How Much Is Cisco Worth?

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I recently took a look at the valuation for Microsoft and concluded that shares of the software giant may be attractively valued right now. In a recent conversation with a fellow Fool, though, he challenged that Cisco (Nasdaq: CSCO  ) may be a better buy in the realm of large-cap tech.

Could the king of networking be a smoking bargain right now? Well, we better take a look at the numbers.

It's a beautiful day in the neighborhood
One way to get an idea of what a stock might be worth is to check out how companies classified in the broader "communication equipment" category and other large high-tech peers compare. So let's take a look at how Cisco stacks up.


Total Enterprise Value / Trailing Revenue

Next 12 Months Price-to-Earnings Ratio

Total Enterprise Value / EBITDA

Trailing-12-Month PEG

Cisco 2.2 13 8 1.3
Brocade (Nasdaq: BRCD  ) 1.6 13.4 7.9 2.2
EMC (NYSE: EMC  ) 2.8 16.7 13.8 1.9
Intel (Nasdaq: INTC  ) 2.3 11 4.8 1
Juniper Networks (Nasdaq: JNPR  ) 4.6 25.8 19.7 2.2
Nokia (NYSE: NOK  ) 0.7 15.1 6.2 1.2
Qualcomm (Nasdaq: QCOM  ) 6.8 18.7 18.9 1.7
Average 3.1 16.8 11.9 1.7

Source: Capital IQ, a Standard & Poor's company, and Yahoo! Finance.
Average excludes Cisco.

Using each of those averages to back into a stock price for Cisco, and then taking the average across those results, we can come up with an estimated price per share of roughly $27. This would suggest today's price of just less than $21 could be undervalued.

A comparable company analysis like this can sometimes raise as many questions as it answers though. For instance, is the entire group properly valued? A supposedly fairly valued -- or even overvalued -- stock among a bunch of other undervalued stocks may actually be an undervalued stock, and vice versa.

Also, while these businesses are comparable to Cisco, none is a perfect match. Brocade and Juniper both sell networking gear, but neither has the size, clout, or brand power that Cisco does. Nokia is another significant networking player, but is primarily driven by its mobile phone division. EMC sells a significant amount of hardware, but it's focused on storage. And, of course, both Intel and Qualcomm are tech giants and like Cisco have dominant market shares in their niches, but both focus on chips.

So with all that in mind, it's best to combine comparable company analysis with another valuation technique.

Collecting the cash flow
An alternate way to value a stock is to do what's known as a discounted cash flow (DCF). Basically, this method projects free cash flow over the next 10 years and discounts the tally from each of those years back to what it would be worth today (since a dollar tomorrow is worth less to us than a dollar today).

Because a DCF is based largely on estimates (aka guesses) and it attempts to predict the future, it can be a fickle beast and so its results are best used as guideposts rather than written-in-stone answers sent down from Mount Olympus.

For Cisco's DCF, I used the following assumptions:

Fiscal 2011 Unlevered Free Cash Flow $5.5 billion
FCF Growth 2011-2015 11.8%
FCF Growth 2015-2020 5.9%
Terminal Growth 3.0%
Market Equity as a Percentage of Total Capitalization 89.0%
Cost of Equity 12.0%
Cost of Debt 4.4%
Weighted Average Cost of Capital 11.0%

Source: Capital IQ, a Standard & Poor's company, Yahoo! Finance, author's estimates.

While most of this is pretty standard fare when it comes to DCFs, the academically inclined would probably balk at the way I set the cost of equity. In a "classic" DCF, the cost of equity is set based on an equation that uses beta -- a measure of how volatile a stock is versus the rest of the market -- and a few other numbers that I tend to thumb my nose at.

But when you get right down to it, the cost of equity is the rate of return that investors demand to invest in the equity of that company. So I generally set the cost of equity equal to the rate of return that I'd like to see from that stock.

Based on the assumptions above, a simple DCF model spits out a per-share value of roughly $22 for Cisco's stock. This is significantly lower than the price we got from the comparable company analysis, but still suggests that Cisco's stock is slightly undervalued.

