In an earlier article we discussed BlackBerry (BBRY), Cisco Systems (CSCO), Ericsson Telephone Company (ERIC), Qualcomm (QCOM) and Motorola Solutions (MSI). Looking at the market fundamentals and base expectations on future investments of these companies, we found out that Cisco Systems was the best bet. In addition, the same story was told about this leading company - much more favorably positioned as compared with some other of its competitors, such as Alcatel-Lucent (ALU) and Juniper (JNPR).
Time has passed. Which changes did the time bring to the communication equipment industry and its main players?
Today we will compare Cisco Systems to its direct competitors in the industry: Nokia (NOK) and Ericsson Telephone Company. As people increasingly prefer smartphones because of the availability of cheap Android options in the market, will these three communications companies be able to sustain profitability in their operations in the long run? Let us find out the results of the sets of valuations prepared for these companies.
Deep Finance Expertise
The investment valuation on Nokia, Cisco and Ericsson will be based on the pricing model, which is prepared in a very simple and easy way to value a company for business valuation purposes. This valuation adopts the investment style of Benjamin Graham, the father of value investing.
My basis of valuation is the company's last five years of financial records - the balance sheet, income statement and cash flow statement. In my valuation, first I will calculate the discounted cash flow, enterprise value and the margin of safety. The relative method was considered as well. Now, let us walk step by step.
1. Discounted Cash Flow Analysis
Today, I am going to share with you the discounted cash flow analysis based upon the five-year historical financial data of NOK, CSCO and ERIC to arrive at the projected cash inflows. The discounted cash flow is one way to decide if the investment is worthwhile. It is the expected cash that the company can generate. It does not predict the future, but it uses the historical data to project a future financial picture so that readers may understand the parameters that are not easily understood without using a spreadsheet. The table below is the summary I gathered from the spreadsheet.
The capitalization rate that was used was 15% and the return on investment for NOK that was used was the forward P/E. For CSCO and ERIC, I used the median rate. In addition, the price to earnings I have used was the median. On the other hand, the rate used was the ROI less the percentage of dividends.
Going forward, the calculated present value of the equity was 1.59, 10.70 and 6.47 USD per share, at a rate of 21.22%, 13.49% and 3.84% from NOK, CSCO and ERIC, respectively. Its future value was 3.43, 17.75 and 7.52 USD per share and that is a 116%, 66% and 16% increase for NOK, CSCO and ERIC, respectively. The future value is equal to the present value. This means having a choice of taking the amount of $1.59, $10.70 and $6.47 per share today or wait for the 5 time periods to have $3.43, $17.75 and $7.52 per share. If you take the present value today, you will have a chance to reinvest the money with the same rate over equal time periods and will end up having more than the present value.
Now, let us walk further and see what's up for net income. The present value of the net income was $1.7, $6.6 billion and $932 million for NOK, CSCO and ERIC, respectively. Furthermore, the fifth year income per share was $1.07, $3 and $0.58 with a value of $4, $15 and $1.9 billion for NOK, CSCO and ERIC, respectively.
2. The Enterprise Value Approach
The enterprise value is the present value of the entire company. It measures the value of the productive assets that produced its product or services, and both the equity capital (market capitalization) and debt capital. Market capitalization is the total value of the company's equity shares. In essence, it is a company's theoretical takeover price because the buyer would have to buy all of the stock and pay off the existing debt, pocketing any remaining cash. This gives the buyer solid ground for making an offer.
The market capitalization for NOK deteriorated at a rate of 81% from 2008, while CSCO has had an erratic movement in its market capitalization. In addition, ERIC's was stable at an average of $33 billion since 2008. The takeover values of the entire companies of NOK, CSCO and ERIC to date of this writing were $32.5, $79 and $30.8 billion at a per share price of $8.76, $14.70 and $9.50, respectively. Moreover, the total debt was lesser than the cash and cash equivalents, therefore buying the entire business would result in paying 100% of their equity with zero debt.
