Stock Valuation Term Paper
- Length: 6 pages
- Sources: 4
- Subject: Business
- Type: Term Paper
- Paper: #16288376
Excerpt from Term Paper :
Valuation of Stock
The stock valuation project calls for the choosing of a stock, and I have chosen Cisco Systems. This company is traded on the NASDAQ under the ticker symbol of CSCO. I wanted to choose a stock that is an important part of the business environment. I wanted a growth stock, and looked to technology, but I also wanted to pick something that was a bit under the radar. Cisco fits that bill because it does not sell to consumers, but mainly to other tech companies. In that sense, Cisco is a bellwether stock for the entire technology business.
General Description of the Economy
The general economy is in a state of downturn. The downturn began in 2007-2008 when the financial crisis emerged. This caused a credit crunch, and then job losses. Unemployment and uncertainty saw the reduction of the overall health of the economy. Since that point, recovery has been slow, but it is an ongoing process. There are definitely those who feel that the recovery should have been faster. One thing, though, is that the technology industry is affected somewhat differently than the overall economy. The period that coincides with the economic slowdown also coincides with the mobile revolution and rapid deployment of smartphones. So some technology companies have gained tremendously in that period. Cisco's end users tend more to be businesses, either directly on via the products they sell that rely on Cisco technology. Therefore, Cisco struggled during the downturn because business spending was very low. The company did remain profitable during this period.
The industry in which Cisco operates is populated by large and powerful firms with high levels of technological innovation and finances. Conditions are either oligopoly or monopolistic competition. Firms often sign contracts for service with their customers to ensure more stable revenue streams. Firms do have individual sales as well. For a networking company, there is also competition in terms of how comprehensive the service that they offer is. Cisco occupies a niche within this industry that is heavily focused on networking.
In general, Cisco is a high growth company. It has strong products such as switches and routers, so it is connected with networking. This means that Cisco has been affected not only by business spending, but positively by the rise of mobile. Growth prospects for Cisco are strong. The company only started paying a dividend in 2011. The strengths of Cisco are with its products, its brands, its customer networks and its strong financial position. If it has any weaknesses, they are mostly with diversification, since Cisco has long been a specialized player in networking solutions rather than a more comprehensive technology company in the way that competitors like Hewlett Packard and IBM are (Duffy, 2010).
The Dividend Discount Model
For a high growth company like Cisco, a multistage dividend discount model can be used. In principle, the dividend discount model assumes that investors seek intrinsic value, that is the present value of expected future cash flows. For stocks, that means both dividends and capital gains. The multi-stage version of this model attempts to build in growth at multiple stages, where growth occurs at different rates. Cisco is not in the early stages of very high growth, but can expect to grow strongly for the next few years as networking becomes more common. Eventually, Cisco will start to mature. Dividends will be a bigger part of its returns at that point in time. For Cisco Systems, therefore, it is better to use a two-stage growth model, but a three-stage model allows for more refined calculation. The first step in this is to use the capital asset pricing model to derive the discount rate. The risk free rate is 0.15% according to the Treasury, for a six-month paper. The beta for Cisco Systems is 1.23. Plugged into the model spreadsheet this gives the following cost of capital K
Risk Free Rate
Market Risk Premium
Using the spreadsheet but changing the numbers to reflect the current circumstances of Cisco, the following value is derived:
3 Stage Growth Model
g (next 5 years)
g (years 6-15)
g (years 16 to infiniti)
Dividend payout, first stage
Dividend payout, 2nd stage
Dividend payout, last stage
Price at the end of stage 2
PV of all dividends in stage 1&2
PV of Stock price at the end of stage 2
Sum of B26 & B27= today's value
The assumptions were lower growth rates and the initial dividend that has just been introduced has been factored in. A standard maturation process of the networking business is assumed. This finding shows that Cisco is probably worth more than its current market valuation. The current valuation of the market is $25.50. Thus, Cisco appears to be undervalued.
The Residual Income Model
The residual income model is not the best model for this type of thing. This model is best used for companies that are not profitable, or do not have positive cash flow, or do not pay dividends. Cisco does not meet these criteria. As such, not much will be expected from the application of the residual income model in this instance.
The point of the residual income model is to take into account not the income of the company, but the income that is left over after financing costs have been taken into account. Interest expense for debt financing is already removed from net income, but the equity financing costs have not been removed. The equation needs the following inputs: equity value, book value, cost of equity. The cost of equity is k, 8.76%. The calculation of residual income is therefore:
Cost of Equity
Total Equity Outstanding
Total Equity Cost
The residual income is $3.067 billion. This is added to the book value of the company, which is $56.788 billion to get $59.855 billion. Divide by 5.315 billion shares outstanding to get a value of $11.26 per share. By this valuation method, Cisco is overvalued at its current level. While this methodology has its weaknesses, it is an interesting exercise to see that it gives quite a different number.
The price/earnings ratio is simple the ratio of the price of a share divided by the earnings per share (EPS). This ratio is commonly used to help value stocks and companies. The current P/E ratio for Cisco is 14.19. The historical value of EPS for Cisco is 17.3, which means that the stock is trading a little lower than it has been relative to earnings. The historic level is what will be used to make this calculation. For this, the EPS needs to be projected into the future. This requires understanding the EPS growth rate. A regression shows the EPS growth rate over the past five years is 0.042, so this is added to the current EPS of $1.50 to get an expected EPS next year of $1.542. With the historic P/E, the stock price should be:
1.542 * 17.3 = $26.67
This is fairly close to the current value of Cisco, but shows that perhaps Cisco is slightly undervalued with respect to P/E. The reason for this is that the P/E multiple has normally been higher in the past than it is today. Thus, perhaps the market is not optimistic about Cisco's growth as it used to be.
The price to cash flow model equates the price of the stock to the operating cash flows. The current operating cash flow is $11.491 billion. The regression of the past five years, however, shows that operating cash flow has been shrinking. As a result, the expected operating cash flow for next year is actually $11.39 billion. The historic price/cash flow ratio for Cisco is 21.1. This gives us the following calculation for the expected price of Cisco:
21.1 * (11.39/5.34) = $45.
By this estimate, Cisco is quite undervalued. The current price seems a bit out of whack with historic price/cash flow ratios, even with the expected slump in cash flow. The market perhaps expects cash flow to be quite a bit lower next year than the model suggests.
The price to sales model is the final model. This model equates the price of the stock to the sales. The current level of sales is $47.88 billion. The regression line shows that next year's expected sales are $50.784 billion. The historic average of price/sales is 2.8. So the expected stock price based on this method is:
2.8* (50.784/5.34) = $26.62
By this model, Cisco is slightly undervalued. It is interesting that this model gives virtually the same price as the P/E model, which suggests a close correlation between sales and earnings, since the figures move in a similar manner.
The following table shows the outcomes of the five different methodologies:
Table 3 Outcomes