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
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
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%|
|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.
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