Cisco: Future Dividend Aristocrat?

Jun. 4.14 | About: Cisco Systems, (CSCO)

Summary

Cisco shares have moved up very steadily in the past two years.

Has the stock moved ahead of fundamentals?

The company's robust dividend is likely to support shares in the future.

Cisco (NASDAQ:CSCO) shares have spent the better part of the last two years heading higher with a minor downtrend late last year temporarily spoiling the fun. Cisco's recent earnings report was a catalyst for sending shares appreciably higher and they are now within striking distance of the highs set last summer. If you're long you love the strong rally but is it time to pull back? We'll take a quick look at Cisco's valuation in this piece to see if it has come too far, too fast.

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To do this, I'll use a model that you can read more about here. In essence, the model uses various inputs such as earnings and dividend projections in order to determine the fair value of shares today. It also provides some clues into the valuation of the company in relation to its future earnings on a nominal basis.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$2.02

$2.04

$2.15

$2.32

$2.49

$2.69

x(1+Forecasted earnings growth)

1.00%

5.40%

7.70%

7.70%

7.70%

7.70%

=Forecasted earnings per share

$2.04

$2.15

$2.32

$2.49

$2.69

$2.89

Equity Book Value Forecasts

Equity book value at beginning of year

$10.90

$12.18

$13.51

$14.94

$16.48

$18.13

Earnings per share

$2.04

$2.15

$2.32

$2.49

$2.69

$2.89

-Dividends per share

$0.76

$0.82

$0.89

$0.96

$1.03

$1.12

=Equity book value at EOY

$10.90

$12.18

$13.51

$14.94

$16.48

$18.13

$19.91

Abnormal earnings

Equity book value at begin of year

$10.90

$12.18

$13.51

$14.94

$16.48

$18.13

x Equity cost of capital

10.10%

10.10%

10.10%

10.10%

10.10%

10.10%

10.10%

=Normal earnings

$1.10

$1.23

$1.36

$1.51

$1.66

$1.83

Forecasted EPS

$2.04

$2.15

$2.32

$2.49

$2.69

$2.89

-Normal earnings

$1.10

$1.23

$1.36

$1.51

$1.66

$1.83

=Abnormal earnings

$0.94

$0.92

$0.95

$0.99

$1.02

$1.06

Valuation

Future abnormal earnings

$0.94

$0.92

$0.95

$0.99

$1.02

$1.06

x discount factor(0.101)

0.908

0.825

0.749

0.681

0.618

0.561

=Abnormal earnings disc to present

$0.85

$0.76

$0.71

$0.67

$0.63

$0.60

Abnormal earnings in year +6

$1.06

Assumed long-term growth rate

3.00%

Value of terminal year

$14.96

Estimated share price

Sum of discounted AE over horizon

$3.63

+PV of terminal year AE

$8.40

=PV of all AE

$12.03

+Current equity book value

$10.90

=Estimated current share price

$22.93

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For this analysis I used earnings estimates from Yahoo! Finance, an assumed dividend growth rate of 8% per year, a perpetual growth rate of 3%, and for the discount rate, I calculated 10.1% using the 10 Year Treasury rate as the risk free rate, Cisco's beta of 1.25 and an equity market premium of 6%. Any one of these inputs is subject to differences of opinion but I've given it a fair shot here.

After all of that we can see the model produces a current fair value of just under $23. With shares trading nearly $2 higher than that right now, my model is suggesting Cisco is overvalued. In fact, I agree with that assertion as we will see now.

If we take a look at analyst earnings estimates to begin, analysts are forecasting nearly 8% profit growth in the out years for Cisco. Think about that for a moment; a business that has struggled to grow for years on end that is in an ultra-competitive market isn't likely to grow profits that quickly. Factor that in with the sheer size of Cisco's business and growing at 8% is a daunting task by itself simply due to the law of large numbers. Finally, Cisco could grow EPS with its gigantic buyback program, but it pays its employees so much with stock that the buyback program can barely keep up with new issuances. In other words, where is this growth coming from?

Cisco has consistently disappointed with growth which is why it pays that robust dividend. Management realized the growth days were over a long time ago and is instead focusing on returning capital to shareholders and themselves via those generous equity compensation plans. With the lack of pricing power and the ultra-competitive nature of Cisco's business, the catalysts for that kind of growth simply don't exist. It takes an enormous amount of money to move the needle for Cisco and it just isn't there.

That doesn't mean all is lost, however. Cisco is a great company that pays a very nice dividend that is more than amply covered by free cash flow each year. Couple that with Cisco's mighty cash hoard and you can be sure shareholders will be enjoying large dividends for years to come. If you need income, you can do much worse than Cisco.

However, those investors wanting capital appreciation should likely look elsewhere. Cisco shares have come too far, too fast to be supported by fundamentals. There is no plausible scenario where Cisco can justify a run at its 52 week high. It certainly doesn't mean it won't happen, but if it does and you're long, make sure you get out the door before everyone else does. Given what I've laid out here and what I think is a realistic expectation for profit growth, I think Cisco is worth perhaps $20 to $22 right now.

The bright side is that dividend. Cisco pays out only a small percentage of its free cash flow in dividends each year and I suspect management will continue to raise it to support the stock price going forward. Earnings could even deteriorate significantly and Cisco would still be able to support the dividend. Thus, I think Cisco is going to hold the coveted title of dividend aristocrat one day. Cisco has all the ingredients; strong, stable cash flow, great products and management that is focused on the future. I wouldn't buy yet but if we see shares dip into the low $20's, you could pick up some of this future dividend aristocrat. Otherwise, you're chasing the stock higher and I think you could get burned.

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.