Cisco Systems: A DCF Valuation
Summary
- While the stock price has appreciated over the past decade, Cisco has yet to reach dot-com era price levels.
- Cisco exhibits healthy financials and growing dividend distributions.
- As the company shifts towards more participation in the software industry, revenue and profitability are expected to increase.
- A DCF valuation indicates that the stock trades at a minor discount compared to fair value.
Thesis
Cisco Systems (NASDAQ:CSCO) rose into prominence during the dot-com era, with a dominant presence in the technology sector and aggressive revenue growth that fueled an explosion in stock price appreciation, before the subsequent drop after the bubble burst in April 2000. While Cisco's stock has yet to reach dot-com era price levels, for the past two decades Cisco has shown signs of growth, while maintaining very healthy financials. In this analysis, after a quick look into the company's fundamentals, an intrinsic value calculation will be presented in an effort to reach a fair value estimation for Cisco's stock.
Fundamentals
Cisco offers a wide range of technology products and services, that revolve around networking, security, collaboration, applications and cloud services. The company operates globally in three geographic segments: Americas; Europe, Middle East, and Africa (EMEA); and Asia Pacific. Cisco groups its products into the following categories: Infrastructure Platforms, Applications, Security and Other Products.
As the company shifts towards more participation in the software industry, Cisco achieved the target of generating 50% of revenue from software and services in the fiscal year 2020. For reference in 2017, the company only generated 29% of total revenue from software and services. Net and gross margins also stand at satisfying levels and are expected to increase as Cisco brings in more and more revenue from software, an industry famous for its huge profitability potential. Cisco also maintains reasonable debt levels, with a Debt/Total Assets ratio of 16% and a current ratio of 1.72. A big reason for that is the considerable amount of cash and cash equivalents that appear on Cisco's balance sheet, which the company has been using consistently over the past decade to reduce debt and perform large-scale stock buybacks.
A deeper look at the stock price history of Cisco will reveal the huge run-up the company experienced during the frenzy of the dot-com bubble and the subsequent massive price drop. In the past couple of decades Cisco, while experiencing a moderate amount of stock price growth, has not been able to claim back all-time high prices of over $75. Over the last decade, after continuous price appreciation, the stock price peaked in July 2019 at $57.36 and has been trading lower since. A considerable price pullback was also caused by the global Covid-19 pandemic.
Data by YCharts
Cisco also offers a respectable dividend growth history and a forward dividend yield of 3.32%. In the past 5-year period dividends have grown at a CAGR of 10.25%, while the company maintains a low payout ratio (under 50%), which implies a high degree of safety. Consistently generating large amounts of free cash flow is telling for the company's ability to provide increasing distributions to shareholders. Dividends per share over the last decade are shown in the chart below.
Source: Tikr.com
Discounted Free Cash Flow Valuation
To determine a fair value for Cisco's stock, a Discounted Free Cash Flow Valuation was deemed appropriate. Using 5-years of trailing financial data and based on analyst expectations, I forecasted expected Free Cash Flow up until the fiscal year 2025. A terminal value was calculated after that, using the Perpetual Growth Model. Some of the input assumptions and determination that were made are detailed below:
- Required Rate of Return: Cisco's Weighted Average Cost of Capital (WACC) was used as the required rate of return. Total Debt/Market Cap was used as the weight for the cost of debt. The cost of debt was computed by dividing the interest expense by the Total Debt and then adjusting for taxes. When calculating the cost of equity, the US 10-year Treasury yield was used as the Risk-Free Rate. The stock carries a 5-year monthly Beta of 0.91. Using the Capital Asset Pricing Model (CAPM), the cost of equity sits at 7.01%.
- Free Cash Flow Forecast: Consensus revenue estimates were used as a baseline for the projection, after being adjusted for the average earnings-beat over the last 3 years. Forecasted Revenue growth falls in line with Cisco's guidance. Net income was derived from Revenue using 3-year and 5-year average trailing Net Margins, and finally, Free Cash Flow was projected up until 2025 with the help of the FCF/Net Income ratio. Analysts estimates, forecasted Top, Bottom-Line and Free Cash Flow are presented below.
- Terminal Value: Using the Perpetual Growth Model, I calculated the terminal value of the Free Cash Flow at the end of the year 2025. The perpetual growth rate of 1.5% that was selected is a very modest and realistic estimate in my view.
As shown, a Fair Price for Cisco's shares was calculated at $51.46, after adjusting for Net debt, using mostly conservative, consensus estimates that match the company's guidance. Given the current stock price of 44.56, as of the time this article is written, Cisco appears to be trading at a discounted compared to the fair value calculated. I do like however to apply a Margin of Safety to a Discounted Free Cash Flow Valuation, given the potential variability for different inputs and/or forecasted items. After a 10% Margin of Safety is applied, a fair price of $46.31 is reached.
Note: In the 2018 fiscal year Cisco reported a huge decrease in Net Income according to GAAP results. However, this was because of tax adjustments and transitions and does not accurately portray the company's profitability. For this analysis, the results for the fiscal year 2018 were adjusted with the help of non-GAAP results and guidance from Cisco's management to reflect the actual financial picture of the company. More information can be found here.
Conclusion
Cisco appears to be what someone would call a value company inside a sector known for being a default choice for aggressive growth opportunities. This, however, might prove to be beneficial to the investor exploring a company like Cisco, since less attention paid to the stock could mean a more inexpensive valuation. The analysis provided above indicated that this is probably the case. Cisco also exhibits healthy financials and growing distributions, providing hope for the company's future. Although at current price levels I do not see a large enough upside potential, a buying opportunity might be presented in the near term if the stock price falls to $40 or less. Currently, I rate the stock as a hold.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Comments (39)
First stage infancy..no profits...
Second stage intense growth..profits...no dividends
Third stage slow growth..cash cow....dividends..
Fourth stage decline...
Rates of 2.5% or 3% are far more realistic.
Using those rates would result in far lower valuations
- your comment “The perpetual growth rate of 1.5% that was selected is a very modest and realistic estimate in my view” feels like a throwaway comment yet 80% or more of your valuation is tied to the terminal value.
- to use 1.5% without substantive support or quantitative analysis justifying the rate IMO makes your analysis very weak.
- change the rate to say 2.5% or .5% and tell the SA community the valuation. You’ll see the majority of the valuation is tied to that simple throwaway perpetual growth rate. I could go ob but strong finance and valuation investors know exactly what I’m talking about. Of course this is just my two cents. Slow and steady! Good luck to all!
My question for anyone who knows since Cisco hit its $75 high 20 years ago, how much cash has it spent in Buybacks?
I am asking since it still is 20% below its nearest high of $57 and in the past 2 years
has only given a 1 penny per year increase in the divvy.
How much $$$ has gone into Buybacks. I don't think it worked out well for shareholders. Do you think Buybacks have helped the stock price or just paid for
the employee stock purchase plan.
Tro
Nix
csco is a buy for the moment :)
