Analysts who cover a stock will typically assign a price target-- that is, where they expect the stock to be in the next year or so. How do they come up with these price targets, you ask? I have no idea. And that's the problem. You'll hear things like "Goldman Sachs Raises Price Target On Apple" (AAPL) or "Sirius XM: Citi Pounds The Table, Boosts Price Target" (SIRI). But the reasoning they give typically offers no indication of how they actually arrived at their number.
The price targets on Netflix (NFLX) before the stock crashed are downright comical. If there is one rule that every investor should follow, it is to not trust a price target unless there is a clear, transparent, quantitative calculation backing it up. I use Discounted Cash Flow (DCF) analysis to determine the intrinsic value of a stock. This involves projecting future cash flows and discounting them back to today, taking account of the time value of money. There are other ways to estimate fair value, such as relative valuation methods, but DCF is the most fundamental method to value a company. Of course, projecting anything into the future is wrought with uncertainty, which is why I try to be conservative with my projections.
Cisco worth $60?
A recent article on Cisco (CSCO), which can be viewed here, suggests that Cisco stock could triple to $60 a share without offering any quantitative reasoning behind this number. There seem to be a lot of articles throwing out target prices without any analysis justifying them. Let's put a fair value on Cisco and see if $60 per share is even plausible.
What Does Cisco Do?
From Morningstar:
Cisco Systems is the world's leading supplier of data networking equipment and software. Its products include routers, switches, access equipment, and network-management software that allow data communication among dispersed computer networks. The firm has also entered newer markets, such as video conferencing, web-based collaboration, and data center servers.
Cisco is the market leader in many of these categories, and they are certainly positioned to reap the benefits of increased mobile data in the future.
Financials
Cisco's revenue and free cash flow is presented below:
| 2007 | 2008 | 2009 | 2010 | 2011 | |
| Revenue ($ Mil) | $34,922 | $39,540 | $36,117 | $40,040 | $43,218 |
| Free Cash Flow ($ Mil) | $8,853 | $10,821 | $8,892 | $9,165 | $8,905 |
| FCF Margin % | 25.4% | 27.4% | 24.6% | 22.9% | 20.6% |
| Interest Expense ($ Mil) | $377 | $319 | $346 | $623 | $628 |
| Tax Rate | 22.5% | 21.5% | 20.3% | 17.5% | 17.1% |
| Unlevered FCF ($ Mil) | $9,145 | $11,071 | $9,167 | $9,678 | $9,425 |
| UFCF Margin % | 26.2% | 28.0% | 25.4% | 24.2% | 21.8% |
Revenue grew by 8% from 2010 to 2011 with interest payments representing only 6.7% of the UFCF, which is perfectly sustainable. UFCF margins are strong, ranging from 21.8% to 28% over the last five years. It's clear that Cisco is a very efficient company that generates an enormous amount of cash. Let's take a look at the balance sheet:
| Cash ($ Mil) | $46,742 |
| Debt ($ Mil) | $16,904 |
| Net Cash ($ Mil) | $29,838 |
| Float (Mil) | 5,450 |
| Cash/share | $5.47 |
Cisco has an extremely strong balance sheet, with over $5 per share in net cash. One note is that Cisco recently acquired NDS for $5 billion. The data used is from the most recent quarterly report, so this acquisition is not reflected. However, it would only amount to a $1 per share correction.
Valuation
I use a discounted cash flow analysis to determine the intrinsic value of a stock. I'll assume that revenue will grow at 6% annually for the next 10 years and 3% annually thereafter. For reference, the average analyst estimate puts earnings growing at 8.69% annually over the next five years. I'll set the UFCF margin to 22% and use a discount rate of 15%. This gives me a fair value of $23.75. Here's a list of buy targets for various margins of safety:
| Margin of Safety | Buy Target |
| 10% | $21.38 |
| 15% | $20.19 |
| 20% | $19.00 |
| 25% | $17.81 |
The stock price as of this writing is $20.57, so Cisco is undervalued but not enough for me to open a position. I'll be looking for it to drop below $18 before picking some up. If you're fine with a smaller margin of safety then Cisco is definitely a buy at this price, and it should be able to generate substantial cash flow for a long time.
As a sanity check, I'll compare my fair value estimate to the Trefis estimate. Trefis puts the fair value at $23.37, which is very close to mine. Trefis provides a detailed breakdown of how they value a stock, so using it as a reference is generally a good idea.
Is $60 Out Of The Question?
How fast would Cisco have to grow to be worth $60 per share? Assuming the same UFCF margin and discount rate and a 3% 10+ year growth rate, Cisco would have to grow revenue at 23% annually over the next 10 years. Free cash flow would have to grow by a factor of 8 over the same period. Cisco's market capitalization would be higher than that of Microsoft (MSFT). I don't think anyone could reasonably argue that this is a likely scenario.
Conclusion
The importance of doing your own research cannot be overstated. Blindly trusting a price target without transparent, quantitative reasoning behind it is a great way to lose money. I would never buy a stock without having a clear understanding of its intrinsic value, and I hope that after reading this you won't either.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
