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Cisco Systems Inc, Inc. Equity Valuation
and Analysis
As of November 1, 2007
Group Analysis
Dallas Branch [email protected]
Robert Eads [email protected]
Jeremy Henderson [email protected]
Joel Shockney [email protected]
1
Table of Contents Executive Summary 3
Business & Industry Analysis 8
Company Overview 8
Industry Overview 10
Five Forces Model 12
Rivalry Among Existing Firms 12
Threat of New Entrants 17
Threat of Substitute Products 20
Bargaining Power of Buyers 23
Bargaining Power of Suppliers 25
Strategies for Value Creation 27
Firm Competitive Advantage Analysis 30
Accounting Analysis 34
Key Accounting Policies 35
Potential Accounting Flexibility 38
Actual Accounting Strategy 40
Potential “Red Flags” 41
Coming Undone (Undo Accounting Distortions) 41
Quality of Disclosure 42
Qualitative Analysis of Disclosure 42
Quantitative Analysis of Disclosure 45
Sales Manipulation Diagnostics 46
Expense Manipulation Diagnostic 53
Financial Analysis, Forecast Financials, and Cost of Capital Estimation 59
Financial Analysis 59
Liquidity Analysis 59
2
Profitability Analysis 67
Capital Structure Analysis 74
IGR/SGR Analysis 76
Financial Statement Forecasting 78
Analysis of Valuations 89
Method of Comparables 89
Cost of Equity 95
Cost of Debt 98
Weighted Average Cost of Capital 99
Intrinsic Valuations 99
Free Cash Flows Model 100
Residual Income Model 101
Long Run Return on Equity Residual Income Model 101
Abnormal Earnings Growth Model 103
Credit Analysis 104
Analyst Recommendation 105
Appendix 106
Liquidity Ratios 106
Profitability Ratios 107
Capital Structure Ratios 108
Method of Comparables 109
Regression Analysis 110
Free Cash Flows Model 122
Residual Income Model 123
Abnormal Earnings Growth Model 125
Altman Z-score 126
References 127
3
Executive Summary Investment Recommendation: Overvalued, Sell (11/1/2007)
CSCO - Nasdaq(11/01/07): $32.1852 Week Range: $24.82 - $34.24 2002 2003 2004 2005 2006 2007Revenue: $4.909 B 3.213 3.211 3.116 3.217 2.336 2.446Market Capitalization: $166.72 BShares Outstanding: 6.07 B Altman's Z Score(After Goodwill Impairment)Percent Institutional Ownership: $166.72 B 2002 2003 2004 2005 2006 2007Book Value per Share: 71% 3.149 3.136 3.041 3.128 2.197 2.298ROE: 16%ROA: 10% Valuation Estimates
Actual Price (11/12007): $32.18
Financial Based ValuationsForward P/E: $145.69Trailing P/E: $197.93P/B: $20.37
Cost of Capital est. R2 Beta Ke D/P N/AEstimated: P.E.G. $41.183-month 0.394 1.81 18.48% P/EBITDA $39.161-year 0.394 1.809 18.47% P/FCF N/A2-year 0.392 1.804 18.44% EV/EBITDA $35.325-year 0.394 1.811 18.49%7-year 0.395 1.813 18.51% Intrinsic Valuations10-year 0.395 1.815 18.52% Discount Dividends: N/A
Free Cash Flows: $38.45Published Beta: 1.1 Residual Income: $8.05Kd(AT): 3.13% Kd(BT): 4.82% LR ROE: $5.73WACC(BT) 42.95% WACC(AT) 12.22% AEG: $8.93
Altman's Z Scores(Before Goodwill Impairment)
*All values stated are after goodwill impairment unless otherwise states
4
Industry Analysis
Cisco Systems, Inc. (CSCO) has been the leader in home and business
networking around the world since 1984. Founded by a small group of computer
scientists from Stanford University, Cisco has grown to produce products in areas
such as: routing and switching, unified communications, wireless, and security.
Cisco entered the technology industry during the boom of internet protocol (IP).
Since its introduction Cisco has spread throughout the world marketing its
products in several geographical regions. These regions include, the United
States and Canada; European markets; emerging markets; Asia Pacific; and
Japan. Cisco’s product lines are available in retail stores nationwide and at
www.cisco.com in the company’s online store.
Cisco Systems has two main competitors in the technology industry,
Juniper and Nortel Networks. Companies in this industry compete for market
share based on economies of scale and scope, product pricing, increasing market
presence, and product performance. Since the technology industry is a
knowledge based industry, the threat of new entrants is low. Firms in the
industry compete on wireless technologies such as speed and security.
Product differentiation does not play a large role in the technology
industry, as most of the products produced have the same basic concepts.
Cisco’s main concern, as well as that of the other firms, is to stay ahead of the
technology curve. Cisco has made sure that they are at the top of the technology
curve, year by year, by spending large sums on research and development. In
2006 Cisco Systems spent $4.1 billion to stay ahead of the curve.
Product performance is the biggest key success factor for Cisco and their
competitors. Firms in the technology industry must always work on developing
products that are faster, more secure, and just as advanced as the growing
world of technology. So long as Cisco keeps developing products with top
performance ratings, they will continue to dominate the communication
technology industry and gaining market share.
5
Accounting Analysis
The ability to accurately and quickly disseminate data from a company is
something that investors look for in companies they may want to purchase. The ability
to take creative liberties with accounting information is an easy way for companies to
overstate assets, understate liabilities and to make the bottom line look rosier then is
actually the case. Because of this, making sure the accounting data is correct is vital to
our valuations.
There are several areas that Cisco could distort accounting information while still
being within the bounds of Generally Accepted Accounting Principals, the largest of
which is the way they handle the impairment of goodwill. Cisco says on its 10-K that
they “perform goodwill impairment tests on an annual basis” (Cisco 10-K 2007, 22),
however they haven’t impaired goodwill since 2003. Because of this, we have decided
to make the adjustments our self, and impair goodwill by 20% per year from 2002 to
2007. This will give us a fair an accurate picture of the asset composition of Cisco and
how it affects the bottom line.
