DCF Model Indicates Cisco Is Deeply Undervalued

May.21.12 | About: Cisco Systems, (CSCO)

Cisco Systems Inc. (NASDAQ:CSCO) shares plunged to ~$16 recently from its 52-week high of ~$21 in April due to the negative outlook. My DCF valuation model shows that the current stock price has likely factored in very pessimistic future profitability and growth prospects which I believe are extremely unrealistic given the firm's fundamentals.

Street analysts have modest estimates for both revenue and EPS growth in the current and next fiscal years. EBITDA margin is expected to be sustained and slightly improved. The data is summarized below:

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Now let's turn to the DCF analysis. My model has 10 discrete projected periods plus a terminal year. I began with a baseline case which incorporates consensus assumptions into the model. Those assumptions yield a stock value of ~$25, which is ~52% above the current price. Details are summarized below:

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To stress test the stock price and assess the priced-in profitability and growth prospects, I ran the model again with the following key assumption changes:

  • Revenue is assumed to have no growth at all;
  • Operating margin is lowered to 18.5%;
  • WACC is increased to 11.5%; and
  • Terminal growth rate is set at 0%.

I arrived at a stock value of ~$16, just slightly below the current price. Obviously, the stock price indeed reflects those inferior assumptions.

I can't convince myself to believe in the fact that CSCO will be experiencing no revenue growth down the road while meanwhile suffering from significantly deteriorated profitability. In addition, it is almost impossible that a WACC of 11.5% exists for a company with ~$90B market cap, ample financial liquidity, and numerous competitive advantages in network and wireless technology. Excessive reaction to the firm's negative outlook appears to be the only explanation, hence the current dip represents a good entry point.

Note 1: Charts and exhibits are created by the author.

Note 2: Financial data is sourced from company 10-Q, 10-K, press release, Yahoo Finance, YCharts, Wall Street Journal, and Morningstar.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CSCO over the next 72 hours.