A recent article concerning Cisco (NASDAQ:CSCO) caught my attention. While I thought the article was generally well written, it was the comments that really indicated potential. Here are just a few examples:
Ok.. now for just how long are ppl gonna be sayin that CSCO is worth $30 ???.. they been sayin that since the start of the year... and the damn thing still cant even pass $20...lol.
CSCO has basically been "dead money" for the last 12 years. Take a look at the chart. As [SUBGAM] says above, the price performance of the stock is pretty conclusive. Not just since the start of the year but going back a heck of a lot further then that. At this point, CSCO is day trading vehicle. I haven't seen much of anything in this business cycle or earnings reports that makes me think otherwise. Add to that the fact that I personally think John Chambers is a VERY mediocre CEO, and you'll know what to do.
"Cisco: A 'Deeply Undervalued' Stock Worth $30"
Try telling that to people who paid about $80 a share in 2000.
Comments like these are reminiscent of those made of Microsoft (NASDAQ:MSFT) back in December and January. These posts assume CSCO is currently a poor purchase, simply because it was a poor purchase in the past. Behavioral Finance calls this line of thinking a type of recency bias. Traders have stopped evaluating the stock in terms of cash flow per dollar spent and instead rely on the past performance as a predictor of the future.
Attitudes like this excite me because I believe that market inefficiencies occur only because of human tendencies toward irrationality. While almost all information is available to almost all the market participants, it is understood at various levels and interpreted in various ways. Usually, different opinions are effectively random, and a market can price equity fairly even if the majority of purchases and sales were guided by irrational decision making. However, at the seams, such as when a company's stock price has been a poor provider in the past (or has trended one way or another for a long time) large enough bodies of traders/investors can be subject to recency, and potential profit can exist. If a company is profitable, and cash flow is cheaper than alternatives, investors will notice at some point, and stock prices will correct.
However, just because negative sentiment surrounds Cisco, doesn't mean it is a value. To determine that, we've got to analyze the stock. In this article, I'll do a cursory look at Cisco to see if I would consider either a purchase or an option strategy.
Discount Cash Flow Analysis
I like to start out any analysis by looking at what the "theoretical" price for a stock share should be. Of course, I view this as nothing but a WAG, because quite a few assumptions and a great many opportunities to err exist in the calculations. Still, I find it a great place to start to strip away some of the ambiguity from the overall process.
According to Finviz, Cisco had free cash flows in 2011 of $1.65 a share. Since I don't know how it calculated free cash flows, I ran my own calculation. I came up with $1.31 a share. Since my numbers are a more conservative, I'll use mine.
Next, I need to project growth over the next few years. According to Yahoo, growth estimates for Cisco average around 8.5% for the next five years. I prefer to be a bit conservative, and I'll cut that growth estimate down to around 8%. I'll use that growth rate for the next 8 years, and then calculate a horizon value (future value from 8 years to infinity) using a 2% growth rate. Since I demand at least a 10 % return, I'll discount everything at 10%.
That was a wordy description, so I'll include a graphic representation of my math:
Income Statement ($ thousands)
Cost Of Goods Sold
Selling, general & administrative
Balance sheet ($ thousands)
Cash and Short Term investments
Total operating current assets
Total operating assets
Total operating current liabilities
Free Cash Flow Calculations ($ thousands)
Tax on Operating Income
Net Operating WC
Net Operating Long Term Assets
Total Net Operating Assets
Investment in net operating assets
Free Cash Flow
free cash flow
growth rate in free cash flow
WACC/ or required rate of return
Value of operations
Value of investments
Total value of firm
value of all preferred stock
Value of equity
Number of shares (millions)
Estimated Share Price
So, as the above screen shot of my work shows, my guess for a fair value is around $22.50. This is a quick and dirty DCF analysis, and hopefully those who see flaws in these calculations will comment and discuss.
We can take a quick look at company ratios to get an idea on how healthy CISCO is. All of this should be taken into the analysts' growth estimates, but it would be nice to confirm their sanity with our own eyes. In addition, by looking at ratios, we may pinpoint potential issues that may deter us from investing, despite overall valuation judgments.
In Cisco's case, I'd like to look at its liquidity, leverage, profitability, and a final sanity check on valuation. With current and quick ratios over 3 (3.37 and 3.28 respectively), we can see that Cisco should have no problem paying its current obligations. Essentially, the ratios tell us that Cisco has three times the liquid assets it needs to pay its current obligations. With a debt/equity ratio of .34, we can see that Cisco is not overly leveraged ( a subjective measurement, I admit). With Return on Equity and profit margins near 15%, we can see that the company is fairly profitable, and an 8% growth rate shouldn't be unattainable. If the current price was our calculated $22.50 a share, CSCO would have a trailing P/E of 17.6, which is not drastically different from the sector average of 18.92.
Based on last Friday's closing price of $19.12, my calculations tell me that CSCO is 18% undervalued. Despite trying to keep my numbers as conservative as possible, I acknowledge that there is plenty of room for error in my calculations. I usually prefer to have at least a 25% buffer between my calculated "fair value" and my purchase price. Since I do not have an adequate buffer, I am not willing to sink money into holding shares just yet.
While a long-term buy and hold trade is not in the cards right now, I may consider several other trades. A diagonal spread, with a long LEAP call and ATM short leap calls may provide a way to prosper from a modest move up with minimal commitment of capital. For my diagonal technique, refer to my article.
I could also sell a covered put out to June with a strike price of $18, which should net me about $0.32 per share. The risk, of course, is CSCO will began a long climb up now, and I will miss out on the value I detected.
Finally, I could initiate a buy write. I could purchase the stock now, simultaneously selling a call on the underlying asset. $20 strike calls with expirations in June are selling for around $0.38. This is my least favorite choice in this case, because I do not gain my required buffer, yet I still take on all the risk of owning the stock, simultaneously risking missing out on substantial gains should the stock rise between now and June 16th.
Personally, I prefer to write diagonals in this situation. It will allow me to invest very little capital and still take a position. I could benefit if the shares go nowhere, if they rise moderately, or if they slowly fall.
With the market drifting down, and CSCO set to release earnings on May 9th, I will be patient taking a position. If I felt CSCO was a screaming buy, I would probably pick it up now, but I'd like to see what the earnings report reveals. If the market continues to drift down, and earnings are not anything out of expectations, we could see CSCO in the 18s in a week or two. At that point, it should be a pretty safe position to go long using one of the three strategies I outlined.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.