Other then goodwill, Cisco has the ability to manipulate liabilities on its balance
sheet through changing the discount rate on its post retirement benefit plans and by
manipulating the amount it expects in product returns and warranty claims. On their
10-K’s, they make every effort to provide transparency by disclosing their discount rates
that they use to value their future obligations to retirees. This level of transparency
shows that Cisco believes it is fairly valuing its liabilities. With product returns, Cisco
adjusts its warranty liability up with an increasing in shipping volume for their products
(Cisco 10-K 2007, 362). This shows commitment to fairly valuing future costs.
Because we saw no “red flags” while doing the ratio analysis for the Sales and
Expense Diagnostics and because of the amount of transparency that Cisco provides in
dealing with liabilities goes above and beyond GAAP, we can say that Cisco has a high
level of disclosure and good transparency in its accounting figures.
6
Financial Analysis, Forecast Financials and Cost of Capital Estimation
To get an idea of how Cisco is competing versus the competition, we did ratio
analysis to chart not only the health of the industry, but the direction that it is going in.
We used them to give us an idea of the financial strength of the companies with the
hopes that they would ultimately provide us with an idea of how the company should be
valued. Some of those ratios would also give us a starting point that would eventually
let us develop a set of forecasted financial statements that we could use to value the
firm. With that piece secure, we could evaluate the regression data that we obtained
from Cisco and obtain a Beta so we could proceed with other cost of capital calculations.
When looking at the financial ratios, we can see that Cisco is generally a healthy
company (at least in respect to those ratios). From the liquidity side, Cisco is right on
target for what is accepted as a strong company, especially with respect to the quick
and current ratios. The profitability ratios show where Cisco stand out, with a level of
profitability that is higher then all other competitors. Over the past six years Cisco has
shows high levels of profit margin and a strong return on assets. The capital structure
ratios show a company that Cisco prefers debt to equity financing, and it gives us a
strong indication that high levels of equity financing will continue. All these indicate a
company that is expected to generate steady profits in the future if the past trends
continue.
Forecasting financial statements proved to be one of the largest challenges of
this valuation, because of the erratic numbers that were presented by the rest of the
industry. However, after looking at previous years operating income and net income,
we were able to come to the understanding that net sales were probably going to grow
at a rate around 15%, with net income growing a little faster. Using these figures, we
were able to back our way into other growth rates for the balance sheet. However, for
the statement of Cash Flows, the Cash Flows from Operations/Operating Income ratio
was key to forecasting out Cash Flows from Operations. With the statements
completed, we were able to start on our valuations.
7
Valuations
After completing a comprehensive study of a company and its competing
industry firms, an analyst begins to see the larger picture and can value the
company. During the comprehensive study, the analyst reviews the accounting
policies and financials of both the company and industry they are in. Once the
financials have been common sized and forecasted, it becomes a simple task to
begin to value the company.
We begin the valuation process by running a series of quick ratios, most
commonly seen in various investing tools to get a quick overview of the valuation
of the company. Most of the quick ratios used showed that the company was
actually undervalued. We found that these results were skewed by their
constant acquisitions of other companies and Cisco not writing off any of the
goodwill obtained in these transactions. During the quick ratio assessment, we
found a variety of valuations ranging from 35.32 using EV/EBITDA all the way to
197.93 using trailing P/E. This wide range of values shows really how inaccurate
and unpredictable these quick ratios can really be. To overcome this, we began
using intrinsic valuations to get a better view of the value of the firm. The first
model looked at was the Discounted Free Cash Flows model. This model
returned result in line with the quick models, but we determined that the
perpetuity consisted of over 4 times the value of the forecasted financials. This
shows that most of the value shown with this valuation is found in the land of
wishful thinking. Next we turned to the Residual Income model, Long Run
Residual Income Model, and the Abnormal Earnings Growth model. Based on
the forecasting numbers these models use and the way they are ultimately
calculated, they are seen as very accurate models. Based on these intrinsic
models, we determined that the valuation of Cisco should be around $8.00 per
share, making it extremely overvalued.
8
Business & Industry Analysis
Company Overview
Cisco Systems, Inc. (CSCO) is the networking leader across the world. Cisco was
founded in 1984 by a group of ambitious computer scientists from Stanford University.
Since their introduction to the world of networking and Internet Protocol (IP), Cisco has
become the market leader in areas including routing and switching, unified
communications, wireless and security. Cisco was at the heart of the IP movement and
now works to improve the way the world communicates. Today, Cisco Systems
distributes their products throughout the world, operating in many geographical
segments including the United States and Canada; European markets; emerging
markets; Asia Pacific; and Japan. Though Cisco operates internationally, their
headquarters are located in San Jose, California.
Cisco sells merchandise to its customers through retail stores, systems
integrators, service providers, and their own online store (www.cisco.com). Cisco carries
a wide range of products including products for use in corporations, small businesses, or
even small home networks. Cisco’s main product lines are routing products and
switching products with a wide range of more advanced technologies. The advanced
technologies produced include application networking services, home networking,
hosted small-business systems, optical networking, and security; none of which make up
the majority of Cisco’s sales.
While there are hundreds of companies in the networking and communication
devices segment of the computer technology industry; Cisco only has a few main
competitors. These competitors include Juniper Networks (JNPR) and Nortel Networks
(NT). With a market capital of 195 billion, Cisco surpasses all its competitors by at least
170 billion in market capital. Cisco has also surpassed its competitors in net sales over
the past 5 years, with net sales of 28.5 billion in 2006 compared to its closest competitor
9
Nortel Networks at 11.4 billion. Though Cisco towers over its competitors in terms of
market capital and net sales, Cisco’s stock price falls short of Juniper and Nortel. With
their stock price increasing 100% in 2002/2003, Cisco’s stock price is climbing but
unable to reach its competitors. Looking at the past 5 years Cisco stock has improved by
200% at an ending price of $32.16 a difference of 20 points since September 2002.
http://moneycentral.msn.com
While Cisco’s stock price falls short of its competitors, Cisco strives to stay at the
top of the networking and communication devices segment of the computer technology
industry. Cisco has acquired several other small companied in the past 5 years, adding
to their product differentiation and market capital.
