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behind the numbers

Now that IBM Corp. has proven it can beat the toughest competition Jeopardy has to offer, the company faces some big decisions. Should it take its chances on Wheel of Fortune? Strut its stuff on Dancing with the Stars?

Oh, all right, perhaps those aren't the best places for a corporate titan to test its mettle. Rather than expanding its domination of the game show universe, IBM may want to focus on an even bigger challenge – maintaining its lofty share price.

Over the past year, IBM's stock has gone on a tear, rising more than 25 per cent. Investors seeking stability, steadily rising earnings and an iconic brand name have fallen in love with the company.

Look more closely, though, and questions emerge about this market darling. Consider, for starters, the discrepancy between the company's top lines and bottom lines. IBM's revenue has plodded ahead by an average of 2 per cent a year over the past five years. Somehow, though, the computer giant has managed to boost its profit during this period by an average of 13 per cent annually, and earnings per share by an even more impressive 18 per cent a year.

How do you generate eye-popping earnings growth from revenue that is barely budging? The answer owes as much to financial engineering as computer engineering. Over the past five years, IBM has slashed costs, taken on debt and bought back millions of shares. The moves make perfect sense from an accounting perspective, but do little to reassure anyone who is concerned about the company's ability to grow its business.

Not that the Street is fretting. Twenty out of 29 analysts covering the stock rate it a "buy," according to Bloomberg. The Wall Street chorus lavishes praise on IBM for its potential in trendy new areas such as cloud computing, which aims to move much of the work currently done by desktop PCs to a networked "cloud" of super-smart computers. (All of which sounds an awful lot like the old days of mainframe computing, but never mind.)

For now, IBM's biggest strength is the sheer breadth of its offerings, from software and hardware to services. The company also boasts research muscle few other firms can match. Watson, its Jeopardy-winning computer, represents a breakthrough in artificial intelligence, one that's capable of understanding questions posed in plain English and producing answers faster than the quickest human brainiacs.

But all that intelligence has not been able to expand IBM's business at anything more than a crawl in recent years. The company's size is working against it. With nearly $100-billion (U.S.) in sales in 2010, IBM may be bumping up against the limits of its traditional markets.

And that brings us back to the question of how much longer IBM can go on wringing out double-digit earnings growth from sales that are expanding in the single digits. To its credit, it is attempting to migrate its business into higher-margin areas such as software, but investors have to wonder how well that transition is going.

A company that is creating value for shareholders typically shows a steady increase in book value per share. IBM, though, is stuck in neutral. Back in 2006, its book value per share was $18.92. Today? It's $18.77.

Share buybacks can distort book value, so let's consider another way to assess a company's value appeal – comparing its enterprise value (the total market value of common and preferred shares, plus debt, minus cash) to its earnings before interest, taxes, depreciation and amortization (EBITDA). The lower this ratio, the better, from an investor's perspective.

IBM's enterprise value is about nine times EBITDA. Meanwhile, Hewlett-Packard's ratio is around six and Microsoft's is under seven. On this measure, IBM is no bargain.

Perhaps IBM's recent initiatives, such as Smarter Planet (a move to digitally monitor everything from highways to power grids to make them more efficient) will result in lush new streams of revenue. Then again, maybe they won't. Many other companies, including Hewlett-Packard and Accenture, are eyeing some of the same territory that IBM now occupies.

IBM is not going to start losing money any time soon, but it does appear to be generously valued for a company with mediocre revenue growth. If the answer on Jeopardy is, "A red-hot, blue-chip stock that investors should be wary of," the question is, "What is IBM?"