IBM (NYSE:IBM) will report its second-quarter earnings on July 19. Expect the stock to rise if it produces earnings like those from Q1. I wrote about this last month and estimated that IBM stock was worth 25% more, or $183 per share.
As of July 14, IBM stock was $139.82 per share, so my analysis still stands. In fact, I have now revised my upside target to 44% higher, or $201.76 per share.
This, of course, is all based on the software company’s excellent free cash flow (FCF) generation last quarter. In Q1, IBM produced $2.153 billion in adjusted free cash flow on revenue of $17.7 billion. That means its FCF margin was relatively high at 12.4%.
Adjusting IBM’s Target Value
Right now, analysts followed by Seeking Alpha expect IBM’s 2022 revenue to hit $75.38 billion. If we use the 12.4% FCF margin metric from Q1, IBM could produce $9.347 billion in FCF. Let’s call it $9.5 billion for simplicity’s sake.
As I showed in my last article, the FCF yield of its peers averages about 5.25%. That means if we divide the forecast 2022 FCF of $9.5 billion by 5.25%, the target market capitalization could be $180.952 billion.
That is $55.6 billion higher, or 44.3% more, than its $125.34 billion market cap today. So the upside for IBM stock is 44.3% more, or $201.76 per share (i.e., $1.443 times $139.82 price on July 14).
Even if it takes two years for IBM stock to rise that high, the increase represents a decent 20.1% annualized compound return for both years.
What Analysts Think About IBM Stock
Moreover, the company’s trailing 12 month (TTM) cloud revenue was up 19% and IBM’s Red Hat revenue was up 17% during the quarter. Most analysts are expecting these trends to continue in Q2 and beyond. The company expects that cloud computing will be a $1 trillion market opportunity, according to Reuters.
In general, analysts are not as positive as I am on IBM stock. TipRanks.com reports that 8 Wall Street analysts have written about the stock in the last 3 months. Their average price target is $151.75, which represents an upside of just 8.5% over yesterday’s price. The same is true for Yahoo! Finance, where the average target price is $144.12, or just 3% higher. In other words, they are not believers in IBM stock.
What To Do With IBM Stock
I wonder what these analysts will say when IBM splits into two companies by the end of this year. Based on the spin-off proposal, IBM itself will focus on cloud computing after the split. Its legacy services business will break off into a company called Kyndryl, which will be based in New York City. The spin-off will allow IBM to focus on its fast-growing cloud computing businesses.
In these situations, I typically use a probability matrix to estimate a stock’s future value.
For example, let’s say there’s a 40% chance that analysts are correct and IBM stock will see 5% returns. That produces a meager 2% expected return (ER).
Next, let’s assume a 40% chance that IBM stock will rise 44%. That produces an ER of 17.6%.
Finally, let’s say that IBM makes a market return of 10%. After deducting the chances of the other two outcomes, there is a 20% chance of that happening. The ER in this third scenario is also 2%.
Adding up all three of these scenarios’ ERs leads to the following equation: 2% (analysts) plus 17.6% (Hake) plus 2% (market return) equals 21.6%. Based on this calculation, the ER is 21.6% for IBM stock over the next year. That is also close to the 20.1% annualized compound return I calculated using IBM’s 44.3% upside over two years.
On the date of publication, Mark R. Hake did not hold a position in any security mentioned in the article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.