As investors, we always want our investments to generate healthy returns. However, investors often forget that such returns stem from two extremely important factors:

  1. The business's ability to generate profits.
  2. The price you pay for one share of those profits.

This idea of price versus returns lies at the heart of value investing. In today's edition of this series, I'll examine both the quality and the pricing of chipmaker IBM (NYSE: IBM), in hopes of gaining a better sense of its potential as an investment right now.

Where should we start to find value?
As we all know, businesses' quality varies widely. A company that can grow its bottom line faster than the market, especially if it does so with any consistency, obviously gives its owner greater value than a stagnant or declining business does. However, many investors also fail to understand that any business can become a buy at a low enough price. Figuring out this price-to-value equation drives all intelligent investment research.

For today's spotlighted stock, I selected several metrics to evaluate returns, profitability, growth, and leverage:

  • Return on equity divides net income by shareholder equity, highlighting the return that a company generates for its equity base.
  • The EBIT (short for earnings before interest and taxes) margin provides a rough measurement of the percentage of cash a company keeps from its operations. I prefer using EBIT to other measurements because it focuses more exclusively on the performance of a company's core business. Stripping out interest and taxes makes these figures less susceptible to dubious accounting distortions.
  • The EBIT growth rate demonstrates whether a company can expand its business.
  • Finally, the debt-to-equity ratio reveals how much leverage a company employs to fund its operations. Some companies have a track record of wisely managing high debt levels, but generally speaking, lower is better here. I chose five-year averages to help smooth away one-year irregularities that can easily distort regular business results.  

With that in mind, let's look at IBM and some of its closest peers.

Company

Return on Equity (5-Year Average)

EBIT Margin (5-Year Average)

EBIT Growth (5-Year Average)

Total Debt / Equity

IBM 52.86% 16.94% 10.95% 132.85%
Oracle (Nasdaq: ORCL) 24.81% 35.55% 17.88% 39.81%
Hewlett-Packard (NYSE: HPQ) 19.52% 8.96% 21.68% 49.27%
Teradata (NYSE: TDC) 32.34% 19.69% 8.13% 0.00%

Source: Capital IQ, a division of Standard & Poor's.

These companies all look strong in their own ways. IBM blows the competition away in terms of return on equity, but it also juices this figure by adding leverage, as seen in its 132.85% debt-to-equity ratio. That doesn't necessarily stand out as a total negative to me. Some companies have long histories of using leverage responsibly. With its outstanding track record, IBM certainly could fit that bill. It also has strong earnings and above-average growth. In all, very impressive.

Oracle scores a 4-for-4 in the above categories, chalking up very impressive totals in every metric.

HP also has a lot of positives, with its less-than-desirable operating margin resulting from more commoditized businesses such as its PC unit. 

Teradata generates very strong returns and margins. Its growth, though not anemic, seems a little lower than ideal. Considering the complete lack of leverage, though, the company's overall performance impresses me as well.

How cheap does IBM look?
To gauge pricing, I studied two important multiples: price to earnings and enterprise value to free cash flow. Similar to a P/E ratio, comparing enterprise value (essentially, debt, preferred stock, and equity holders combined, minus cash) to unlevered free cash flow conveys how expensive the entire company is versus the cash it can generate. This gives investors another measurement of cheapness when analyzing a stock. For both metrics, the lower the multiple, the better.

Let's check these companies' performance against the price we'd need to pay to get our hands on their shares.

Company

Enterprise Value / FCF

P / LTM Diluted EPS Before Extra Items

IBM 14.58 14.34
Oracle 20.05 23.39
Hewlett-Packard 12.66 10.34
Teradata 22.04 30.98

Source: Capital IQ, a division of Standard & Poor's.

IBM looks attractive, but it's not an absolute steal at these prices. On one hand, you rarely see franchise businesses like this trading for low-to-mid-teens multiples. Overall, the company probably looks cheap enough to make it a portfolio addition. Both Oracle and Teradata seem expensive by my standard. Trading for less than IBM, albeit with some flaws on the margin front, HP looks like a possible buy at its current levels.  

In reviewing these numbers, I like all the companies I've reviewed in this article. They all have strong, quality businesses that generate impressive figures. As a more value-oriented investor, I naturally gravitate toward the cheaper stocks here. However, I understand that many tech investors tend to accept higher multiples for better future growth prospects. Depending on your inclination, it seems like a group that's hard to beat on the whole.

Although IBM looks like a great stock for your portfolio right now, your search shouldn't end here. To really get to know a company, you need to keep digging. If any of the companies mentioned here today piques your interest, you can continue your research by examining their quality of earnings, management track record, and analyst estimates, among other metrics.

Need a little help? Stop by Motley Fool CAPS, where our users share ideas and chat about their favorite stocks, or add the four stocks I've covered here to  My Watchlist. Our new, free watchlist service will keep you up to date with Foolish coverage of any developments surrounding IBM and its competitors.

Andrew Tonner holds no position in any of the companies mentioned in this article. Teradata is a Motley Fool Stock Advisor pick. The Fool owns shares of IBM and Oracle. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.