assessed intrinsic value is still high.
In the next topic we revisit our estimate for the discount rate (the cost of equity capital).