Tech giants Apple (AAPL 2.15%) and Nvidia (NVDA 1.56%) are on top of the world nowadays. They are the two most valuable stocks on the market, looking back at market-beating returns in the past five years. Apple's total returns delivered a compound average growth rate (CAGR) of 36% in that period. Nvidia soared even higher with a 100% five-year CAGR. The artificial intelligence (AI) boom has been mighty kind to Nvidia's investors.
They achieved these massive gains in a strong era for the general market, but the S&P 500 index looks downright sleepy by comparison:
AAPL Total Return Level data by YCharts
It would be cool if Nvidia and Apple were poised to continue their market-beating ways from here. Invest in the biggest, baddest names on the market, sit back and relax, and let them deliver more of the same good stuff for years to come. Unfortunately, I'm afraid that both stocks are a bit overvalued at today's massive market caps -- $3.1 trillion for Nvidia and $3.4 trillion for Apple. I know it's like comparing mountains of cash to rivers of revenues, but these two market caps add up to about 23% of America's gross domestic product.
I think that's too much. Apple and Nvidia may be overdue for a painful correction. At best, I don't expect them to rise much higher in the foreseeable future.
At the same time, good old International Business Machines (IBM 0.58%) is gaining ground in the AI space, and its stock is undervalued today. I don't expect IBM's stock to pass the trillion-dollar mark in the next five years, but it should most certainly rise as Big Blue's enterprise-class AI tools add value to the stock. Most investors don't see this traditional computing giant as a promising AI investment yet. That's a big mistake.
Don't forget IBM's cash-profit chops
IBM's valuation ratios don't look terribly exciting at first glance. The stock is changing hands at 22 times trailing earnings and 2.9 times sales. Those are perfectly acceptable middle-of-the-road values for mature companies, just below the averages seen in the S&P 500 and Dow Jones Industrial Average market indices.
Then your eye slides over to IBM's price-to-free cash flow (P/FCF) ratio, and the stock suddenly looks different. When you calculate IBM's values based on its massive cash profit, the stock seems to belong in Wall Street's bargain bin instead. This ratio stops at 14 times free cash flows, just over half of the S&P 500's or Dow Jones' readings.
Cash is king, and IBM has plenty of it. The company's rich cash profits and relatively modest bottom-line earnings show that Big Blue's accountants are very good at lowering taxable profits while putting lots of real greenbacks in the bank. I see cash flow as a higher-quality measure of profitability, so it's easy to look away from IBM's moderate price-to-earnings ratio.
IBM's place in the AI boom
Remember the five-year chart I showed you? IBM's chart for the same period is a different animal:
IBM Total Return Level data by YCharts
The stock has underperformed broad market indices for many years as it transformed a hardware-heavy business model into a more profitable software and services plan. In particular, you should know that the revamped Big Blue comes with a heavy focus on cloud computing, data security, and AI tools.
Yes, this company was a leading AI researcher long before ChatGPT's release opened the floodgates for AI investments. Many investors seem to have missed that connection since IBM's business results didn't immediately skyrocket in this soaring AI era. The big AI contracts are coming, just a bit late.
You see, IBM is happy to leave consumer-friendly ideas such as ChatGPT-style chatbots to other tech providers. This company will always go after large corporate contracts instead, adding extra layers of security, business-friendly data analytics, and lawsuit-repellant data tracking to the mix. Potential clients may take several quarters to test and approve the resulting AI recipe, but the end result is a lucrative long-term deal that won't be easy to replace.
The approvals are rolling in now, building a robust revenue stream for the long run. Market makers are still not paying attention, so IBM's stock keeps trading at incredibly low cash flow ratios. I can't wait to see what happens in a couple of years, when the AI contracts have become generous and highly profitable revenue streams.
NYSE: IBM
Key Data Points
One more thing...
I'll admit that Nvidia and Apple are making solid cash profits, too. However, their sky-high stock prices already account for these high-quality profits. Apple's P/FCF ratio stands at 33 today, and Nvidia's is soaring at 79 times free cash flows.
Thanks, but no thanks. I'd much rather buy IBM's undervalued stock instead.