10
Industry Overview
The technology industry is broken up into 32 segments ranging from
communication equipment and networking & communication devices to wireless
communications and telecom services. Due to Cisco’s high volume of sales being in
networking and communication, Cisco is considered to be a part of the networking &
communication devices segment of the technology industry. The networking segment of
the industry concentrates on providing networking and communications to large
corporations, small businesses, and consumers.
The technology industry requires companies to have large amounts of human
capital. By investing in knowledgeable human capital companies in the industry are able
to ensure entry into the technology industry. Since the networking and communication
devices industry requires such high human capital there are only 32 main firms. Due to
the small number of firms operating in this segment and the need for human capital,
entry into the technology industry is a hefty challenge.
Networking and Communications Industry Growth Rate
-3.49%
9.35%11.74% 11.57%
-5.00%
0.00%
5.00%
10.00%
15.00%
2003 2004 2005 2006Years
Per
cent
age
Cha
nge
*Percentage obtained from the average sales growth of Cisco,
Juniper, and Nortel
11
The networking and communications segment of the technology industry has
grown a total of 29.17% over the past 4 years. As time goes on, the needs of
consumers and businesses will rise and the need for computer networking and
communication devices will be at an all time high.
Five Forces Model
12
In 1979 Michael Porter developed “a framework for industry analysis and
business strategy development” (Porter 5 forces analysis). Since its introduction into the
business community, it has been used to consider the strategic positioning of companies
and whether they exist in an industry that has a high level of competitive pressures or a
low level of competition. This model will allow us to ascertain the overall state of the
network and communications industry, a crucial step for our valuations to come.
Rivalry Among Existing Firms Moderate
Threat of New Entrants High
Threat of Substitute Products Moderate
Bargaining Power of Buyers Low
Bargaining Power of Suppliers Moderate
Rivalry Among Existing Firms
When looking at the competition that exists in an industry, several factors have
to be considered before that industry has high or low competition. The speed at which
the industry is growing, how companies deal with extra capacity and the ease at which
companies can leave the industry all must be considered before evaluating the rivalries
in that industry.
Industry Growth
13
Networking and Communications Industry Growth Rate
-2.41%
10.26%12.08% 11.44%
-5.00%
0.00%
5.00%
10.00%
15.00%
2003 2004 2005 2006Years
Per
cent
age
Cha
nge
*Percentage obtained from the average sales growth of Cisco,
Juniper and Nortel.
When attempting to identify the competitive nature of any industry, taking into
account the rate at which that industry is growing is crucial to making informed
decisions. Industries that are growing at a fast rate have the luxury of not worrying
about increasing their profit margins or being the largest or most developed company,
they simply have to keep up with the growing demand for their product. This reduces
overall competitive pressures between firms because it gives every company in an
industry a little room to breath, rather than attacking each other for small pieces of the
market. Looking at the Networking and Communications industry, we see that growth is
happening at an excellent pace, with double digit gains the last five years. This says a
few distinct things. First, that because of the availability of a market for their product,
companies in this industry are able to worry more about their product and less about
their competitors in the market. It also signals that may be able to establish cooperative
14
partnerships with other companies because there is less pressure against each individual
company to battle for supremacy against the other ones. This is something that many
players in the industry have already taken advantage of, with Cisco keeping strategic
partnerships with HP, Microsoft, Motorola, Oracle and Sony; Juniper with Microsoft, NEC,
Symantec and Avaya and Nortel with the Innovation Communication Alliance with
Microsoft. This allows companies in the industry to continue to innovate and create
future growth, relieving competitive pressures in regards to already established firms.
Economies of Scale
Total Assets
2002 2003 2004 2005 2006
Cisco Systems 37,795 35,594 35,594 33,883 43,315
Juniper Networks 2,614 2,411 6,981 8,183 7,368
Nortel Networks 19,961 16,591 16,984 18,112 18,979
*In millions of dollars
A firm’s ability to use its size to drive down prices by using its size is crucial for
companies looking to obtain a competitive edge over customers. Economies of scale are
the way that companies achieve this ideal. By becoming large, you allow yourself to
fully realize the benefits of mass production and allow specialization of labor which can
not allow you to produce a better quality product, but one that is also cheaper than your
competitors. In a highly competitive industry, most if not all of the firms would have a
high number of assets to realize the benefits of economies of scale. However, in
Networking and Communications industry, it isn’t so. It seems that not all the
companies in the industry are concerned about economies of scale (such as Juniper and
Nortel). This may be because other companies focus on more specialized markets in the
networking industry, but it is probably more likely because Cisco is one of the more
15
developed companies in the industry, serving both the mass consumer markets (through
their ownership of companies like Linksys) and more unique markets (like large
enterprise businesses and service providers). Either way, competitive pressures have
not forced other companies to try to compete in the industry through economies of
scale.
Excess Capacity
Industry Total Employment
74,502 70,693 71,09877,928
88,519
010,00020,00030,00040,00050,00060,00070,00080,00090,000
100,000
2002 2003 2004 2005 2006
Year
Empl
oyee
s
*Employment figures taken from the financial statements of Cisco Systems, Nortel Networks and Juniper Networks.
In the technology industry, excess capacity can be a dangerous proposition.
With the rate at which most tech products become obsolete, increasing your ability to
produce more and different types of goods can be a little uncomfortable. If left with
excess capacity without a market, it can cause the end of a company. However, steady
growth in excess capacity can show that a company is anticipating large demands that it
will have to fill, and can signal that there may be less worries about competition. The
industries recent boost in employment shows that it is prepared for higher growth in the
future; the industry is unlikely to be cutting costs anytime soon.
