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Cisco Systems, Inc. (NASDAQ:CSCO) recently increased its dividend by 75%. The increased quarterly dividend of 14 cents a share will be paid out from fiscal year 2013. I have been critical in the past on the payout policy adopted by Cisco Systems and other technological firms. Although the company continues with its hefty share buyback program, the substantial increase in the dividend yield (2.8%), putting it slightly ahead of other tech giants such as Microsoft Corporation (NASDAQ:MSFT) and its 2.5% yield, is a welcome development.

In this article, I will perform a valuation analysis for Cisco Systems using both relative and absolute valuation techniques and determine whether it makes sense to purchase the CSCO stock at the current levels.

CSCO currently has a market capitalization of a $104.78 billion and has appreciated in value by 26% during the last 12 months - on par with the tech heavy NASDAQ index. It has a long-term debt to equity ratio of 32% and has grown its revenues at an annual rate of 5% during the last three years. Year on year, the growth rate has expanded to 7%. Analyzing the EPS growth rates, over the last three years, the average EPS growth rate has lagged the revenue growth rate by 4%. However, quarter on quarter, the EPS is up 18%.

Going forward, analysts expect the company to grow its earnings at an annual rate of 8% compared to the 15% growth rate of the industry. I hold a similar view of the growth rate and using a long-term return on equity of 19% and a payout ratio of 60%, I estimate a growth rate of 7.5%.

On the margins front, CSCO's gross margins have been fairly constant in the 62% range over the last 3 years. A similar trend can be seen when it comes to operating and net margins (22% and 17%, respectively). Return on Assets has historically averaged 9%.

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

Ticker

Market Cap

P/E

P/S

Lt Debt/Equity

ROA

ROI

GM

OM

CSCO

104.78B

13.15

2.27

31.77

8.99

11.2

61.24

21.85

IBM

227.98B

14.51

2.13

113.5

13.79

21.58

46.89

19.64

JNPR

9.85B

39.35

2.21

14.09

4.61

5.48

64.48

13.9

ERIC

30.51B

13.1

0.87

16.25

4.47

6.9

35.13

7.89

ALU

2.61B

15.45

0.14

111.31

2.97

5

33.85

0.76

Average

19.11

1.52

57.38

6.97

10.03

48.32

12.81

As shown in the table above, CSCO's operational numbers are fairly competitive compared to its selected peers. The firm does trade at a discount to its peers when it comes to its earnings multiple and on par with JNPR on a P/S basis.

Relative Valuation:

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

Next Yr Proj EPS

$2.09

My EPS Growth Rate Est

7.49%

Future EPS (5 Yr)

$2.60

Expected P/E

14

Price 5 Yrs Out

$36.34

Unlevered Beta

1.06

Market D/E Ratio

14%

Current Tax Rate

20%

Levered Beta

1.18

Risk Free Rate

2%

Risk Premium

8.00%

Size Premium

-0.36%

Cost of Equity

11.0%

Fair Value (RV)

$21.57

Based on relative valuation, CSCO has a fair value of $21.5 a share.

Absolute Valuation

Valuation analysis was also performed using residual income method. Key inputs and valuation results are shown below.

Growth Rate (years 1 through 10) - 6.8%

EPS 2012 - $1.57

EPS 2022 - $3.0

PV of Residual Income = $7.1

PV of Terminal Value = $5.8

Existing Book Value = $9.6

Intrinsic Value = $22.5

By combining the fair value estimates from relative and absolute valuation, my price target of $22 a share is obtained. Trading at approximately $19.50 a share, CSCO is undervalued by 13%. Including dividends, the stock offers a return of 16% and is attractive in my opinion.

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

Source: Cisco Systems: Capital Gains And Dividend Increase Opportunity