In an earlier article we discussed Cisco Systems (NASDAQ:CSCO), Nokia (NYSE:NOK) and Ericsson Telephone Company (NASDAQ:ERIC). Looking at the market fundamentals and base expectations on future investments of these companies, we found out that Cisco Systems was the best bet.
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 other peers in the industry: BlackBerry (NASDAQ:BBRY) And Qualcomm (NASDAQ:QCOM).
Concerning the Investment valuation for these three companies, the margin of safety was more than 50%, which is above the requirement of Benjamin Graham of at least 40-50% below the true value of the stock. Let us find out which stock among these three companies is the best candidate for a Buy. The historical net earnings of CSCO have remained stable from 2008, up to the trailing 12 months at an average of 18%. On the other hand, BBRY reported an 8% average net earnings due to a recent drop of 280% from 2011. Moreover, the net earnings of QCOM seems favorable at a 30% average, although the figures were erratic.
Deep Finance Expertise
The investment valuation for BBRY, CISCO and QCOM will be based upon 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.
The essence of Graham's Value Investing is that any investment should be worth substantially more than an investor has to pay for it. He believed in thorough analysis, which we call fundamental analysis. He looks for companies with a strong balance sheet or those with little debt, above-average profit margins and ample cash flow. His method seeks out undervalued companies whose stock prices are temporarily down, but whose fundamentals are sound in the long run. His philosophy was to buy wisely when prices fall and to sell wisely when the prices rise sharply.
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, I will calculate the discounted cash flow, enterprise value and the margin of safety. The relative method will be 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, which is based upon the five-year historical financial data of BBRY, CSCO and QCOM, to arrive at the projected cash inflows. The discounted cash flow is one way to determine 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.
(click to enlarge)
The capitalization rate that was used was 15% for the three companies. Furthermore, the return on investment that was used for BBRY and CSCO was the median ROI, while with QCOM I used the average ROI. With regards to P/E, the average was used for the three communication companies. On the other hand, the rate was computed at ROI less the average percentage of dividends from 2008.
Going forward, the calculated present value of the equity is $8.8, $57.8 and $53.1 billion at a rate of $16.82, $10.7 and $30.52 per share for BBRY, CSCO and QCOM, respectively. Furthermore, the future value of equity is $27, $100.8 and $37.6 billion at a rate of $51.56, $18.66 and $30.52 per share for BBRY, CSCO and QCOM, respectively. The future value is equal to the present value and this means having a choice of taking the amount of the present value or waiting for the 5 time periods to attain the future value. 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 continue and see what's up for net income. The present value of the net income was $4.3, $7.96 and $3.96 billion for BBRY, CSCO and QCOM, respectively. Furthermore, the fifth year income was $8.7, $16 and $7.97 billion with a share price of $16.66, $2.96 and $4.58 per share, for BBRY, CSCO and QCOM, respectively.
2. The Enterprise Value Approach
The concept of enterprise value is to calculate what it would cost to purchase an entire business. 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 a 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 grounds for making an offer.
The formula for Enterprise Value:
Enterprise Value = Market Capitalization + Total Debt - (Cash and Cash Equivalent + Short Term Investment)
Note: Market Capitalization = Market Price x Number of shares outstanding
Total Debt = Market value of Short Term Debt + Market value of Long Term Debt
In my spreadsheet, the market capitalization of BBRY and QCOM has moved erratically at a rate of average -3 and 14 %, respectively. The market capitalization of CSCO has increased by a 6% average from 2008. However, in 2011 it experienced a decrease of 13%.
The takeover prices for each entire business to date of this writing were $5.3, $83 and $99 billion at $10.2, $21.27 and $56.67 per share for BBRY,CSCO and QCOM, respectively. The share price to date was $15.25, $21.27 and $65.32 per share for BBRY, CSCO and QCOM, respectively.
Furthermore, BBRY and QCOM have zero total debt, while CSCO has 16%. However, CSCO's cash and cash equivalents are greater. Purchasing the entire business for any of these companies would mean that the investor would be paying 100% of the equity.
3. Benjamin Graham's Margin of Safety
The basic meaning of "Margin of Safety" is that investors should only purchase a security when it is available at a discount to its underlying intrinsic value - what the business would be worth if it were sold today. The key point for investors to remember is that they should only invest in a company when its stock is trading below what the firm would sell for in the open market. Those investors who ignore valuation concerns and overpay for their investments are operating with a zero margin of safety. Even if their underlying companies do well, these investors can still get burned, according to many passionate followers of Graham.