But there are some very significant challenges when it comes to performing a discounted cash flow analysis for Cisco. The first is the company's growth. My starting point -- and the number in the table above -- is the average analyst estimate for the company's growth. I believe that that 11.8% is the high end of what we can expect from Cisco over the next five years. Over the past 10 years, the company has grown its operating income at a rate of roughly 7% per year. Over the past five years, the annual rate has dropped to 4%.

For obvious reasons, if we drop the growth rate in the model, the price falls. If we lower the five-year growth rate to 7% (and the out-years to 3.5%), for example, the estimated share price falls to around $18.

Even more significant though is the matter of Cisco's acquisitive history. In calculating the company's free cash flow I've included the money that it spends on acquisitions -- after all, it's unlikely it would grow at the rates that it's historically grown without the acquisitions. However, at some point, Cisco may throttle down the acquisitions and at that point it would start producing a tremendous amount of cash flow for investors.

As an example of how much of a difference it makes, if I assume that starting in 2011 the company doesn't make any acquisitions, and I drop the company's growth rate to a flat 3% forever, the estimated price per share jumps to nearly $25.

Do we have a winner?
The valuations that we've done here are pretty simple and, particularly when it comes to the DCF, investors would be well-advised to play with the numbers further before making a final decision on Cisco's stock.

My take is that we're likely not going to see Cisco grow quite as fast as analysts expect. However, we're also probably going to see the company start churning out a heck of a lot more free cash flow at some point in the future. Based on these uncertainties, I'll proclaim my ignorance here and say that I don't have a good sense of just how much Cisco's stock is worth. What I would say, though, is that it appears -- based on the comparable company analysis and the company's cash generation ability -- that the stock is worth more than the current $21 price tag.

Circling back to the question that brought us here in the first place -- is Cisco a better large-cap tech buy than Microsoft -- I'd say that it's a close call. What I like very much about both stocks is that both have been the subject of significant investor pessimism lately -- and that often creates good buying opportunities.

Want to keep up to date on Cisco? Add it to your watchlist.

Juniper Networks is a Motley Fool Big Short short-sale recommendation. Intel and Microsoft are Motley Fool Inside Value selections. The Fool has created a bull call spread position on Cisco Systems. The Fool owns shares of and has bought calls on Intel. Motley Fool Alpha has opened a short position on Juniper Networks. Motley Fool Options has recommended buying calls on Intel. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of EMC, Microsoft, and Qualcomm. Motley Fool Alpha owns shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Microsoft and Intel, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends to a sharp stick in the eye.

Read/Post Comments (6) | Recommend This Article (14)

Comments from our Foolish Readers

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  • Report this Comment On January 10, 2011, at 3:26 PM, melegross wrote:

    In other words, all these numbers you used are of no real value. I'm not surprised, because they rarely are of any value going past the next year or so.

    As we see from your conclusion, you have no idea at all what will happen, though your "feeling" is that they are worth more than what the stock is now, but you also have no idea as to how much more, or when it might reach that unknown value.

    In other words, this article is of no help whatsoever in answering the question you started out asking.

    And this is why investing depends more on someone understanding the industry more than any analyst does. The numbers are rarely of much value when trying to know whether a stock should be bought, held, or sold. And that's the problem with investing using the "technicals". Unless it's obvious the numbers are good or bad, they are of little use.

    You have to go with gut feelings.

  • Report this Comment On January 10, 2011, at 4:55 PM, TMFKopp wrote:


    A few comments...

    "And that's the problem with investing using the "technicals""

    A point of clarification -- what I've done above works with the fundamentals, not the technicals. Technical analysis involves using charts and past price movements as the basis for analysis where as fundamental analysis uses (among other things) the company's financial performance.

    "In other words, all these numbers you used are of no real value"

    As you might guess, I strongly disagree with this statement. Even though you can't expect that projecting the future will ever give you a perfectly clear, absolute answer, it can still be very instructive as far as better understanding the company and getting a sense for how much the stock is worth.

    It's also notable that some companies -- think P&G or Coke -- are easier to model out because of their long histories and dependable performance. Other companies -- think really high growth, young companies, or unprofitable companies -- are much more difficult to model and therefore are typically much more speculative investments.

    It seems a pretty big leap to say that since the kind of analysis above doesn't lead to a concrete, specific value that it's utterly useless.

