IBM (IBM - Get Report) has been a stock to be avoided in the past several years. However, the fact that so many of its most bullish shareholders have thrown in the towel on IBM has caused it to have largely been forgotten.

Admittedly, IBM has many problems, both in terms of governance and technology. Nevertheless, I contend that overall, IBM today remains very much under undervalued and under-appreciated.

Recent Rally Post-Earnings

Shareholders positively received IBM's Q4 2018 results, which showed top-line revenue down 1% year-over-year at constant currency to $21.8 billion, and largely flat full-year over year.  Nevertheless, in spite of feeble top-line performance, IBM's shares rallied roughly 8% post-earnings and have remained at that level since. 

So What Actually Drove This Rally?

Strong guidance made investors turn positive on IBM. Although IBM offers no top line forecast, it does offer both bottom line non-GAAP EPS numbers and its forecast for free cash flow for FY 2019.

While IBM's non-GAAP EPS of $13.90 for FY 2019, which exceeded analyst estimates for $13.80, certainly looks enticing, I have little confidence in the substance of this number. It is made up of so many assumptions, which makes it a largely useless figure on which to base any sort of investment decision. On the other hand, IBM's free cash flow expectation of approximately $12 billion is both meaningful and reassuring.

Having said that, one could point out that this amount of free cash flow is flat with what IBM generated in FY 2018. To which, I would counter, that investors are unlikely to get a cheaply valued stock when its free cash flow is growing at a strong clip.

Biggest Strategic Pivot in Years

IBM recently acquired Red Hat. At the time, back in October 2018, IBM deployed the equivalent of a third of its market cap into acquiring Red Hat (approximately $34 billion). This new acquisition was intended to be a last-ditch attempt by IBM to remain relevant in the cloud wars.

Red Hat specializes in offering a multi-cloud platform. IBM hopes that IBM's infrastructure and client base, together with Red Hat's technology, will create a strong offering so that together it might succeed in carving out a niche alongside the likes Amazon's (AMZN - Get Report) AWS, Microsoft's (MSFT - Get Report) Azure and Alphabet's (GOOGL - Get Report) Google Cloud.

However, despite being several months after the announcement of this groundbreaking acquisition, IBM has remained relatively tight-lipped on the tangible numbers and results this acquisition would ultimately provide to IBM. Furthermore, CFO James Kavanaugh said on the call that the acquisition of Red Hat is expected to close in the second half on 2019, and as such, the expectations from this business have not been fully reflected in IBM's fiscal 2019 forecast expectations.

Capital Return: A Strong Positive

As a value investor, while I'm interested in a businesses' dynamic developments, I'm obsessed with how my businesses go about deploying their excess capital. Typically, businesses which have a strong history of having robust cash flow generation capabilities often become complacent with their excess capital and ultimately end up squandering this capital. Recently, though, this has not been the case with IBM.

In fact, during Q4 2018, while IBM's share price turned south and hit multi-year lows, IBM used the opportunity to aggressively repurchase its own shares. Specifically, during Q4 2018, IBM deployed $2.1 billion towards share repurchases. Further, FY 2018 saw IBM deploy more capital towards repurchases than during the previous two full fiscal years of 2017, 2016.

Valuation - Potential Upside?

As shown in the above table, IBM's cash flows are being meaningfully undervalued. IBM is cheaply valued relative to itself, as it trades on 8x cash flows from operations compared with 8.5x for its historical valuation. However, even more meaningful is that IBM presently trades for just 10x its free cash flow.

Additionally, given that IBM presently supports a dividend yield of 4.7%, as well as the fact that its dividend continues to grow, I argue that this, too, points to another aspect of IBM that is undervalued.

Final Word

I believe that IBM shareholders are likely to see strong positive returns from the roughly $120 billion market cap IBM currently trades at. Having said that, these returns are not likely to come swiftly, but I trust that over the next one to two years, IBM's valuation will more closely match its intrinsic value.

Amazon, Microsoft and Alphabet are holdings in Jim Cramer's Action Alerts PLUS Charitable Trust Portfolio. Want to be alerted before Cramer buys or sells AMZN, MSFT or GOOGL? Learn more now.

I have no positions in any stocks mentioned.