2. The Net Current Asset Value Approach
Benjamin Graham's Net Current Asset Value (NCAV) method is well known in the value investing community. Graham was looking for firms trading so cheaply that there was little danger of the stock prices falling further. The object of this method is to identify stocks trading at a discount to the company's Net Current Asset Value per Share, specifically at two-thirds or 66% of net current asset value.
The formula for the net current asset value was: NCAV = Current Assets - Current Liabilities. It shows that the stock prices of NOK, CSCO and ERIC were overvalued because the stocks were trading above the liquidation value of the companies. The 66% ratio represents only 24%, 21% and 30% of the market price, and, therefore, the stock has not passed the stock test of Benjamin Graham.
3. Benjamin Graham's Margin of Safety
The Margin of Safety is the difference between a company's value and its price. Value investing is based on the assumption that two values are attached to all companies - the market price and the company's business value or true value. Graham called it the intrinsic value. Value investing is buying with a sufficient margin of safety.
The question is, how large of a margin of safety is needed to be considered sufficient? Graham considers buying when the market price is considerably lower, a minimum of 40% than the real or true value of the stock. (click to enlarge)
Let us find out the average margin of safety for NOK, CSCO and ERIC. Remember the historical data, which were gathered for each company as we take into consideration the prior period's performance. NOK, CSCO and ERIC each have a sufficient margin of safety, and, therefore, their stocks are good candidates for buying because the stock passed the requirement of Benjamin Graham of being 40% below the true value of the stock.
Going forward, let me show you the formula for the intrinsic value or the true value of the stock, as it factors into the calculations for the margin of safety.
The formula for intrinsic value is:
Intrinsic Value = EPS * (9 + 2G)
The explanation of the calculation of intrinsic value is as follows:
EPS -- the company's last 12-month earnings per share;
G -- the company's long-term (five years) sustainable growth estimate;
9 -- the constant which represents the appropriate P/E ratio for a no-growth company as proposed by Graham (Graham proposed an 8.5, but I changed it to 9);
2 -- the average yield of high-grade corporate bonds.
The sustainable growth rate (SGR) shows how fast a company can grow using internally generated assets without issuing additional debt or equity, while the return on equity shows how many dollars of earnings result from each dollar of equity.
As shown above, NOK has negative growth because its earnings for the last three periods were negative, while CSCO and ERIC have a 17% and 2% sustainable growth rate, respectively. This is how fast a company can grow using internally generated assets - without using debt or equity. Furthermore, CSCO has a higher annual growth rate and ROE compared to ERIC. However, the payout ratio of ERIC was at a 79% average compared to CSCO's 9%. During 2009, the payout ratio of ERIC was high at 162%. Furthermore, the net margin of CSCO was 18%, compared to ERIC's 4% net margin.
4. Relative Valuation Method
The Relative Valuation method for valuing a stock is to compare market values of the stock to the fundamentals (earnings, book value, growth multiples, cash flow, and other metrics) of the stock.
(click to enlarge)
The Price to Earnings/Earnings Per Share (P/E*EPS) will determine whether the stock is undervalued or overvalued by multiplying the P/E ratio by the company's relative EPS and then comparing it to the enterprise value per share. The table above shows that the P/E*EPS ratio was 76, 84 and 46 percent of the price, for APC, APA and CHK, respectively. Thus, it tells us that the stock price was overvalued because the price was higher than the ratios.
On the other hand, the EV/EPS valuation is used to separate price and earnings in the enterprise value. Dividing the enterprise value by projected earnings results in the price (P/E) and the difference represents the earnings.
The relative valuation tells us that the stock price was overvalued for NOK and undervalued for CSCO and ERIC. Moreover, the EV/EBITDA tells us that it will take 10, 8 and 8 times of the cash earnings of NOK, CSCO and ERIC, respectively, to recover the costs of buying the entire business of each company. In other words, it will take 10, 8 and 8 years to recover the costs of buying.
Overall, it indicates that the stock of NOK was overvalued, while the shares of CSCO and ERIC were undervalued. In addition, although ERIC has a high payout ratio, CSCO's growth rate was better and has a good P/E. Therefore, I recommend a HOLD on the stock of both NOK and ERIC, whereas a BUY - on the stock of Cisco.