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Cisco (CSCO) designs, manufactures and sells internet protocol based networking products for the communications and IT industry. This San Jose, Calif.-based company conducts business around the world and has a market capitalization of approximately $110 billion. The stock is up 19% over the last year compared to the 10% returns of the Nasdaq index. The company started offering a dividend in 2011 and currently yields 1.57%. In this article, I will perform valuation analysis to determine the fair value and 12-month price target.

Growth Rates

CSCO grew its earnings at an annual rate of 4.3% during the last 5 years. The net income did reduce by 16% during the last fiscal year. The revenue was, however, up 8% year over year.

Cisco has averaged a return on equity of 20% over the last 5 years. The ROE declined to 14% during the past 12-months. Based on the company's policy of buying back stock as a way to reward the shareholders (a practice that I am not really a big fan of), and the dividend offered by the company, I project a payout ratio of 65% over the next several years. Assuming a bearish position of no ROE expansion, my projected long-term growth rate of 5.25% is obtained. This is lower than the consensus estimate of a long term growth rate estimate of 9%. Finally, my model assumes a stable growth rate of 3%.

Margins and Profitability

CSCO's gross margins have decreased over the last 3 years from 64% to TTM gross margins of 61.3%. The operating margins were steadily declining marginally from 22% to 21%. The operating margins have, however, expanded over the last year, recovering from 19.6% in fiscal year 2011. The net margins were also lower, decreasing from 17% to 15.6% over the last 3 years.

To compare CSCO's performance to that of its peers, I evaluated the margins and operational aspects of some of the other companies in the competing industry segments. The peers selected for analysis included Alcatel-Lucent (ALU), Hewlett Packard (HPQ) and Juniper Networks (JNPR). The table below presents the peer analysis.

CSCO

ALU

HPQ

JNPR

Market Cap

109.66B

4.97B

46.01B

11.37B

Qtrly Rev Growth (YOY):

11%

-8%

-7%

-6%

Gross Margin (TTM)

61.54%

34.97%

23.24%

64.48%

Operating Margin

21.64%

4.36%

8.41%

14.75%

P/E

15.81

3.88

8.14

27.34

P/S

2.5

0.26

0.37

2.59

As shown in the table above, CSCO's operational numbers are fairly competitive compared to its selected peers. The firm does trade at a sizeable premium to ALU and HPQ.

Valuation

Valuation analysis was performed using discounted cash flow analysis. The major inputs and model outputs are shown below:

  • Growth Rates - Year 1 through 5: 4.5%
  • Terminal Growth Rate - 2%
  • EBIT margin - 22%
  • Capex - 2.7% of Revenues
  • Present Value of Free Cash Flow of Equity (Years 1 through 5) - $34.61 billion
  • Present Value of Terminal Value - $58.54 billion
  • Cash - $46.74 billion
  • Long Term Investments - $3.47 billion
  • Total Debt - $16.9 billion
  • Total Value of Equity - $126.47 billion
  • Shares Outstanding - 5.38 billion
  • Value per Share - $23.50

As shown in the above, CSCO trading at $20.36 offers a return potential of 17% (including dividend). The stock is cheap in my opinion and makes a good investment candidate for the short term.

Disclaimer: Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision.

Source: Tech Giant Cisco Offers Safe 17% Potential Upside