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Cisco Systems (NASDAQ:CSCO), the fallen star of the techno-bubble show, is among the most widely followed stocks in the market. As a company, Cisco is in a variety of businesses, with the primary concentration in the designing and marketing of consumer electronics, networking, voice, communications technology and services. The business is pretty profitable, but the stock has been going south for almost a year. As of the June 10 close, Cisco was trading at $15.10, which makes it a cheap deal. Cisco sports a market cap of $82.1 billion, a ttm [trailing twelve month] P/E ratio of 11.9, and a forward P/E ratio of 8.7. The company has a 5-star rating from Morningstar.

What is the fair value of Cisco given the forecast estimates? Let's calculate it together, using a discounted earnings plus equity model.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs.

The methodology is based on discounting the present value of future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. The entire complexity of stock metrics is reduced to just three parameters. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Cisco's Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of $1.27 along with the mean estimate of $1.73 for the next year.

E0 = EPS = (1.27 + 1.73) / 2 = $1.50

Wall Street holds diversified opinions on Cisco's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five year growth forecast is 10.2%.

The rest is as follows:

V0

E0

$1.50

V1

E0 (1+g)/(1+r)

$1.49

V2

E0((1+g)/(1+r))2

$1.48

V3

E0((1+g)/(1+r))3

$1.47

V4

E0((1+g)/(1+r))4

$1.46

V5

E0((1+g)/(1+r))5

$1.45

D

E0(1+g)5/[r(1+r)5]

$14.18

BV

Equals

$8.36

Fair Value

Equals

$23.02

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. According to my 5 year, discounted-earnings-plus-book-value model, the fair value estimate for Cisco is $23.02 per share. As of June 10, Cisco was trading at a dirt-cheap price of $15.10. Cisco is undervalued by almost $8. While I do not expect this gap to be closed by this year, I think Cisco will beat market returns for the next five years.

O – Metrix Confirmation

If the math above looks too complicated for you, try estimating the fair value using the O-Metrix as such:

O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5

Dividend Yield: Higher is better.
EPS Growth: Higher is better.
P/E Ratio: Lower is better.

I multiplied the original formula mentioned by Jeremy Siegel by 5 to get a scale over 10. The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as five years. I am also continuously checking on specific sectors, and the formula works very well so far.

What is the O-Metrix Score for Cisco?

  • Cisco offers a dividend yield of 1.59%. That is a bonus for shareholders.

  • Growth estimate is the same as discounted earnings model, and is equal to 10.2%.

  • Since we are at the middle of the year, taking the average of ttm [11.9] and forward [8.7] P/E ratios will smooth the results. Thus, average P/E ratio to be used in the model is 10.3.

O-Metrix = [(1.59 + 10.2) / (10.3)] * 5 = 5.7

As of June 10, the average trailing P/E ratio of stocks tracked by finviz is 15.97, while the forward P/E ratio is 12.07. The EPS growth estimate for the next five years is 12.18%, and yield is 1.91%. The average market O-Metrix score is calculated as follows:

Market O-Metrix = [(1.91 + 12.18)/14.02]*5 = 5

Cisco has an O-Metrix score that is significantly higher than the market average. Back-testing of this ranking system shows that companies with higher-than-average O-Metrix scores beat the market with lower volatility. With a positive dividend yield, Cisco is almost in the B-Grade, above-average return zone.

Click to enlarge:

Summary

As of the June 10 close, Cisco was trading at $15.11 which is almost 35% lower than my fair value estimate. The model suggests a fair price of $23, implying upside potential of 50%. While I do not expect this gap to be closed in a short period of time, I think Cisco will beat general market returns by a large margin. If the analyst estimates hold, returns of above 15% are easily attainable. Cisco has been going down since last year, and recently broke a strong support point. However, sooner or later the market will appreciate Cisco's fair value. While that may not happen tomorrow, for the long-term, Cisco has great market-beating potential. Analysts also agree with me. The mean intermediate target price estimate is $21, implying significant upside potential.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Cisco Has 50% Upside Potential