    "You have to go with gut feelings."

    This is your alternative to fundamental analysis? Sorry, but this is really terrible advice.


  • Report this Comment On January 10, 2011, at 5:41 PM, BradReeseCom wrote:

    Hi Matt,

    I believe Cisco acquisitions are "the key" to profitably trading Cisco's stock.

    How so?

    Well, when the owners of a Cisco acquisition candidate accept Cisco stock instead of Cisco cash for their shares, I firmly believe it's because the acquisition candidate's investment banker and/or venture capital advisers forecast a near term appreciation in Cisco's stock price.

    Also simultaneously, I believe that when the owners of a Cisco acquisition candidate only accept cash, it's because their investment banker and/or venture capital advisers are not keen on Cisco's stock price appreciating near term.


    Brad Reese

  • Report this Comment On January 10, 2011, at 8:59 PM, TMFKopp wrote:


    Howdy Brad!

    That's an interesting theory and could be so, but I'm generally more interested in finding stocks that are attractively valued as longer-term investments rather than looking for shorter-term trading opportunities.

    I'd also note that I've worked on IB teams working on M&A deals and fairness opinions and what we were looking at was similar to what I've done above (moreso the comparable company analysis than the DCF).

    Finally, while an acquisition target may prefer shares when Cisco's stock has room to appreciate and cash when it doesn't, Cisco is going to prefer the exact opposite. That is, when its stock has room to appreciate, its preference will be to pay in cash rather than dilute shareholders, and when the stock is less attractive (possibly overpriced) management will prefer to pay in shares. So there will always be some push-pull between the two sides in terms of how the transaction is financed.

    Thanks for the comment!


  • Report this Comment On January 10, 2011, at 10:48 PM, BradReeseCom wrote:

    Hi Matt,

    I also believe Cisco's dilutive management compensation practices are something you have not taken into consideration:

    For example, stock buybacks were first authorized by Cisco's board in September 2001 when Cisco's lowest closing stock price that month hit a low of $11.24 per share on September 27th, giving Cisco a stock market capitalization of $82.063 billion.

    Astonishingly over the past 10 years, Cisco has extravagantly spent $67.482 billion on stock buybacks.

    Simultaneously, having spent $67.482 billion on share buybacks, the number of Cisco shares outstanding has only decreased by a mere -23% (7.301 billion shares - 5.595 billion shares = 1.706 billion shares).

    However most revealingly, Cisco has actually repurchased a total of 3.240 billion shares, implying that 1.534 billion in shares were repurchased at a weighted average price per share of $20.83 to support Cisco's dilutive management compensation practices.

    Cisco's management has handed themselves a ton of stock, then they had Cisco buy it back (indirectly) from themselves. As an example, view the stock buybacks of Cisco CEO John Chambers:

    Furthermore, keep in mind that any time you see stock options plus buybacks, you're looking at a net transfer of cash from Cisco's shareholder pockets into the pockets of Cisco's management.

    Exactly how much of Cisco shareholder cash appears to have been transferred into the pockets of Cisco's management?

    Well, over the past 10 years, 1.534 billion of Cisco shares were repurchased at a weighted average price per share of $20.83 = $31.953 billion.

    Yep, that's right, $32 billion of Cisco shareholder cash has gone into the pockets of Cisco's management team!


    Brad Reese

  • Report this Comment On January 11, 2011, at 4:53 PM, TMFKopp wrote:


    That's a great point Brad and a big reason why I'm not a fan of equity compensation through options (I prefer restricted stock if equity is to be used...).

    I'm not totally sure I follow the math though. First, the company has also issued shares to make acquisitions so the difference between the number of shares bought back and the decline in the share count will be = management shares issued + acquisition shares issued. Also, when options are exercised and insiders buy stock there is a cash inflow to the company that provides some offset to the cash spent to buy shares to keep share count down. In fiscal 2007, for instance, the company took in more than $5 billion in cash from exercises and employee purchases.

    What I will note though is that my cashflow projections do take into account the current equity comp. Specifically, I don't back out the non-cash charge on the P&L when calculating the company's free cash flow.

    Bottom line though, you're definitely right that investors and potential investors need to be sure they're comfortable with how Cisco compensates its management team.


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