The Motley Fool: Is Big Blue for you?

International Business Machines (NYSE: IBM), or IBM, is more than 100 years old and has had to reinvent itself over the years. It’s in the midst of another transformation, which has put pressure on its shares, with many investors taking a wait-and-see approach.

In 2015, the company’s revenue and earnings dropped, with management expecting a further earnings drop this year. However, there are some good reasons to buy into IBM. First, it appears undervalued, with its price-to-earnings (P/E) ratio recently near 11, and its dividend recently yielded a hefty 3.5 percent. (It has doubled its dividend over the past five years, too, with more room for it to grow.) Net profit margins have trended up over the past few years and recently topped 16 percent, and IBM is generating more than $13 billion in free cash flow annually.

Meanwhile, CEO Ginni Rometty has IBM cutting loose its low-margin hardware businesses to focus on more profitable services and software sales. Its “Strategic Imperatives” initiatives, featuring products for cloud computing, data analytics and user engagement, is now generating more than a third of IBM’s revenue and recently posted 26 percent year-over-year growth on a constant-currency basis.

IBM is not fully out of the woods yet, but it has a good plan, ample resources and management that’s taking a long-term view. It’s also rewarding patient believers with a generous dividend and share buybacks.

Ask the Fool

Q: Would you please explain how a $20 stock can be viewed as more expensive than a $100 stock? – R.K., Lake City, Florida

A: A stock’s price alone is far less meaningful than you think. You need to compare it to other measures, such as sales, earnings or cash flow, in order to be able to draw conclusions.

Imagine shares of two companies – Alpha and Omega – each trading for $36 per share. If Alpha’s earnings per share (EPS) for the past 12 months is $2 and Omega’s is $3, then Alpha’s price-to-earnings ratio (representing price divided by EPS) is 18 while Omega’s is 12. You’d have to pay $18 for each dollar of Alpha’s earnings, versus just $12 for Omega’s. Already, Omega looks cheaper.

To get a sense of a company’s size, focus on its annual revenue or its market capitalization. Market cap is the current share price multiplied by the number of shares outstanding, reflecting the current total price tag the market is placing on a company. If Alpha sports 10 million shares and Omega has 1 billion, then Alpha’s market cap is $360 million and Omega’s is $36 billion. Despite the same stock price, Omega is a much bigger company.

When evaluating a company, look far beyond its price. Assess how rapidly it’s growing, how much cash and debt it has, what its competitive advantages and prospects are, and how undervalued or overvalued it appears to be.

Q: If I donate $50 to charity and my company matches that donation with another $50, can I claim a $100 deduction on my tax return? – P.H., Parchment, Michigan

A: Nope. You can deduct only the $50 that you contributed.

My dumbest investment

My dumbest investment, many years ago, was in Iridium, which successfully launched dozens of satellites into orbit in order to create a mobile telephone network. Their technology seemed good, as did their launch success rate. But they were carrying a multibillion-dollar debt load and didn’t have sufficient revenue coming in with which to stay afloat. I learned that lots of debt and little revenue will overwhelm any technological advantage. – Tom, Clinton, Washington

The Fool responds: Iridium, the brainchild of Motorola, did have compelling technology, but it also had many headwinds preventing it from becoming a great stock performer. It spent about $5 billion creating a phone network in space in the 1990s, but the phones that would use the network cost several thousand dollars apiece – much more than most folks would consider spending. The first call was made with Iridium technology in 1998, but within a year, the company had filed for bankruptcy protection. About a million customers had been needed in order for Iridium to break even, but it only signed up tens of thousands.

It’s easy to be swayed by impressive technology, but you need to also make sure a company is or will be successful in the market, serving lots of customers and generating profits. Also, when there are competing technologies, the best one doesn’t always win out. It’s best to seek companies that are already successful and that have bright futures.