Exit Barriers
16
The inability to leave an industry is the primary characteristic of an exit barrier.
There can be many reasons that a firm may have problems leaving an industry, from
political, social or legal ramifications to the inability to sell long term assets. In the case
of the Networking and Communications industry, most of its manufacturing is
outsourced to factories outside of the United States (whereas most of the firms in the
industry previously used an in-house model of manufacturing , so getting out of the
industry would avoid most of the political or legal ramifications. Since third parties are
so involved in the manufacturing process, it would only take the ending of
manufacturing contracts (which are prevalent in an industry with a high level of
outsourcing) to get many of the industry players out of most of their obligations, making
leaving the industry relatively easy.
Concentration
Market Share
01020304050607080
2002 2003 2004 2005 2006
Year
Per
cent
age
of M
arke
t Sha
re
CiscoJuniperNortel
*Figures derived from net sales of Cisco Systems, Juniper Networks and Nortel Networks.
When looking at the level of rivalry between existing firms in an industry, the
concentration is one of the most important aspects to consider. An industry with low
concentration would most certainly have fierce rivalries between competitors, because
with nobody really dominating the competition with a larger market share, all
17
competitors would be on a more even footing when it comes to competing on costs. In
the networking and communications industry, concentration is high, with Cisco
dominating the overall market share of the industry, with Nortel in 2nd place, which a
much smaller percentage of the overall market share. This means that using this
metric, the level of competition between existing firms would be low, because no other
firm would have the capabilities to compete against Cisco. Until another firm gained
market share, Cisco (as the dominant firm with respect to market share) would be able
to dictate price and control the dominant supply chains of the industry.
Conclusion
By using these metrics to evaluate the level of preexisting firm competition, we
can see that the networking and communications industry is a mixed bag when it comes
to competition. On one hand, the industry is growing at a rapid pace and excess
capacity is being added, making competition between firms low. On the other hand,
exit barriers are relatively low due to the fact that most companies outsource their
manufacturing, as well as the fact that most companies of the industry aren’t realizing
large economies of scale. So for much of the industry, the rivalry is moderate.
Specifically for Cisco however, their ability to corner the market share, as well as their
use of economies of scale has put them at a better position when it comes to
competition with their rival companies.
THREAT OF NEW ENTRANTS
The networking and communications industry is highly concentrated and is a
much more differentiated industry, meaning that it is an industry that produces unique
products that cannot be found just anywhere. It is an industry that is comprised of 4
major companies. In order to gain a foothold on competitors it is imperative to have a
great amount of expertise and capital to invest in research and development that is
needed in this high-tech industry. Seemingly, there are an unlimited number of
18
obstacles that would keep new entrants from being able to enter the market; limited
resources and competition with industry leaders are among the most problematic.
Economies of Scale
It would be virtually impossible for a new entrant to enter this market and
effectively challenge any of the minor companies for an equivalent market share, let
alone the major 4 that dominate the industry. New entrants lack the capital, customer
base, and positioning that their competitors have already gained. It would take an
incredible amount of start-up capital for a company to enter this industry and begin their
research and development program. Research and Development is the core of a
company’s success or failure. Networking is a technology based industry that consumes
the mass of a company’s assets. In 2007 Total Assets equaled 53.24 billion dollars, of
which, 4.5 billion dollars were poured into R&D. Without an abundant flow of capital,
new entrants would find it quite difficult to maintain a competitive market edge for a
long period of time.
Distribution Access and Supplier Relationships
Acquiring all of the parts for the hardware and creating the software that ties it
all together is an everyday task for even the established firms in the market. New
entrants would find this task all the more difficult, perhaps impossible, due to the lack of
suppliers that may not be willing to do business with a company half the size, ordering
fewer parts, and paying far less money than Cisco, Juniper, and Nortel. Companies
emerging into the industry would also be working with limited capacity that would
prohibit the effective and efficient distribution of the products made. Without a supply
chain and proper distribution channels, a new entrant would not survive in this high-tech
industry. Cisco itself was the perfect example of how poor supply chain management
can generate disaster within this industry. In 2001 Cisco had its first ever negative
earnings and subsequently wrote off 2.2 billion in inventory. This industry leader’s
highly superior technological infrastructure was to blame. Cisco then revamped its
19
supply chain management, connecting all of its suppliers and manufacturers online,
instantly communicating customer orders, eliminating inventory lag time. This doubled
its inventory turnover and lowered inventory by 45%. So even though, at the time, it
was perceived as possibly one of the nation’s leading supply chains, we realize that even
the best can fail. So without proper supply chain management entering competitors
have no chance.
Legal Barriers
When a company enters any market there are going to be legal barriers to overcome;
most are fairly easy to surmount. Many of the legal barriers in the networking market
that can cause problems stem from importing goods from foreign countries. Importing
these parts is a fickle matter, usually considered a “thorn in the back” but is a necessity
for all companies. It may take some time, patience, and legal work but usually the
outcome is favorable. Of course, anytime there is research and development programs
involved, the issue of copyrights and patents come into play. These are the problems
that do not have a simple solution. Large amounts of time and capital are invested into
the development of hardware and software. Large amounts of time and capital are also
spent ensuring that the “secrets” are kept within the company, and not copied by
competitors. Patents play a key role since technology is the cornerstone of this industry.
For example, one of the newest bundled services known in this industry as “the triple
play,” which is TV, internet, and phone services all sold as one package, is patented by
Cisco. This is an infringement nightmare for any new competitor trying to take
advantage of low cost service bundling, but just another power move by Cisco ensuring
its industry dominance.
Conclusion
The network and communication market is a highly concentrated industry. In the
market there are some competitors; none of which rival Cisco in size, and market share.
Entering this type of high-tech industry would be futile. Although the market is
constantly growing, it seems that almost every company entering is being bought out by
the existing companies. New entrants should be aware that Cisco itself has bought out
20
over a hundred smaller companies within the last decade. They controls over two-thirds
of the market, and its three largest competitors are left fighting for the remaining third.
