Cisco Systems: Wait For A Correction

Apr. 3.12 | About: Cisco Systems, (CSCO)

Incorporated in 1984, San Jose, California-headquartered Cisco Systems (CSCO) has gradually come to be one of the top networking companies in the world. Cisco has a wide expertise in almost all forms of personal and business communications systems, including the cutting-edge video conference technology. The company is a truly global technology giant with customers around the globe.

Cisco's total revenues amounted to $44.84 billion in the last 12 months. The company was able to generate a net income of $7 billion in the same period. While Cisco has been a big disappointment for the long-term holders, it outperformed the broad market indices in the last 12 months.

As of the time of writing, Cisco stock was trading at $21.30 with a 52-week range of $13.30-$21.30. It has a market cap of $114.13 billion. Trailing twelve month [ttm] P/E ratio is 16.55, and forward P/E ratio is 10.65. P/B, P/S, and P/CF ratios stand at 2.3, 2.6, and 10.3, respectively. Operating margin is 19.15%, and net profit margin is 15.61. With a low debt/equity ratio of 0.34, the company seems to have a minor debt issue. Cisco's dividend yield is 1.51%, supported by a low payout ratio of 18.61%.

Cisco has a 4-star rating from Morningstar. Out of 13 analysts covering the company, 9 have buy, 1 has outperform and 3 have hold ratings. Wall Street has optimistic opinions about Cisco's future. Average five-year annualized growth forecast estimate is 9.40%.

What is the fair value of Cisco given the forecast estimates? We can estimate the fair value using discounted earnings plus equity model as follows.

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 the 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. 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 growth estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.

E0 = EPS = ($1.29 + $1.99) / 2 = $1.64

Wall Street holds optimistic expectations on the company's future. Average five-year growth forecast is 9.40%. Book value per share is $9.16.

The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$1.64

V (t=1)

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

$1.62

V (t=2)

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

$1.59

V (t=3)

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

$1.57

V (t=4)

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

$1.55

V (t=5)

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

$1.53

Disposal Value

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

$13.88

Book Value

BV

$9.16

Fair Value Range

Lower Boundary

$23.38

Upper Boundary

$32.54

Minimum Potential

10.15%

Maximum Potential

53.32%

Click to enlarge

You can download FED+ Fair Value Estimator, here.

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Cisco is between $23 and $32.5 per share. At a price of $21.19, Cisco is at least 10% undervalued.

Click to enlarge

Click to enlarge

Source: Finviz

Summary

Technology stocks are pretty cheap in general, and Cisco is no exception. It is trading at a significant discount to the rest of the market. Due to the recent global financial crisis, Cisco collapsed to its dip of $14 on March, 2009. While it was showing an upward momentum, the eurozone concerns pulled the stock back to a second dip of $14.92 on June, 2011. Since then, Cisco is on the move. The stock showed a sparklingly upward trend.

Cisco has been trying to boost its market position with innovative data networking systems, IT software solutions, switches, routers and IT related components. With this intention, Cisco has been making big investments. On March 15, 2012, a press release reported Cisco's intend to acquire NDS Group Limited. On March 28, 2012, another press release was published about the transaction of ClearAccess to Cisco. The acquisition of Lightwire is expected to be complete in the third quarter of this fiscal year. Recently, Cisco announced its new investment in Brazil: A huge data center. I think Cisco will keep its competitive edge in the future. I also support Ry Frank, who oversaw the upward trend a couple of days ago.

Based on my FED+ valuation, Cisco is trading at least 10% below its fair value range. I rate Cisco as a buy for long-term investors. However, at the current prices, Cisco is trading at the peak of its trading range. The stock is in the overbought range. It is a risky investment at the moment. I think a general correction in the stock markets can pull Cisco into a better valuation level. Therefore, I suggest waiting for a correction before buying in.

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