I will share with you the formula for the margin of safety and the intrinsic value:
Margin of Safety = Enterprise Value - Intrinsic Value
Intrinsic Value = Current Earnings x (9 + 2 x Sustainable Growth Rate)
Expected Annual Growth Rate = Long Term Growth Rate or G
The Intrinsic Value factors the current earnings and the growth of the company. The formula is used to identify the difference between the company's value and its price.
Before considering buying any stock, I advise you to dig a little deeper and study the results of these calculations. I will guide you step by step. The table will show us the results of the calculations.
(click to enlarge)
There was a sufficient margin of safety for each of the three companies - meeting the requirement of Benjamin Graham, which means the stock prices were 40-50% below the true value of the stocks. Therefore BBRY, CSCO and QCOM are good candidates for a Buy.
Moving forward, in line with the calculation of the margin of safety is the growth of the companies. The margin of safety factors the intrinsic value and the intrinsic value factors the earnings per share [EPS], the sustainable growth rate [SGR] plus the annual growth rate. The sustainable growth rate factors the return on equity [ROE] and the payout ratio. Thus, the computation for the margin of safety includes many important factors.
The table below will show us the results of the calculations for growth. Let us walk through the table.
The three companies have nearly the same growth rate. BBRY has a zero percent payout ratio because the company is not paying dividends to its shareholders, while QCOM has the highest payout ratio at a rate of 39%. The net margins were 8, 18 and 30% for BBRY, CSCO and QCOM, respectively.
In addition, the sustainable growth rate 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.
4. Solvency Ratio
This ratio is used to gain insights into the long-term health of a business. The Solvency Ratio is a tool with which an investor can measure a company's ability to meet its long-term obligations. The solvency ratio measures the size of a company's after-tax income, excluding non-cash depreciation expenses, as compared to the firm's total debt obligations. It provides a measurement of how likely a company will be to continue meeting its long-term debt obligations.
Liquidity Ratios are used to determine a company's ability to meet its short-term debt obligations. A company that is consistently having trouble meeting its short-term debt obligations is at a higher risk for bankruptcy. Liquidity ratios are a good measure of whether a company will be able to comfortably continue as a going concern.
BBRY has no total debt, and thus the solvency ratio was not applicable, while QCOM had only short-term debt during 2010 and 2011. QCOM has a satisfactory solvency ratio, which indicates that the company has the capability of meeting its long-term obligations. Moreover, the liquidity ratios also show satisfactory results for BBRY, CSCO and QCOM. Therefore, it indicates that the three companies have the capability of meeting their short-term financial obligations as well.
5. Relative Valuation Methods
The Relative Valuation Methods 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.
Under the relative valuation, we will use the Price to Earning - Earning Per Share (P/E*EPS) valuation. This valuation divides a company's enterprise value per share by its projected earnings per share. The concept is to determine whether a stock is under 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 below is the summary of the results of the calculations.
(click to enlarge)
It tells us that the stock prices for BBRY and CSCO were undervalued because their market prices were less than the P/E*PS ratios. Furthermore, the stock price of QCOM was fair valued because the market price and the P/E*EPS ratio are the same.
The EBITDA/EV was 17, 14 and 7% for BBRY, CSCO and QCOM, respectively. The EV/EBITDA tells us that it will take 6, 7 and 15 times the cash earnings of the company to recover the costs of purchasing each entire business of BBRY, CSCO and QCOM, respectively. In other words, it will take 6, 7 and 15 years to recover the costs of buying each of their entire businesses.
Make or Break for Investors?
Overall, the stock prices of both BBRY and CSCO are undervalued, while the stock price of QCOM is fair valued. Moreover, the return on equity and the earning per share showed favorable results for the three companies. However, BBRY does not pay a cash dividends to its shareholders, while QCOM has a 39 % payout ratio and CSCO has a 9% payout ratio. Moreover, buying the entire businesses of any company requires paying 100% of its equity and no debt. Therefore, I recommend a BUY on the stock of BBRY, CSCO and QCOM.
I believe the best bet in this selection is Cisco Systems.