Threat of Substitute Products
The threat of substitute products is one that looms large over most companies,
however in technology based industries the threat is different from most. The largest
concern is getting behind the technological curve and not being able to offer customers
the products they desire. Cisco minimizes the threat of substitute products by spending
$4.1 billion in research and development expenditure in 2006 to stay ahead of the curve
(Cisco 06 10-K, 8), with Juniper spending only $480 million (Juniper 06 10-K, 47) and
Nortel spending $1.9 billion, less than ½ of what Cisco spends (Nortel 06 10-K, 42).
This was done while also targeting specific customer groups in order to provide them
with a product that others could not replicate.
21
Buyers’ Willingness to Switch
R&D Expenses
0.00%5.00%
10.00%15.00%20.00%25.00%30.00%35.00%
2002 2003 2004 2005 2006
Years
R&D
as a
% o
f Net
Re
venu
e CiscoJuniperNortel
*Figures taken from the 10-K reports of Cisco Systems, Nortel Networks and Juniper Networks.
The willingness or ability to switch is a central issue for many companies in the
Networking and Communication Devices industry. With the advances in technology,
companies must stay on the cutting edge of research and development to keep up with
demands. If customers perceive that a company is falling behind in innovative products,
they may be more inclined to choose a company who will provide them with the latest
equipment. Over the several years, we have seen a decline in the commitment to
investment in Research and Development as shown in the above chart (when seen as a
percentage of total Net Sales). However in the more recent years we are seeing
something of an upward trend, signaling that companies in the industry are looking to
minimize the buyer’s willingness to switch. This would create a more competitive
industry, because each company is putting more money into securing innovation to keep
their customers happy.
22
Relative Price and Performance
Differing consumer markets place different weights what they consider
paramount to what they look for in networking equipment. For large scale businesses
and networking service providers, a much higher emphasis will be placed on
performance and the ability to deal with large volumes of information in a complex
environment. Because of the challenges faced by these companies and the important
role networking plays, these buyers would tend to be more price insensitive and focus
more on quality and customer service provided by a company. On the other hand, the
consumer markets, which would normally be using equipment in the home or small
office setting, is going to be much more sensitive to the pricing of the products, since it
is most likely that these products will be used mostly to access the internet, and not in
any particularly large in complex network where specialized features would be needed.
When looking at this measure of competition, we see distinct differences. In the
industry different companies have staked out different position. Cisco has decided to be
overall player, catering to both the consumer market and enterprise market. To better
cater to the individual consumer market, Cisco acquired Linksys in 2003 for the purpose
of servicing customers with,”affordable, easy-to-install, high-quality reliable
products”(Linksys Company Profile). Nortel and Juniper however, have decided to take
more specialized positions (with large enterprises as a primary focus. Nortel states its
primary focus is on “transforming the enterprise to support a hyper connected world,
delivering next-generation mobility and convergence to enable a true broadband
experience, and providing networking solutions that integrate networks and applications
into a seamless framework” (Nortel 06 10-K, 3), while Juniper states that their
customers are “service providers, enterprises, governments and research and education
institutions” (Juniper 06 10-K, 4). Each company has taken a different customer base
(although there is some overlap). Because of this, when it comes to relative price and
performance, the level of competition should be lower, because there is less competitive
pressure in each market segment when it comes to pricing.
23
Conclusion
In this complex industry, a company must put forth quiet an effort to ensure that
other similar products won’t overtake their business. With the specialization that has
occurred throughout time, the pressure created by price is low, however companies in
the industry have recently decided to step up their R&D spending, which creates less
incentive for customers to switch to other companies, creating more competitive
pressures. Overall, the level of competition created by the threat of substitute products
is moderate.
BARGAINING POWER OF CUSTOMERS
In differentiated industries, firms do not generally compete over the price of their
products; therefore, buyers have very little bargaining power. In price leading industries,
a firm’s primary concern is obviously going to be price, and the price of their
competitors. It is in this type of market, a low concentration market, that the buyer has
a great deal of bargaining power and this forces competitors to keep their costs of
production lower that costs of goods sold in order to compete, and still turn a profit. The
company is at the mercy of their competitors and the consumers. In differentiated,
highly concentrated industries are focused on the quality of the item.
The networking and communication industry falls into the category of low
competition, high concentration, and differentiated market. The consumers of this
industry have little effect on the price of the products sold, mainly because Cisco and
other firms do not compete on price so much as they do on quality, brand image, and
flexibility. Companies that run above 50% gross profit margin, typically have products
that offer much higher quality for customers willing to pay premium prices. These
companies know that consumers are not looking for the cheapest product, but that they
are looking for the best product at the most affordable price. They are companies that
would like to be thought of as durable, high quality brand names. Cisco generally runs a
64% gross profit margin showing the value they have in their products.
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Price Sensitivity
Being price sensitive takes several factors into account; the key factor being the price of
their product as well as the price of any substitute products made by competitors. Price
sensitivity is a much larger issue when the company operates with a cost leader
strategy, meaning that there are several other substitutes readily available for the same,
if not lower price. There is much more competition in those markets making it easy to
find what is needed at the lowest possible price. Having a differentiated product
however, means that that companies in the market compete over quality because of the
amount of capital spend on the research and development of the product. Companies
with this type of strategy gain a competitive advantage by having the best quality with
the more viable price.
Cisco is by far the largest company in the networking and communications
industry with the three largest competitors being Juniper Networks, Nortel Networks,
and Lucent-Alcatel, along with a several other smaller companies. All of these firms
produce specialized hardware servers and software that cater from the small family
households, to the large corporations. Consumers are willing to pay top dollar for the
most state of the art equipment on the market, making this industry almost impervious
to price sensitivity. This industry runs an average gross profit margin of about 65%
once again showing the consumer need for high quality. There are industry laggards
that run well below 50%, but these are never the top three competitors.
