By: Ahmed Ishtiaq
Cisco Systems (CSCO) has shown substantial growth over the past months, and the stock has made an impressive recovery. At the moment, there is a massive opportunity in the cloud segment, and the company is trying to exploit this opportunity. Cisco has some of the best equipment in the market, and one of the biggest client networks. As a result, the company has a unique advantage over its competitors. Furthermore, recent acquisitions have further strengthened the foothold of the company in the cloud segment. After the recent resurgence, I decided to see if the stock can carry on its momentum. I developed a model to value the stock, and the results were quite encouraging. Let's discuss the model first and then the results.
Like any other financial model, there are certain assumptions about the revenue growth, cost structure and capital structure of the company. In my ProForma earnings estimate, I have assumed a declining revenue growth rate for Cisco . Cisco has been posting impressive revenue growth figures, despite a decline in the growth rates for the industry. The market is optimistic about the revenue growth of the company due to the lucrative cloud market. At the moment, the market expects Cisco to grow its earnings at about 11% for the next five years. However, I have taken a more conservative view and assumed a growth rate of 9% for the first four years, and 2.5% constant growth rate after the fourth year.
Currently, Cisco's cost of revenue is around 39% of the sales. For my model, I have kept cost of revenues at 39%. Furthermore, I have assumed year-over-year increase of 3% in operating expenses. At the moment, tax rate for Cisco stands at about 21%, which have been used to calculate the tax liability for my model.
Cost of Revenue %
Cost of Revenue
Other Income (Expense)
Income before income taxes
Provision for Income Taxes
According to my earnings estimate, Cisco should be able to maintain healthy margins. I expect the company to post EPS of $2.58 by the end of 2017. Cisco should be able to maintain healthy growth after the valuation period.
For the valuation purposes, I have assumed a discount rate of 9%. Cisco has a strong history of revenue growth, healthy cash reserves and immensely strong business model. Taking into account the strong position of the company, I believe a discount rate of 9% is justified.
Present Value Factors
Terminal year Value @2.5% constant growth
Discounted Terminal Value
There are two conventional methods to calculate the terminal year value; multiple of terminal year earnings and a constant growth model. I have used the latter, and assumed a 2.5% constant growth rate after the high growth period of four years. I believe Cisco will be able to generate impressive growth figures after the high growth period. Furthermore, the terminal year earnings of $2.58 are discounted using the single stage growth model, where the earnings are first adjusted for constant growth and then discounted by the discount rate of 9%. The single stage growth model also adjusts discount rate for growth by deducting the terminal growth rate from the discount rate. Once the terminal year value is calculated; it is then discounted to reach at the present value. On the other hand, earnings before the terminal year are simply discounted to reach at the present value. Finally, the discounted earnings are added to the discounted terminal value to reach at the true value/fair value of the stock. According to my valuation model, Cisco should trade at $27.57. The stock is currently trading at a significant discount to its fair value. I expect the stock to keep its steady rise to the fair value.
Comparison with Peers
Debt to Equity
Cisco is trading at attractive price multiples at the moment. The stock is trading at a discount compared to its competitors. Furthermore, the company has strong margins and improving profitability.
Cisco Systems is one of the biggest players in the market. The company has massive presence in the market and a great network of clients. Furthermore, Cisco's recent foray in the cloud market is sure to bring substantial revenue and cash flows to the company. I believe the stock will continue its rise during 2013 and reach $27 mark. At current price levels, this will represent a gain of about 32%. In addition, the company pays an attractive dividend. There are a few stocks that provide such growth opportunity with a chance to collect income. I believe Cisco can be a great long-term investment at current price levels.