"One major criticism that we always hear about value investing is 'what's your risk management, how do you know when you're wrong'? Well, a great value investor gives himself a margin of safety, in other words you don't have to know how much a fat person weighs to realize they're overweight. Like John Keynes said 'It is better to be roughly right than precisely wrong.' If you come to a conclusion that a $100 stock is trading at $65, even if you're overestimating the stock's value by 25%, at $81.25 there is still plenty of room for the stock to appreciate to $100." -- The Irrelevant Investor
The discounted cash-flow (DCF) process is one of the most informative paths to understanding intrinsic value. Contrary to popular criticism of the DCF, the goal of making forecasts in a DCF model is not to seek precision with every future assumption in the model (the future will always be unpredictable to a degree). Instead, the goal of the DCF is to arrive at reasonable and supportable forward-looking projections in order to derive a cash-flow-based intrinsic value estimate of the company. The process has little to do with exactitude, and almost everything to do with identifying valuation outliers. It's not as important that an investor know whether a firm is worth exactly $29, $30 or $31 per share as it is for that investor to understand that its stock is cheap if it is trading at, for example, $20 per share.
For every firm in our coverage universe, we apply a complete three-stage free cash flow to the firm (enterprise cash flow) valuation model, which generates an estimate of a company's equity value per share based on its discounted future free cash flows and the company's net balance sheet impact, including other adjustments to equity value (namely pension and OPEB adjustments). Our ValueRisk rating, which considers the underlying uncertainty of the capacity of the firm to continue to generate value for shareholders, sets the margin of safety bands around this fair value estimate. For firms that are trading below the lower bound of our margin of safety band, we consider these companies undervalued based on the discounted cash-flow process. For firms that are trading above the higher bound of our margin of safety band, we consider these companies overvalued based on our discounted cash-flow process. The DCF process and the application together represent the first pillar (the Valuentum Value Rating) of the three-pillar Valuentum Buying Index.
Cisco (NASDAQ:CSCO) is a firm that is trading near the low end of its fair value range (at about $25 per share), and one that we think is 'undervalued' on the basis of its risk-adjusted price-to-fair value ratio. Please be sure to view its 16-page report and dividend report by accessing its landing page here.
The communication networking giant recently reported better-than-feared fiscal third-quarter results. On a GAAP basis, revenue, net income and earnings-per-share declined across the board, but the firm held the line on non-GAAP earnings per share, exceeding the consensus estimate. Part of the better-than-expected performance came from the company's non-GAAP gross margin, which came in at 62.7% in the quarter relative to management's target of 61%-62%. Cisco ended the quarter with $50.5 billion in cash and cash equivalents and just $20.4 billion in long-term debt, revealing significant financial flexibility to keep raising its dividend or buying back stock (which we consider cheap). The firm generated an impressive $3.2 billion in cash from operations during the quarter, paving the way for significant free cash flow generation. During the first nine months of its fiscal year, Cisco has pulled in $8.72 billion in cash from operations compared to just $950 million in capital expenditures, resulting in $7.77 billion in free cash flow. Looking ahead, the company guided fiscal fourth-quarter revenue and non-GAAP earnings slightly better than consensus forecasts.
Given the large weightings in technology in both the Best Ideas portfolio and Dividend Growth portfolio, we don't plan to rush to add the company to either one at this juncture. However, Cisco has a nice 3.3% annual dividend yield and a solid 3+ Valuentum Dividend Cushion score, meaning that its dividend growth potential is strong. With shares trading at just under $25 at the time of this writing and the high end of our fair value range north of $30 per share, the company isn't too expensive for a dividend growth idea. We'd like to keep Cisco in front of members, though we'd grow more comfortable investing in shares once its fundamental revenue and earnings trajectory improves.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.