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One of the key tenets of the "12 Most Important Steps To Understand The Stock Market" is that investors should strive to calculate the intrinsic value of a company based on its future free cash flow stream. In this vein, let's dig into what we estimate Cisco (NASDAQ:CSCO) is worth.

Our Report on Cisco

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Investment Considerations

Investment Highlights

  • Cisco's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
  • Cisco's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.
  • Cisco has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 22.4% in coming years. Total debt to EBITDA was 1.3 last year, while debt-to-book capitalization stood at 24.1%.
  • The firm's shares have underperformed the market benchmark during the past quarter. Although Cisco's valuation appears attractive, the company is currently exhibiting characteristics of a potential value trap, and we'd still be cautious at these levels. There may be a better entry point yet.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Cisco's three-year historical return on invested capital (without goodwill) is 59.5%, which is above the estimate of its cost of capital of 10.9%. As such, we assign the firm a ValueCreation™ rating of Excellent. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Cisco's free cash flow margin has averaged about 22% during the past three years. As such, we think the firm's cash flow generation is relatively strong. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At Cisco, cash flow from operations increased about 13% from levels registered two years ago, while capital expenditures expanded about 12% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Cisco's shares are worth between $22.00 and $32.00 each. The margin of safety around our fair value estimate is driven by the firm's Low ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $27 per share represents a price-to-earnings (P/E) ratio of about 18.1 times last year's earnings and an implied EV/EBITDA multiple of about 8.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.5% during the next five years, a pace that is lower than the firm's three-year historical compound annual growth rate of 8.4%. Our model reflects a five-year projected average operating margin of 26.1%, which is above Cisco's trailing three-year average. Beyond year five, we assume free cash flow will grow at an annual rate of 0.5% for the next 15 years and 3% in perpetuity. For Cisco, we use a 10.9% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $27 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Cisco. We think the firm is attractive below $22 per share (the green line), but quite expensive above $32 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm in our opinion.

Future Path of Fair Value

We estimate Cisco's fair value at this point in time to be about $27 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Cisco's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in year three represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $35 per share in year three represents our existing fair value per share of $27 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Source: Striving To Understand Cisco's Intrinsic Value