Cisco´s Results Beat Wall Street Expectations

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Feb 12, 2015
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In this article, let's take a look at Cisco Systems, Inc. (CSCO, Financial), a $148.81 billion market cap company, which is a tech giant and today is a trending stock in the market.

Reversing Direction

The company´s results beat Wall Street expectations. Yesterday, Cisco reported $11.9 billion in second quarter fiscal 2015 revenue, up 7% year-over-year, above the analyst consensus. Also, it reported 53 cents in earnings per share, beating the Wall Street estimate by two cents per share. Thomson Reuters´ consensus estimates were $0.51 in EPS and $11.80 billion in revenue.

“Our second quarter results reflect continued progress as we transform Cisco to become the #1 IT company. In the quarter we grew revenues by 7%, with strong EPS growth, and saw the best balance of growth across all our geographies, products, and segments,” Cisco chairman and CEO John Chambers said in a statement Wednesday afternoon.

Further, the board of directors declared a quarterly dividend of $0.21 per common share, which was a two-cent increase over the previous quarter’s dividend.

Shares of the company closed yesterday down 2% at $26.93, but in after-hours trading, shares were up 1% at $27.30, and in today´s session it is now trading at $29. This mean the market reacts positively to the news. So now, we can try to find the intrinsic value of the stock, and determine if it is appropriate to buy the stock.

Valuation

In stock valuation models, dividend discount models (DDM) define cash flow as the dividends to be received by the shareholders. Extending the period indefinitely, the fundamental value of the stock is the present value of an infinite stream of dividends according to John Burr Williams.

Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.

This formula condenses to: V0=(D0 (1+g))/(r-g)=D1/(r-g)

where:

V0 = fundamental value

D0 = last year dividends per share of Exxon's common stock

r = required rate of return on the common stock

g = dividend growth rate

Let´s estimate the inputs for modeling:

Required Rate of Return (r)

The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stockj = risk-free rate + beta of j x equity risk premium

Assumptions:

Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%. This is a very low rate because of today´s context. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So I think it is more appropriate to use this rate.

Beta: β =1.31

GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rCSCO = RF + βCSCO [GGM ERP]

= 4.9% + 1.31 [11.43%]

= 19.87%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´t issue new equity.

g = b x ROE

b = retention rate

ROE=(Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

Let´s collect the information we need to get the dividend growth rate:

Financial Data (USD $ in millions) 26-Jul-14 27-Jul-13 28-Jul-12
Cash dividends declared 3,758,000 3,310,000 1,501,000
Net income applicable to common shares 7,853,000 9,983,000 8,041,000
Net sales 47,142,000 48,607,000 46,061,000
Total assets 105,134,000 101,191,000 91,759,000
Total Shareholders' equity 56,654,000 59,120,000 51,286,000
Ratios
Retention rate 1 0.67 0.81
Profit margin 0.17 0.21 0.17
Asset turnover 0.45 0.48 0.50
Financial leverage 1.82 1.83 1.86
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0.52
Profit margin = Net Income ÷ Net sales = 0.17
Asset turnover = Net sales ÷ Total assets = 0.45
Financial leverage = Total assets ÷ Total Shareholders' equity = 1.86
Averages
Retention rate 0.67
Profit margin 0.18
Asset turnover 0.48
Financial leverage 1.84
g = Retention rate × Profit margin × Asset turnover × Financial leverage
Dividend growth rate 10.66%

Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage, until it reverts to the long-run rate. A smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

g = (P0.r - D0)/(P0+D0)

= ($26.93 ×19.87% – $0.84) ÷ ($26.93 + $0.84) = 16.25%.

The growth rates are:

Year Value g(t)
1 g(1) 10.66%
2 g(2) 12.06%
3 g(3) 13.45%
4 g(4) 14.85%
5 g(5) 16.25%

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Calculation of Intrinsic Value

Year Value Cash Flow Present value
0 Div 0 0.84
1 Div 1 0.93 0.78
2 Div 2 1.04 0.72
3 Div 3 1.18 0.69
4 Div 4 1.36 0.66
5 Div 5 1.58 0.64
5 Terminal Value 50.58 20.44
Intrinsic value 23.92
Current share price 26.93

Final Comment

We have covered just one valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

Trading nearly the 52-week high seems to be announcing a fall in price. According to the valuation, the stock is overvalued today and based on this I would recommend to take the gains.

Hedge fund managers like John Hussman (Trades, Portfolio), Steven Romick (Trades, Portfolio), Chuck Royce (Trades, Portfolio), Richard Pzena (Trades, Portfolio), Charles Brandes (Trades, Portfolio) and Ken Fisher (Trades, Portfolio) have added the stock in the last quarter of 2014, as well as Pioneer Investments (Trades, Portfolio).

Disclosure: Omar Venerio holds no position in any stocks mentioned.


[1] This values where obtained from Blommberg´s CRP function.