Is Cisco Undervalued?


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Written by

Jae Jun

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What You’ll Learn

  • Why I’m Waiting to Buy CSCO again
  • What I like and dislike about CSCO
  • How to find out what the market is expecting from CSCO
  • What CSCO is valued at today

I sold Cisco (CSCO) in the $24 range last year.

I have 3 reasons for selling stocks.

  1. The stock price hits my valuation range
  2. I need to free up cash to invest in a much better idea
  3. I make a mistake in my analysis and thesis

So I sold Cisco last year based on a combination of 1 and 2.

My initial valuation range was between $25 and $28 but I wasn’t going to quibble over cents so I sold in the $24 range for a decent 24.5% over a 1 year holding period.

But is Cisco cheap now? Does it offer value at this price?

A Quick Glance at CSCO to See Where it Stands

Here are the numbers from the old school value analyzer.

  • 5yr FCF growth of 6.3%%
  • 10yr FCF growth of 4.6%
  • CROIC of 13%
  • FCF/Sales of 22%

Some TTM valuation numbers:

Quick Insights from Fundamentals

Before diving into the products, management and deeper aspects of the business, I like to go through the numbers first to see whether it’s worth the research time.

As a value and fundamental investor, it’s a way for me to filter ideas and allows me to focus my time and energy on the best stocks instead of wandering around in circles and wasting a lot of time.

Based on the numbers above, here is what I’m interpreting.

  • By comparing the 5yr and 10yr data, you can see that the recent performance is better compared to its 10 year history
  • Cisco has lost a lot of its competitive edge over the past 10 years as CROIC has steadily dropped to 13.1%. Margins also confirm that Cisco is struggling.
  • A FCF/Sales of 22% shows that the business still generates a ton of cash to the bottom line
  • It’s not as cheap as it used to be
  • Market expectations for Cisco is higher than it used to be 1-2 years ago where it was expecting zero to negative growth.

What Are Market Expectations?

An easy way to gauge whether the stock is investable or not is to also check market expectations by using reverse stock valuation methods.

Instead of trying to figure out what a stock is worth, figure out what expectations and assumptions are priced into the stock price to make an easy decision.

e.g. If CSCO is priced such that the market is expecting 20% growth, that leaves little room for error and that’s not the time I want to invest.

Last time, I wrote about Cisco, the market was expecting a -9.6% growth rate. This is the type of uncertainty that I want.

Here’s a screenshot going back in time. At the top, you’ll see that with a 9% discount rate, you’ll see how the intrinsic value matched the then stock price using a growth rate of -9.6%.

reverse-dcf-csco

Reverse CSCO DCF from 4 Years Ago in 2011 | Enlarge

4 years later, here is how it looks today.

There have been some changes to how I perform my DCF for certain companies, but the overall method is still largely the same.

Updated Reverse DCF of CSCO

Updated Reverse DCF of CSCO | Enlarge

To cross check, I’m seeing that analysts are expecting a growth rate next year of 4.8%.

Surprisingly close to the 4.5% growth rate from reverse DCF.

Doing the same reverse valuation with the Graham’s formula, the expected growth rate in the stock price is 4.8%.

Updated Reverse Graham for CSCO | Enlarge

Updated Reverse Graham for CSCO | Enlarge

So the growth rate of 4.8% looks to be consistent.

Now the important question to ask is, will CSCO grow faster than 4.8%?

If yes, then it’s on the cheap side.

If no, it’s on the expensive side.

Back in 2011/2012, it was much easier and quicker to answer than now. The answer was a clear “Yes it’s cheap”.

But now…

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More Important to Find Valuation Ranges

The more important thing to figure out is what the potential range of valuation is.

There is no such thing as a hard single valuation target. The best method is to find the best value range.

Wall Street loves to give price targets rounded to the nearest dollar, but that’s absurd.

If a company stood still every quarter, then it’s possible, but trying to place a single hard dollar value to a stock doesn’t work.

You have to account for a low range and high range.

Here are my assumptions to the various models that I’m using to get a 360% view of the company.

  • Low range growth: 4%
  • High range growth: 8%

1. DCF Valuation Range

  • 9% discount rate
  • Starting DCF value of $8,800m

Low growth range is: $28

High growth range is: $34

2. Graham’s Formula Range

  • Analyst EPS estimate of $2.18

Low growth range is: $27

High growth range is: $37

3. EBIT Model Valuation Range

  • Using the estimated revenue of $48,960m
  • then applying a normalized operating margin of 21.6%
  • to give normalized EV/EBIT multiple of 9.6x and aggressive EV/EBIT mutliple of 11.3x

Low EBIT Multiple range is: $26.5

High EBIT Multiple range is: $30

4. Absolute PE Adjustment Valuation Model

By giving points based on the quality of its business, financials and earnings predictability, the PE is adjusted to come with a fair value PE.

  • 11/20 points for business
  • 20/20 for financial
  • 11/20 for earnings predictability

Low growth range is: $24

High growth range is: $27

The Final Valuation Range

Based on the four methods used here, the valuation range I’m getting is$24 to $37.

With the stock sitting at $29, it’s right in the fair value range.

But I’m human and I have to account for the fact that my numbers can be wrong. So I want to buy with a margin of safety of 25%.

That puts my buy price range between $18 to $27.75.

The current stock price doesn’t meet this criteria which means I’ll be sitting on the sidelines and waiting until Mr Market becomes disappointed with Cisco again.

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