It's often best for investors to largely ignore the stream of upgrades and downgrades coming from analysts. The worst mistake an investor can make is acting on the opinion of others without doing research of his or her own. It can still be useful to see what analysts are saying, but things like price targets should be taken with a grain of salt.
Recently, shares of networking-hardware giant Cisco Systems (CSCO 0.60%) received a price-target bump from Deutsche Bank. Citing new growth areas like cloud security, Deutsche raised its price target on Cisco stock to $37, up from a previous target of $35. This new price target implies that shares of Cisco could rise 20%.
Is Cisco really worth $37 per share? Let's dig in and find out.
Slow and steady growth
Cisco produced non-GAAP (adjusted) earnings of $2.36 per share in fiscal 2016, putting the price target at about 15.7 times earnings. Like many technology companies, Cisco backs out stock-based compensation in order to arrive at its non-GAAP earnings figures. On a GAAP basis, Cisco earned $2.11 per share in fiscal 2016, putting the price target at about 17.5 times GAAP earnings.
Given that the S&P 500 currently trades at a P/E ratio of roughly 25, neither of these ratios seems all that unreasonable. Cisco is dominant in its core switching and routing markets, enjoying competitive advantages that have proven to be durable. The company isn't growing particularly fast, but it is targeting a few growth opportunities that should help produce steady growth going forward.
While the switching business was flat and the routing business suffered a small decline in fiscal 2016, two of Cisco's smaller businesses helped pick up the slack. Collaboration, which includes products ranging from video-conferencing equipment to messaging apps, grew by 9%, producing $4.35 billion of revenue. Collaboration is Cisco's third-largest segment, accounting for about 8.8% of total revenue, and the recent partnership with Salesforce.com should help drive further growth going forward.
Security is a second major growth area for Cisco. The company has been making a slew of acquisitions as its builds out its security business, aiming to take advantage of a fragmented market by offering integrated solutions. The security business generated $1.97 billion of revenue during fiscal 2016, up 13% compared to 2015. Double-digit growth should be the norm as Cisco continues to go after the security market.
While Cisco's revenue growth will be slow overall due to the size of its switching and routing businesses, a shift toward software and services could lead earnings to grow at a faster rate. Cisco expects revenue from software to grow by 10% to 15% annually over the next three to five years, easily outpacing the core business. While revenue growth may be confined to a low-single-digit percentage, EPS could grow substantially faster, driven by expanding margins and share buybacks.
A fortresslike balance sheet
Even without considering the balance sheet, a price target of $37 seems reasonable for Cisco based on its earnings and the strength of its business. But the company is sitting on tens of billions of dollars in net cash, and backing that out lowers the effective P/E ratio and makes this price target seem even more attainable.
At the end of fiscal 2016, Cisco had $65.8 billion of cash and $28.6 billion of debt, good for a net cash position of $37.2 billion. If this cash is valued fully and backed out, a $37 price target would represent a P/E ratio based on GAAP earnings of just 14, and a P/E ratio based on non-GAAP earnings of just 12.6.
One could argue that this cash shouldn't be backed-out entirely, since much of it is held overseas and can't be bought into the U.S. without Cisco paying taxes. But the cash is really just icing on the cake; Cisco's earnings justify the $37 price target regardless.
Shares of Cisco have doubled over the past five years, and that may make some investors hesitant to invest in the stock. But another 20% gain to $37 per share would be more than justified.