Does the 46% undervaluation of Cisco Systems, Inc. (NASDAQ: CSCO) provide an opportunity?
Today we are going to do a simple overview of a valuation method used to estimate the attractiveness of Cisco Systems, Inc. (NASDAQ:CSCO) as an investment opportunity by taking the streams of expected future cash flows and discounting them to the present value. This will be done using the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF ($, millions)||$15.8 billion||$16.8 billion||$16.8 billion||$16.8 billion||$17.0 billion||$17.2 billion||$17.4 billion||$17.7 billion||$18.0 billion||$18.3 billion|
|Growth rate estimate Source||Analyst x7||Analyst x7||Analyst x2||Is at 0.36%||Is at 0.83%||Is at 1.16%||Is at 1.4%||Is at 1.56%||Is at 1.67%||Is at 1.75%|
|Present value (millions of dollars) discounted at 6.2%||$14,900||$14,900||$14,000||$13,200||$12,500||$11,900||$11,400||$10,900||$10,400||$10,000|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $124 billion
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.9%. We discount terminal cash flows to present value at a cost of equity of 6.2%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$18 billion × (1 + 1.9%) ÷ (6.2%–1.9%) = US$434 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $434 billion ÷ (1 + 6.2%)ten= $237 billion
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is $361 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of US$47.4, the company appears to be pretty good value at a 46% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. You don’t have to agree with these entries, I recommend you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Cisco Systems as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes debt into account. In this calculation, we used 6.2%, which is based on a leveraged beta of 1.013. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
While important, calculating DCF shouldn’t be the only metric to consider when researching a business. DCF models are not the be-all and end-all of investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Why is the stock price below intrinsic value? For Cisco Systems, we have compiled three relevant aspects that you should explore:
- Financial health: Does CSCO have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as leverage and risk.
- Future earnings: How does CSCO’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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