In this article we are going to estimate the intrinsic value of Cisco Systems, Inc. (NASDAQ:CSCO) by taking the forecast future cash flows of the company and discounting them back to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$14.1b||US$15.2b||US$15.5b||US$16.2b||US$16.7b||US$17.2b||US$17.6b||US$18.0b||US$18.5b||US$18.9b|
|Growth Rate Estimate Source||Analyst x9||Analyst x9||Analyst x4||Analyst x2||Analyst x2||Est @ 2.63%||Est @ 2.51%||Est @ 2.42%||Est @ 2.36%||Est @ 2.32%|
|Present Value ($, Millions) Discounted @ 7.7%||US$13.1k||US$13.1k||US$12.4k||US$12.1k||US$11.6k||US$11.0k||US$10.5k||US$10.0k||US$9.5k||US$9.0k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$112b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.2%. We discount the terminal cash flows to today’s value at a cost of equity of 7.7%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$19b× (1 + 2.2%) ÷ (7.7%– 2.2%) = US$354b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$354b÷ ( 1 + 7.7%)10= US$169b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$281b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$41.6, the company appears quite undervalued at a 37% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at 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 accounts for debt. In this calculation we’ve used 7.7%, which is based on a levered beta of 0.908. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you’d apply different cases and assumptions and see how they would impact the company’s valuation. For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Cisco Systems, we’ve put together three pertinent factors 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 like leverage and risk.
- Future Earnings: How does CSCO’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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