- Cisco trades at a fraction of its all time high. History tells us it was mis-priced then, is it mis-priced now?
- We look at Cisco the company, as opposed to its price action, and consider whether it is a good company, trading at a fair price.
- We consider Cisco's value to determine whether it is currently priced to deliver alpha.
In its glory days, Cisco (NASDAQ:CSCO) was a darling of the market, trading at a price over three times its current market price. Hindsight tells us that the stock was mispriced then. That was then, this is now. Does foresight tell us that Cisco remains mispriced today?
Let's have a look at Cisco the company, instead of its price.
We know that Cisco's revenue has grown from near $15 billion in 2000 to $47.87 billion today. Revenue has increased over three-fold over the past 14 years: that increase of 219% works out to an 8.64% annualized growth rate. I would not call that bad.
Diluted earnings have increased over four-fold from below $0.50 to $1.569 today. That increase of 309% represents an annualized rate of growth of 10.59%. Again, that is not what I would call shoddy.
Diluted Shares Outstanding
Some of that earnings growth has come about as a result of aggressive value return to owners through buybacks. Diluted share count has declined from near 7.5 billion to 5.38 billion. This annualized decline of 2.29% represents value returned to owners. Add it to your dividend yield to determine the total value returned to owners. The bad news is that part of the growth in per share earnings comes about not because the company is growing, but because the number of owners is falling. But an adjusted earnings growth rate of 8.3% (10.59% per share growth less 2.29% caused by decline in diluted share count), is pretty neat too. And the net growth in earnings is consistent with revenue growth rates, indicating that margins have been maintained while sales growth slowed.
CSCO Average Diluted Shares Outstanding (Annual) data by YCharts
CSCO Average Diluted Shares Outstanding (Annual) data by YCharts
Cisco is a baby as far as dividend payment is concerned. Yet the growth in dividends tells us that the baby is growing up fast, strong and healthy. The total value returned via dividends and buybacks yields, assuming buybacks, net of dilution continue to run at 2.29%, is very attractive at 5.81%.
How do different market participants view Cisco?
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better. The model output for Cisco can be viewed here. This quantitative analysis of investor behavior suggests that the market is neutral on Cisco. The valuation is attractive as is the return quality, while the stock scores weakly on growth and momentum. Value investors allocating capital, using a sector or industry allocation strategy like this stock. All other investor stock selection and capital allocation style combinations remain neutral.
Why look at Cisco now?
The Case for Cisco:
Firstly, Cisco is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, the stock has a low beta. This adds to the defensive characteristics and protects downside during weak markets. Thirdly, following the recent hike in dividend to $0.19 per quarter, the stock delivers a generous yield of 3.52%, which is a premium to the market yield. This too adds defensive characteristics to the stock. Finally, Cisco as recently priced includes potential alpha. Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. When a low beta stock includes potential alpha, downside protection is provided by the low beta, while upside total return potential is not compromised, because we earn returns from alpha in addition to the lower upside beta driven gains associated with low beta stocks.
However, I believe that we are now either in, or fast approaching the late or mature phase stage of the economic expansion. As I mentioned in a recent post, during such periods, the technology sector has displayed a historic tendency toward under-performance: it might make sense to wait. Having said that, this time might be different - the technology valuations outside a small band of internet based companies are quite reasonable.
Analyst price expectations
Recently Cisco traded at $21.57. From Yahoo Finance we know that thirty-three analysts expect an average price target of $23.71 (median $24.50), with a high target of $30 and a low target of $16. This is a pretty wide dispersion in expectations. The wide dispersion in high and low price estimates suggests that the risk is somewhat high. However, so far, neither the bulls, looking for $30, or bears looking for $16, have the upper hand. Which shall it be?
We might believe that Cisco is attractive. But thus far its attractiveness has been viewed relative to other stocks in its sector, industry, or the coverage universe. We do not know whether the stock is priced to deliver a long-term return in-line with our expectations.
Mathematically, the worth of Cisco is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.05, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? This beta of 1.05 differs from the beta you will see in other places because it is based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one. You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Cisco, we should be targeting a long-term return of 10.5375%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. I will work with $1.569 (the trailing twelve month diluted earnings) as a reasonable estimate of sustainable earnings.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect Cisco will pay out approximately 55% of earnings via dividends and buybacks over the long-term. This 55% estimated adjusted payout ratio implies a return on incremental equity invested of 17.8%. Over the past five years between 2009 and 2013, return on equity has ranged from a low of 15.9%, to a high of 19.5%, with a standard deviation of 1.44%, an average of 18.08%, and a median of 18.40%. Thus 17.8% is a fairly conservative estimate of what Cisco can be expected to generate over the course of a typical economic cycle.
If we use a very long-term growth expectation of 6.23%, Cisco is worth $21.27. Cisco Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.23% * $1.57 * 55% / (10.5375%-6.23%) = $21.27. At this price it is likely that an investor with a return expectation of 10.5375% will be satisfied.
The growth estimate implied by the current market price of 6.23% is low. In my view, Cisco can be expected to grow at a faster rate: an 8% growth rate in line with potential real Global GDP growth of 4.2% and global inflation of 3.8% should be achievable. In recent times, Cisco's earnings have grown earnings at long-term annualized rates of 8.30%: 10.59% per earnings per share growth, less the 2.29% of per share growth which was driven by buybacks net of dilution. In order to not wander to far from consensus I will go with Reuters' consensus long-term growth estimates of 7.58%. The spread between the 6.23% growth priced by markets, and a 7.58% growth expectation, is 1.35%: this represents potential long-term alpha. Alpha is the difference between actual returns and the risk adjusted return expectation. Since we have a risk adjusted return expectation of 10.5375% for Cisco, a long-term investor targeting a risk adjusted return of 10.5375% will end up earning a return of 11.8875%.
Now 1.35% alpha might seem like a small number, but remember, over the course of a 50-year working life, $1,000 invested for an annualized return of 10.5375%, gives you near $150k. With the 1.35% alpha, it delivers near $275k. It often pays to buy good companies trading at a good price.
An investor with a shorter time horizon might do quite well too. A price target of $30 implies confidence in long-term earnings growth rising to 7.45% from 6.23% at present. And a 7.45% long-term growth rate expectation remains well below my expectations of 8%, and below analysis consensus of 7.58%. Cisco Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 107.45% * $1.57 * 55% / (10.5375%-7.45%) = $30.
The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.
If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations and the equity risk premium. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted pay-out assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stock's beta and stock return expectations.
There is a high degree of inter-connectivity between beta, growth, adjusted pay-out ratios, risk free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas which I hope will help.
1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is long-term return expectation minus long-term growth rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations, and higher for stocks where the confidence in growth is low. In the very-long term, the growth risk premium has tended toward 4.5% for the market.
2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings
3. When you look at long-term growth rates, remember it is not the next years' growth or the next five years growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rates for some years, reversion to market growth rates, and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five year forward rate, and then assume growth shall revert to being in-line with market growth expectations for the following 45 years. What this signals is that I'm willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].
4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the payout ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long-term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk and this implies a higher beta, and a higher market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.