Conclusion
Because the main companies in this market create specialized products, it makes
it hard for consumers to go out to and find their products at a Wal-Mart or Target. In
most cases, in order to get a hold of something that is sold by Cisco, or Juniper, it must
be found online. This makes it difficult for the consumer to have the “I will find it
somewhere else” mentality. Therefore, the bargaining power is not in the hands of the
consumer, and the market is not based on price wars with their competition. The firms
can charge what they think is fair for their own product.
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BARGAINING POWER OF SUPPLIERS
Suppliers for the firms are ultimately the most essential part of how the firm is
going to operate. The supplier determines the entire structure of the supply chain. If the
supplier has high bargaining power, then the firm is must go along with the demands of
a supplier, whether it is price, or delivery date, etc.., especially if suppliers in the market
are scarce. The firm cannot afford to strain or sever ties with their supplier because the
supplier is the lifeline of the company. Without steady supplies a firm can lose its market
share and invested capital trying to find a new supplier. If suppliers in the market are
plentiful, then bargaining power shifts over to the firms. If a firm has bargaining power
over the supplier then they firm is able to decide delivery schedules and prices.
The larger firms are able to produce many suppliers needed, typically diminishing
all supplier power. Cisco is brilliant at this. Their directory of importers and exporters
topped 3,000,000 at one time. More recently they have decreased it by almost 50%
adding only the suppliers that will provide them with a competitive edge in the industry.
So only to suppliers that have invested large amounts of capital into technological
advances are typically used. This typically destroys any bargaining power at all. Most
of the bargaining power in this industry falls toward the buyer; in this case it would be
the networking industry. Because this market is so large and because companies like
Cisco and Juniper buy in such large quantities; they have a bit more say in the price
they are being charged by suppliers.
Price Sensitivity
Once again price sensitivity between the suppliers and the consumers is based
upon the price, availability of substitutes, and demand. The major difference with in this
case would be that the buyers in this industry are not purchasing finished goods, and
the overall transaction is on a much larger scale. Suppliers are supplying multi-billion
dollar companies with parts and accessories and with such a vast amount of suppliers,
supplier prices can be measured extremely closely for changes. But the focus for
suppliers in this industry is not so much the price, but what else they can bring. Can
they provide a full array of services or improve the company’s competitive position with
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new technology. This brings price sensitivity to a lower importance than other
industries.
Relative Bargaining Power
The suppliers of the four largest firms in the market have two options they can
choose. On the one hand, since there are a limited number of suppliers, they could
squeeze the “buyer” for the highest possible price. On the other hand they cannot afford
to push the “consumer” too far, because if their primary source of commerce decides to
take their business elsewhere, the supplier is losing out on millions of dollars. Suppliers
and “buyers” in this industry are usually at equilibrium in terms of the price and supply.
Neither the firm nor the supplier can afford to lose the other, especially in a market with
the amount or return as the networking and communications industry.
The equilibrium between supply and demand lets all of the firms concentrate
more on the other aspects of their corporate strategy. Since the bargaining power lies
on both sides, it does little damage in terms of gaining competitive advantage over rivals
allowing the more profitable firms to stay atop the market. The smaller companies may
be a little more under the influence of the supplier since their business is not as vital as
their larger counterpart; making it harder to negotiate a better price for their smaller
business.
Conclusion
The giants of the industry are able to control almost every aspect of the market.
Although they do not control the supplier, the important aspect is that they are not
being controlled by the supplier. Both the consumer and the supplier have an
understanding that keeps the other in business. There is interdependence that exists
between them because the supplier is supplying market leaders in a billion dollar
industry, eradicating price sensitivity.
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Strategies for Value Creation
This section will explain the actions performed in this industry which enhance the
value of the goods and services to the consumers. Typically a company should position
itself with one of the two general business strategies cost leadership or differentiation.
Cost leadership is supplying the same products or services by focusing on cost control.
Differentiation is supplying unique products or services at a cost below what customers
are willing to pay. Today's companies have redefined innovation. They have
manipulated the classic business value chain and developed new strategies to gain the
competitive advantage. Instead of a pure business strategy of either cost leadership or
differentiation, it is increasingly popular to have pieces of one matched with pieces of
the other to take the competitive edge. Not only is the industry breaking the typical
mold in that sense, but a combination of extreme scale economies, and rapid
technological advance has established a market where competitors are willing to invest
tremendous financing into research and development seeking the majority market
share. This industry has established a brilliant dog eat dog strategy to expand its
product technology and range, through the acquisition of smaller companies that have
developed a niche, but have no real chance in the industry.
Cost Leadership and Differentiation
The strategy of cost leadership AND differentiation is achieved by utilizing
economies of scale and scope, lowering distribution costs, efficiency of production, and
also utilizing superior quality products with superior customer service, and investing
heavily into Research & Development. Efforts of this industry focus mainly on
leveraging massive sales of superior products with quick distribution and superior
support capacities. By developing networking alliances and mergers/acquisitions with/of
suppliers, and sometimes even competitors, this industry makes the most of scale and
scope, enabling acquisitions to concentrate on manufacturing while supplying their own
superior customer solutions. It is by these mergers, together with the power of the
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internet, that industry leaders can tip the competitive balance by reducing transaction
costs and taking a competitive advantage.
Economies of Scale and Scope
Simplistically, economies of scale is an economic term for the supply-side of
production that generalizes the reduction in the cost per unit as your production
increases, typically by expanding the overall scale of operation. Classic practice for this
is done by buying your materials in bulk and having extremely efficient production.
Most of the industry leaders have created on-line infrastructures connecting them to
their suppliers which can constantly monitor each other’s inventories. Economies of
scope typically reduce the cost per unit by increasing your overall product line or
services, focusing on the demand-side increasing range and efficiencies in distribution
and marketing. Many of the network industry competitors which originally focused on
the sale of routers have since expanded to a much larger line of network equipment.
