Cisco Systems Stock Valuation: Five Pricing Models Compared

Introduction: Choosing Cisco Systems

This stock valuation project examines Cisco Systems, a company traded on the NASDAQ under the ticker symbol CSCO. Cisco was selected because it represents an important part of the business technology environment. As a growth stock in the technology sector, it occupies a somewhat under-the-radar position in that it does not sell primarily to consumers, but mainly to other technology companies. In that sense, Cisco is a bellwether stock for the entire technology business, making it a compelling subject for valuation analysis.

General Economic and Industry Overview

The general economy is in a state of downturn. The downturn began in 2007–2008 when the financial crisis emerged, causing a credit crunch and subsequent job losses. Rising unemployment and widespread uncertainty reduced the overall health of the economy. Since that point, recovery has been slow but ongoing. There are those who feel the recovery should have been faster. One important nuance, however, is that the technology industry has been affected somewhat differently than the broader economy. The period coinciding with the economic slowdown also coincides with the mobile revolution and the rapid deployment of smartphones, meaning some technology companies gained tremendously during this same period.

Cisco's end users tend to be businesses — either directly or via products that rely on Cisco technology. As a result, Cisco struggled during the downturn because business spending was very low, though the company did remain profitable throughout this period.

The industry in which Cisco operates is populated by large and powerful firms with high levels of technological innovation and significant financial resources. Competitive conditions are either oligopolistic or characterized by monopolistic competition. Firms often sign service contracts with their customers to ensure more stable revenue streams, though individual sales also occur. For a networking company, competition extends to how comprehensive the services offered are. Cisco occupies a niche within this industry that is heavily focused on networking.

The Dividend Discount Model

In general, Cisco is a high-growth company with strong products such as switches and routers. This means Cisco has been affected not only by the contraction in business spending, but also positively by the rise of mobile. Growth prospects for Cisco remain strong. The company only began paying a dividend in 2011. Its key strengths lie in its products, its brands, its customer networks, and its solid financial position. If it has any weaknesses, they are primarily related to diversification: Cisco has long been a specialized player in networking solutions rather than a more comprehensive technology company in the manner of competitors like Hewlett-Packard and IBM (Duffy, 2010).

For a high-growth company like Cisco, a multistage dividend discount model (DDM) is appropriate. In principle, the dividend discount model assumes that investors seek intrinsic value — that is, the present value of expected future cash flows. For stocks, this encompasses both dividends and capital gains. The multi-stage version of the model attempts to incorporate growth occurring at different rates across multiple periods. Cisco is not in the earliest stages of very high growth, but it can expect to grow strongly over the next few years as networking becomes more prevalent. Eventually, Cisco will begin to mature, at which point dividends will represent a larger share of its total returns.

A three-stage growth model is used here, as it allows for more refined calculation than a two-stage alternative. The first step is to apply the Capital Asset Pricing Model (CAPM) to derive the discount rate. The risk-free rate is 0.15%, based on the six-month Treasury rate. The beta for Cisco Systems is 1.23. These inputs yield the following cost of capital:

Applying the three-stage growth model with assumptions reflecting the current circumstances of Cisco produces the following results:

The assumptions incorporate lower growth rates and factor in the initial dividend that Cisco has recently introduced, along with a standard maturation process for the networking business. This finding suggests that Cisco is worth more than its current market valuation. With a current market price of $25.50, Cisco appears to be undervalued according to this model.