In an article dated September 21, 2010, I commented that MSFT held a monopolistic position in the field of operating systems with a 90% market share. Well, Cisco (CSCO) is the Microsoft of the networking world holding a commanding 70% market share in Ethernet switching market and 50% market share in the routing market (Source – S&P Equity Research). The company also offers products in advanced technologies such as security, storage area networking, video systems and wireless technologies. In fact, advanced technologies has been a recent focus area for CSCO with a major portion of its R&D spending going towards Cisco TelePresence systems products, physical security, digital media, and the Cisco Unified Computing System.
In this article, I will attempt to determine the fair value of CSCO using discounted cash flow analysis and relative valuation.
As a multinational company, CSCO derives approximately 54% of its revenues from USA and Canada, 20% from Europe, 11% each from Asia Pacific and Emerging Markers, and 4% from Japan. According to the latest available 10-K report, the company had approximately $40 Billion in cash and short term investments, and had approximately $12 Billion in long term debt. Like MSFT, which was pressured by investors and analysts to return excess cash to its investors, John Chambers (CSCO Chairman and CEO) recently announced plans to begin paying a dividend in the range of 1% to 2% before the end of current financial year (July 2011). The exact amount will be dependant on the changes in US government tax policies including the taxes on repatriation of overseas cash holdings.
Although the company currently does not pay a cash dividend, CSCO does have a stock buyback plan in place. During the last 9 years, the company has repurchased $65 Billion worth of stock (Source – WSJ). The company has approximately $7 Billion remaining under the stock repurchase program.
Market Cap = $121.54 Billion
Sales (TTM) = $40.04 Billion
Income (TTM) = $7.76 Billion
Net Profit Margin = 19.4%
LT Debt to Equity ratio = 0.28
Return on Equity (TTM) = 18.7%
Return on Equity (Last 5 Yrs) = 22.04%
Current Ratio = 2.67
TTM EPS = $1.33
Average Analyst 2011 EPS Estimate = $1.73
Average Analyst 2012 EPS Estimate = $1.98
Discounted Cash Flow Valuation (Conservative)
DCF valuation of Cisco was performed by employing a two-stage model with a high growth period of 10 years. The major inputs and the valuation results are presented below. It should be noted that R&D expense was capitalized as part of the analysis.
High Growth Period:
- Bottom-Up Beta for High Growth Period – 1.51
- Risk Premium – 6.5% (adjusted to account for non-US revenues)
- High Growth Rate (Years 1 through 5) – 11% (analysts estimate a 12.5% growth rate)
- Average High Growth Rate (Years 6 through 10) – 6.05%
- WACC during High Growth Period = 11.45%
Stable Growth Period:
- Bottom-Up Beta for Stable Growth Period – 1.2
- Risk Premium – 6%
- Stable Growth Rate – 2.75%
- WACC during Stable Growth Period = 8.38%
Present Value of FCFF in High Growth Period = $63.5 Billion
Present Value of Terminal Price = $69.5 Billion
Value of Operating Assets of the Firm = $133 Billion
Cash, Marketable Securities and Non-Operating Assets = $40.6 Billion
Market Value of Firm = $173.6 Billion
Outstanding Debt = $15.3 Billion
Market Value of Common Stock = $158.3
Market Value of Equity/share = $28.33
The estimated fair value using various relative valuation methods is presented below. It should be noted that the historical data was relied upon to develop the estimated shown below. Adjustments were made to account for outliers present in the dataset.
Existing P/E – 16.39
P/E Estimate – 18.66
Fair Value - $24.81
Existing P/S – 3.1
P/S Estimate – 3.51
Fair Value - $25.14
Existing P/FCF – 13.35
P/FCF Estimate – 14.13
Fair Value - $23.18
(P/E) / (P/E – Peers)
Existing (P/E) / (P/E – Peers) – 0.69
(P/E) / (P/E – Peers) Estimate – 0.83
Fair Value - $26.67
(P/E) / (P/E – S&P 500)
Existing (P/E) / (P/E – S&P 500) – 0.86
Historical (P/E) / (P/E – S&P 500) – 0.99
Fair Value - $25.18
Average Fair Value based on Relative Valuation - $25
Taking an average of fair value estimates from my DCF and relative valuation, the fair value of Cisco is $26.66 a share. As of October 4, 2010, the stock was trading at $21.76 implying a discount of approximately 18%.
The discounted cash flow analysis presented in this article assumed an 11% growth rate which is conservative in my opinion. The company is aiming for a medium term growth rate of 12% to 17% which is achievable considering its ever broadening portfolio of products. The stock is down 9% for the year compared to the 3% gain of the NASDAQ index. Any further decline in CSCO stock price would make it a compelling “buy” in my opinion.
Disclosure: Long MSFT. I plan on opening a position in CSCO if and when it trades below $21/share implying a 20% discount to its fair value. On a side note, following up on the disclosure in my article on MSFT dated September 21, 2010, I did open a position in MSFT yesterday when the stock fell below $24.