Low Cost Distribution
The old school direct sales method is all but a thing of the past. While it is still
an important method, many companies have adopted distribution systems that partner
them with large wholesale distributors, who sell the products to secondary sellers which
purchase the products for their customers. This establishes a two-tier distribution
strategy that increases customer base exponentially and places much of the storage
burden on your resellers, reducing costs.
Superior Product Quality and Variety
You have to be careful with cost control in this market emphasizing controls with
suppliers and distributors. The companies must still provide excellent quality, well
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engineered products. While there will always be a market for the least-expensive
product, you definitely do not want to become for cheap products. Because, you have
the potential to lose the high-end shopper, which is a large part of the technology
market. Most companies in this industry understand the need for higher quality
products which is why there is about a 65% gross profit margin among industry leaders.
When the products in this industry become cheaper, it is typically because the adequacy
and level of performance tends to have gone down as well. There is always a demand
for innovation, keeping your technology on the cutting edge, giving your products a
distinct advantage. Research and development is the key here, not only for industry
leaders but for possible entrants as well. This industry has a voracious appetite for
expansion of variety in products and services offered. Most of this is not done by the
company itself but by an acquisition or merger with a company that has either created a
new technology or can expand the services offered. This has become the number one
technique to not only expand product lines but technological advancement as well.
More Flexible Delivery
The technology industry advances at an incredible rate and with advancement of
the internet and broadband streaming technology, some networking services are
continuously available. Access is readily available to virtually everybody. This industry
has utilized the internet to connect customer orders directly to manufacturers, and
manufacturers directly with their suppliers, increasing efficiency tremendously.
Manufacturers can begin filling orders instantaneously while suppliers can monitor
inventory levels keeping the process constant. All the while distributors observe this
entire process and are ready as soon as the products are finished, ensuring quick and
accurate delivery of final goods.
Investment in Research and Development
In this industry there is an ever-present determination to have the latest
technology to maintain the advantage. Tremendous amounts of resources are
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dedicated to research and development. Most companies in this industry sustain about
15% research and development compared to revenue ratio to maintain competitive
technology. Some of these costs are attributed to mergers, acquisitions, and funding of
Research and Development for newly acquired companies since they are mainly
acquired for a leading technology only they possess.
Firm Competitive Advantage Analysis
With Cisco further expanding its business into international markets and trying to
gain market share, they need to use several different competitive strategies. Cisco has
and will employ many strategies in order to stay at the top of the networking and
communication devices market. Cisco will need to provide a broad range of networking
products and services, compete in product performance, and use economies of scale
and scope to differentiate their products in the technology markets. In addition to
differentiating their business Cisco must compete in product price and increase market
presence.
Broad Range of Networking Products and Services
Cisco has been able to provide a broad range of products and services through
investment in research and development and acquiring other companies. Over the past
3 years Cisco has invested “$4.1 billion, $3.3 billion, and $3.2 billion in fiscal 2006, 2005,
and 2004 respectively” (Cisco 10k 2006).
Research and Development
2006 2005 2004
Research and Development Investment 4.1 3.3 3.2
*In Billions of Dollars
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With large investments in research and development being made Cisco allows itself to
develop new products while making improvements on current product lines. Another
way in which Cisco is able to provide a broad range of products and services is through
the acquisition of other networking and communication device businesses. In the past
year Cisco has acquired several companies such as, Reactivity, Inc., Neopath Networks,
Scientific-Atlanta, Metreos Corp., and many others. By acquiring several smaller
companies Cisco enables itself to differentiate its products, as well as develop new
products to be sold in the networking and communications market segment.
Competing in Product Performance
In the networking and communication segment of the technology industry
product performance is a must have. In order for Cisco to stay on the top of the market
they must improve the performance of their products constantly. On December 4, 2006
Cisco announced that they would make “significant enhancements to the Cisco 7600
Series Router” (www.cisco.com). This improvement in product performance made Cisco
“the industry’s first comprehensive Carrier Ethernet service edge platform for converged
Internet Protocol (IP) video, voice and data offerings with mobility” (www.cisco.com).
The Cisco 7600 upgrades added investment protection, and gave businesses the ability
to configure the router to support several different Carrier Ethernet IP services. When
Cisco upgraded the 7600 router it also upgraded the Cisco 10000 and 7200 series at the
same time providing service and policy control. Cisco will continue to make
improvements to current products to ensure pristine performance above and beyond
that of its competition.
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Economies of Scale and Scope
Cisco has used economies of scope to their advantage over the past 14 years.
When Cisco entered the networking and communications segment of the technology
industry years ago they produced a very limited amount of routers. In 1993 Cisco
acquired Crescendo Communications which “became a massive expansion of scope”
(www.strategy-business.com). After acquiring Crescendo, Cisco began to start making
routers and switches widening the scope of their business. From 1993 to 1999 Cisco
acquired several other companies and now offers a wide range of networking devices. In
addition to Cisco’s use of economies of scope, they have also employed the use of
economies of scale. Cisco over time has become a leading company in several
geographical locations such as United States and Canada; European markets; emerging
markets; Asia Pacific; and Japan. By expanding their business geographically they have
added to the scale of the business, while allowing for cheaper production costs. With
operations in Asia Pacific and Japan Cisco is able to produce network devices at lower
costs due to cheaper labor. As Cisco expands its business into foreign countries the price
per unit produced compared to company size is reduced, showing economies of scale.
Product Price
In the world of computer technology companies such as Cisco must have price
competition. With only slight differentiation between products and product features,
price plays a large role in the mind of the consumer. In order for Cisco to compete with
companies such as 3Com, Juniper and Nortel they use competitive pricing. To
accomplish low pricing while not sacrificing quality Cisco out sources manufacturing
processes. By out sourcing manufacturing labor Cisco is able to cut prices on their entire
range of products. Another way that Cisco lowers product price is through online sales
allowing consumers to buy the product direct and not have to pay price premiums
placed on items in retail stores.
