Cisco (NASDAQ:CSCO) shares have been on an impressive, multi-year run since 2011, up over 50% off of their panic lows set in that year. Shares have been boosted by increased IT spending in the enterprise space and in no small measure due to the now-robust dividend of $0.68 per share annually. After the big run, are Cisco shares still cheap? This article will take a look at Cisco's valuation in relation to its prospects and determine whether or not Cisco deserves your capital.
To determine a fair value for CSCO shares, we'll use a DCF-type analysis that requires some assumptions: 1) book value and analyst growth rates from Yahoo! Finance 2) perpetual growth rate of 3.5% (my estimate) 3) dividend growth rate of 10% per annum (my estimate) and finally 4) discount rate of 10% (my estimate). Of course, you may disagree with some or all of my estimates but I used what I believe to be reasonable approximations for Cisco's prospects given available information. Keep in mind that all forecasting is subject to conjecture.
2013 | 2014 | 2015 | 2016 | 2017 | 2018 | ||
Earnings Forecast | |||||||
Reported earnings per share | $1.99 | $2.10 | $2.27 | $2.46 | $2.66 | ||
x(1+Forecasted earnings growth) | 5.50% | 8.27% | 8.27% | 8.27% | 8.27% | ||
Forecasted earnings per share | $1.99 | $2.10 | $2.27 | $2.46 | $2.66 | $2.88 | |
Equity Book Value Forecasts | |||||||
Equity book value at beginning of year | $10.43 | $11.67 | $12.95 | $14.32 | $15.78 | $17.35 | |
Earnings per share | $1.99 | $2.10 | $2.27 | $2.46 | $2.66 | $2.88 | |
-Dividends per share | $0.68 | $0.75 | $0.82 | $0.91 | $1.00 | $1.10 | $1.20 |
Equity book value at end of year | $10.43 | $11.67 | $12.95 | $14.32 | $15.78 | $17.35 | $19.03 |
x Equity cost of capital | 10.00% | 10.00% | 10.00% | 10.00% | 10.00% | 10.00% | |
Normal earnings | $1.17 | $1.29 | $1.43 | $1.58 | $1.74 | $1.90 | |
Forecasted EPS | $1.99 | $2.10 | $2.27 | $2.46 | $2.66 | $2.88 | |
-Normal earnings | $1.17 | $1.29 | $1.43 | $1.58 | $1.74 | $1.90 | |
Abnormal earnings | $0.82 | $0.80 | $0.84 | $0.88 | $0.93 | $0.98 | |
x discount factor (10%) | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 | 0.564 | |
Abnormal earnings disc to present | $0.75 | $0.66 | $0.63 | $0.60 | $0.58 | $0.55 | |
Abnormal earnings in year +6 | $0.55 | ||||||
Assumed long-term growth rate | 3.50% | ||||||
Value of terminal year | $16.37 | ||||||
Estimated share price | |||||||
Sum of discounted AE over horizon | $3.78 | ||||||
+PV of terminal year AE | $9.24 | ||||||
PV of all AE | $13.01 | ||||||
+Current equity book value | $10.43 | ||||||
Estimated Current share price | $23.44 |
Given my model's inputs, Cisco has an approximate fair value of $23.44 today. With shares trading at $20.65 as of this writing, shares are trading at a nearly 14% discount to my fair value estimate. It is important at this point to understand what the fair value estimate means. The model's output is a price at which, given the parameters specified, shares can be bought at a "good price" today. The estimated fair value is the net present value of the company's cash flows plus its current book value. Therefore, the fair value of the business today, according to my estimates, is about 14% higher than where shares are trading.
There could be many reasons for this discrepancy. For instance, indices are near major highs, CSCO shares have risen sharply in the past 18 months, fears about IT spending going forward and others are all valid risks for the stock. However, with a 14% estimated cushion, some of these fears are surely priced in already. In addition, it is important to note that $23.44 is not a nominal price target; rather, it is the net present value of all the company's estimated future earnings and current book value. Given CSCO's current forward PE of 9.8, if CSCO hits $2.88 in earnings per share in 2018, a price of greater than $28 is implied with no multiple expansion.
In addition, my model is forecasting that over this same period, shareholders will receive something like $5.78 per share in cash dividends, or 28% of the current share price. This offers huge downside protection in the shares and sizable current income as well.
There are risks, of course, to my estimates. First, CSCO may not hit 8% earnings growth each year. If that does not happen, there is potentially significant downside risk to my fair value. For instance, if only 3% earnings growth is achieved, the fair value decreases to about $19, implying CSCO is slightly overvalued. However, given the fact that shares are very attractively priced with a reasonable 10% discount rate and the enormous amount of dividends that are due shareholders in the coming years, I believe the margin of safety is large enough to warrant taking the risk at this point. Also remember that this analysis assumes no share repurchases and CSCO is seemingly perpetually engaged in buybacks so that could be an additional tailwind for EPS in the future. I consider the $1.50 per share fall in CSCO stock from its recent highs to be a meaningful enough pullback for investors to consider a long position or add to an existing position. The combination of share repurchases, dividends, earnings growth and current cheap valuation means Cisco shares have a large enough margin of safety to mitigate future earnings risk.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CSCO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.