How Much Is Hewlett-Packard Worth?

In my quest to find the cheapest large-cap tech stock out there -- a quest that had me digging into Cisco (Nasdaq: CSCO) a week ago -- I had Hewlett-Packard (NYSE: HPQ) suggested to me as a worthy contender.

Certainly it looks cheap based on a quick glance: Shares currently change hands at a mere 8.8 times expected 2011 earnings per share. And HP is an interesting story, too. It's been on an acquisition tear over the past few years that has significantly extended the company's reach outside of printers and computers, adding networking equipment from 3Com, services from EDS, mobile devices from Palm, and storage from 3PAR. And with the dark cloud that formed after the Mark Hurd scandal just now starting to pass, investors may start to gravitate back to its shares.

So then, is HP cheap enough to buy? Let's take a closer look.

It's a beautiful day in the neighborhood
One way to get an idea of what a stock might be worth is to check out how similar companies are valued. So let's take a look at how HP stacks up.

Source: Capital IQ, a Standard & Poor's company, and Yahoo! Finance; average excludes HP.

Using each of those averages to back into a stock price for HP, and then taking the average across those results, we can come up with an estimated price-per-share of roughly $80. This would suggest that today's price of $46 is seriously undervalued.

A comparable company analysis like this can sometimes raise as many questions as it answers though. For instance, is the entire group properly valued? A supposedly fairly valued -- or even over-valued -- stock among a bunch of other undervalued stocks may actually be an undervalued stock, and vice versa.

HP's wide reach puts it in competition with all of these companies through one venue or another. It runs into IBM and Accenture through its consulting services, Dell via its computer sales, Apple in both mobile devices and computers, Cisco in networking equipment, and EMC in the storage arena. Granted, Apple fans will balk at the company's name even being whispered in the same sentence as HP's, while Cisco aficionados will point out that 3Com is no Cisco, but it's still worthwhile to consider the range of valuations across the businesses that HP is involved in. However, since we're not getting perfect comparisons, we don't want to stop our analysis here.

So with all that in mind, it's best to combine comparable company analysis with another valuation technique.

Collecting the cash flow
An alternate way to value a stock is to do what's known as a discounted cash flow (DCF). Basically, this method projects free cash flow over the next ten years and discounts the tally from each of those years back to what it would be worth today (since a dollar tomorrow is worth less to us than a dollar today).

Because a DCF is based largely on estimates (aka guesses) and it attempts to predict the future, it can be a fickle beast and so its results are best used as guideposts rather than written-in-stone answers sent down from Mount Olympus.

For HP's DCF, I used the following assumptions:

Sources: Capital IQ, a Standard & Poor's company; Yahoo! Finance; and author's estimates.

While most of this is pretty standard fare when it comes to DCFs, the academically inclined would probably balk at the way I set the cost of equity. In a "classic" DCF, the cost of equity is set based on an equation that uses beta -- a measure of how volatile a stock is versus the rest of the market -- and a few other numbers that I tend to thumb my nose at.

But when you get right down to it, the cost of equity is the rate of return that investors demand to invest in the equity of that company. So I generally set the cost of equity equal to the rate of return that I'd like to see from that stock.

Based on the assumptions above, a simple DCF model spits out a per-share value of roughly $31 for HP's stock. That's a pretty wide range from what we saw above and almost certainly a big disappointment for HP bulls.

So why the huge variance? A key issue is HP's acquisitive history. When a company has relied heavily on acquisitions to fuel growth, I include that in my cash flow projections. If we don't, I don't think the 12% growth estimate over the next five years is particularly believable.

As with Cisco, another very acquisitive company, when HP decides that it's time to throttle down the acquisitions, its cash-flow spigot will gush green. To give a sense of what that would look like, if we assume that HP stopped making acquisitions in 2011, spent only on "normal" capital spending, and, as a result, growth stayed at flat 3% forever, the stock's DCF value jumps to $48. And if the company could manage better-than-3% growth without acquisitions, that price climbs even higher.

The problem, however, is that we can only speculate as to when HP is going to slow down its growth by acquisition. This is risky for shareholders because it defers the day when cash flow starts accumulating for them, and as noted above, a dollar of cash flow today is worth significantly more than a dollar of cash flow 10 years from now.

Do we have a winner?
The valuations that we've done here are pretty simple and, particularly when it comes to the DCF, investors would be well advised to play with the numbers further before making a final decision on HP's stock.

As with Cisco, HP's acquisition spending makes it particularly difficult to value the company based on its cash flow (my preferred of the two methods). However, based on the extent to which the stock is undervalued versus the selection of technology services and equipment companies above, along with the company's free cash flow generation ability, I think the true value of HP's stock likely lies above today's current price.

So is HP the cheapest large-cap tech stock? I'm not convinced. Based on certain metrics, the stock looks insanely cheap, but others leave me less enthusiastic. What do you think? Head down to the comments section and share your thoughts on the prospects for HP's stock.

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