Edited By Marianna Avilkina
Cisco Systems Inc. (NASDAQ:CSCO) is one of the largest networking companies in the world. Established in 1984, the San Jose, Californiaheadquartered company has grown into a giant multinational networking company. In 2011, the company invested $5.8 billion in research and development aimed at the introduction of new products, and has recently been focusing on routing and switching technology. Cisco has operations spanning the globe, and has just acquired Foxconn Technology Group's manufacturing facility in Juarez, Mexico. The demand for Cisco products is also on an upward track, as annual sales have increased by 7.3%. However, while the demand for Cisco products is quite high, the lower prices have led to a 16.4% reduction in income.
As of the time of writing, Cisco's stock was trading at $19, with a 52week range of $14.93$21.30. It has a market cap of $101.3 billion. Trailing twelvemonth P/E ratio is 12.75, and forward P/E ratio, 9.1. P/B, P/S, and P/CF ratios stand at 2.0, 2.3, and 9.2, respectively. Operating margin is 20.1%, and net profit margin, 16.14%. The company has minimal debt issues; a debttoequity ratio of only 0.3 is well below the market average of 2.4. Cisco pays reasonable dividends; trailing yield is 1.47%, half the forward yield. I expect the yield to be higher by the end of 2012, as the company has already increased quarterly dividends by 75% to $0.14 as of Q3 2012.
Cisco has a 4star rating from Morningstar. Out of fifteen analysts covering the company, eight have a "buy" rating; two, "outperform"; and five, "hold"  Wall Street clearly has divided opinions regarding the company's future. The average fiveyear annualized growth forecast estimate is 9.4%.
What is the fair value of Cisco Systems given the forecast estimates? We can estimate Cisco's fair value using discounted earnings plus equity model as follows.
Discounted Earnings Plus Equity Model
This model is typically used for estimating the returns from longterm projects. It is also frequently used to price fairvalued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E_{0} + E_{1} /(1+r) + E_{2} /(1+r)^{2} + E_{3}/(1+r)^{3} + E_{4}/(1+r)^{4} + E_{5}/(1+r)^{5} + Disposal Value
V = E_{0} + E_{0} (1+g)/(1+r) + E_{0}(1+g)^{2}/(1+r)^{2} + … + E_{0}(1+g)^{5}/(1+r)^{5} + E_{0}(1+g)^{5}/[r(1+r)^{5}]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E_{0}(1+g)^{5}/[r(1+r)^{5}] = E_{5} / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the currentperiod earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.
Valuation
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.
E_{0} = EPS = ($1.49 + $2.09) / 2 = $1.79
Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average fiveyear growth forecast is 9.4%. Book value per share is $9.62 The rest is as follows:
Fair Value Estimator  
V (t=0) 
E_{0} 
$1.79 
V (t=1) 
E_{0} (1+g)/(1+r) 
$1.76 
V (t=2) 
E_{0}((1+g)/(1+r))^{2} 
$1.74 
V (t=3) 
E_{0}((1+g)/(1+r))^{3} 
$1.71 
V (t=4) 
E_{0}((1+g)/(1+r))^{4} 
$1.69 
V (t=5) 
E_{0}((1+g)/(1+r))^{5} 
$1.66 
Disposal Value 
E_{0}(1+g)^{5}/[r(1+r)^{5}] 
$15.13 
Book Value 
BV 
$9.62 
Fair Value Range 
Lower Boundary 
$25.49 
Upper Boundary 
$35.11 

Minimum Potential 
34.19% 

Maximum Potential 
84.83% 
(You can download FED+ Fair Value Estimator, here.)
I decided to add the book value per share so that we can distinguish between a lowdebt and debtloaded company. The lower boundary does not include the book value. According to my 5year discountedearningsplusbookvalue model, the fairvalue range for Cisco is between $25.5 and $35 per share. At a price of $19, Cisco is trading at a significant discount. The stock has at least 34% upside potential to reach its fair value.
Peer Performance
While there are many companies in the networking business, Juniper Networks (NYSE:JNPR) is probably Cisco's closest competitor. To assess how much profit companies generate on the money shareholders have invested, we consider return on equity. Cisco has a ROE of 14.9%, while Juniper's rate of 3.6% is pretty poor. Obviously, Cisco has a relatively strong advantage in terms of profitability; however, Juniper does not typically pay dividends.
Another competitor, HewlettPackard (NYSE:HPQ), is also a cheap stock trading at single digit P/E ratios. I think HewlettPackard is also offering a deep value as well. Its yield of 2.9% is also better than that of Cisco's yield. However, investing in HewlettPackard is riskier as the company has a debt to equity ratio of 0.94.
Dividend History
Cisco recently boosted its dividends by 75%. The trailing yield stands at 1.5%, but the forward yield is 2.9% thanks to the boosted yield. This is the second time Cisco announced a dividend increase in thisyear. The next quarterly dividend payment will be 14 cents. The stock will go exdividend after October 2. I think Cisco will keep increasing dividends as the company keeps generating substantial cash flows.
Summary
Based on historical valuation metrics, Cisco is trading at a solid discount. The trailing P/E ratio of 12.75 and P/B ratio of 2.0 are significantly lower than the fiveyear average P/E ratio of 17.7, and P/B ratio of 3.1. Compared to the market's forward P/E ratio of 13.8, Cisco's stock also seems to be significantly undervalued. Currently, investors have an exclusive opportunity to obtain Cisco stock at a solid discount while the company is providing the best entry point for three years.
Based on my FED+ valuation, Cisco is substantially undervalued. The stock has at least 34% upside potential to reach its fair valuation range. Morningstar analysts also agree with me: their fair value estimate of $24 suggests about 25% upside potential, tallying with my model.
Disclosure: I 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.