Cisco also uses price competition through its Linksys product line, which is for
average consumer in-home use. After acquiring Linksys in June 2003, Cisco was able to
move into the consumer and small business market. Cisco took the user friendly
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products of Linksys and added some of their more technologically advanced features in
order to make it a top performer at a low price. With Cisco’s large manufacturing
facilities and out sourced production, they were able to lower the price of Linksys
products making it easier for the average consumer to take advantage of the networking
world.
Increasing Market Presence
Over the years Cisco has succeeded in gaining market presence in 23 countries.
Cisco currently operates in markets located in the United States and Canada; European
markets; emerging markets; Asia Pacific; and Japan. As the popularity of Cisco products
grows so must their market presence in the United States and over seas. Cisco has also
allowed itself to gain market presence through the acquisition of Linksys Systems, Inc.
In 1995 Cisco Systems entered into the Sri Lankan markets; adding two system
integrators and 25 resellers. With an ever growing need for networking and
communication devices in Sri Lanka, Cisco’s expansion will help to increase profits and
solidify its presence in Sri Lanka and the Asia Pacific region. With its added presence in
over seas markets, Cisco has become, “the No. 1 networking vendor in APAC with over
60.3% market share” (www.cisco.com). Even with entering into markets abroad, Cisco
must also expand its operations in the United States.
Linksys has brought about a very vital change for Cisco by allowing them to
enter into the consumer and retail markets. As the new leader in home and small
business networking, Cisco will continue to use the Linksys name to sell an extensive
line of consumer equipment. Once Cisco acquired Linksys they were able to increase
their market presence in the United States.
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Accounting Analysis
When we consider the ramifications that come about because of the figures that
are on financial statements, they are very large indeed. The extent to which accounting
can change the way a business looks to people on the outside looking in gives us a
reason to be skeptical about what we see on financial statements, especially when
Generally Accepted Accounting Practices gives us the ability to have some leeway or
flexibility with the numbers. In the case of this project, this flexibility directly affects our
ability to value a company correctly. Because of this, it is essential for us to look at the
figures presented by Cisco Systems and study them to make sure that they reflect a
truthful assessment of the operations of the business. The assumptions and estimations
implicit in financial statements create the possibility for shifts in values that may distort
the true value of a company, making accurate valuations much more difficult for
analysts.
Because of the problems stated above, we will proceed with an analysis of the
accounting data presented by Cisco and its competitors to ensure that we are getting a
reliable picture of the companies that we will be analyzing further. There are six steps
when proceeding with accounting analysis of a company, the first of which is identifying
principal accounting policies. In our effort to determine if the statements are fairly
presented, we will attempt to use the information we have gathered about the key
success factors for both the company and the industry and use that to determine what
accounting principals are most important and have the greatest ability to influence those
factors. Essentially, we will be deciding what information in useful as it pertains to the
financial statements, and what is not. The second step is to determine the amount of
flexibility that is possible in accounting for those key success factors. Knowing that will
allow us to determine whether or not accounting can influence those success factors.
The third step is to evaluate the company’s actual accounting strategies. This involves
comparing the companies way of accounting for key success factors with the way other
similar companies in the industry are doing it. The fourth step is to evaluate the quality
of disclosure by the company. This is key because a company has limited their
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disclosure of key information; it makes it much harder to predict that the accounting
information given by them is reliable. If we know that the company has a history of
strong disclosure, then we can safely say that their data is more likely to be reliable.
The fifth step is to identify any potential “red flags” that may exist in the financial
statements. There are many possible “red flags” in accounting information, and their
presence can alert us to problems that exist in the way a company does its accounting.
The sixth and final step is to undo any significant accounting distortions that have been
found through the process. This means if it is necessary, changing allowances for
doubtful accounts, discount rates for pension plans or anything else which may be
misrepresenting financial information. Once this is done, then we will have a much
clearer and representative picture of the true nature of the company.
Key Accounting Policies
When attempting to identify key accounting policies, it is first important to look
back on the key success factors that were outlined for Cisco Systems earlier in the five
forces model and the firm competitive advantage analysis. Since these are the things
that will add the most value to the firm and contribute to the success (or failure) of the
firm, these are the ones that must have their accounting policies most scrutinized. We
will be concentrating on success factors that have a more subjective element to them,
because they are the ones that are most likely to be distorted to the point that there
would be a material change in figures by poor accounting policies. All of these values
that will be evaluated influence our strategies for value creation(which was addressed
earlier in this analysis), such as economies of scale and scope, the ability to create a
superior product, and the development of new products. Once they are identified, then
it will be possible to complete the other steps involved with accounting analysis and let
work with the numbers to make sure things are financially truthful.
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New Product Development
The ability to develop new and innovative products is one of the things Cisco has
realized it must do to stay ahead in this highly competitive market. With the rapid
development in new technology, a strong commitment to new product development is
necessary to stay afloat. Cisco’s main research and development (R&D) focus is to,
“continue to enhance our existing products and to develop and introduce new products
that improve performance and reduce total cost of ownership” (Cisco 2007 10-K). This
necessitates the importance of a very strong internal research and development
department. While R&D is crucial to be successful in any technology based industry, it
poses particular problems that exist on the accounting side. Because revenues from
R&D are in no way guaranteed (in fact most initial R&D projects will most likely not
come to fruition), it makes accounting for it increasingly difficult. There is a natural
inclination for companies to capitalize this spending as an expense, attempting to show
the possibility for a windfall that could possibly occur if there is a breakthrough success
in R&D. This type of accounting can create an overstatement of assets and net income
above the actual values the firm should be representing, making accounting data
misleading to someone who doesn’t know the actual workings of the way R&D is being
expensed by the company.
Product Returns and Warranty Costs
The amount of merchandise that is returned by customers can serve as a good
indicator of how a company is doing. Not only does it tell you about the quality of good
that are being produced, but it also speaks to the ability for a product to meet customer
satisfaction expectations and the ability for a company to provide good service for their
products. We can also see similar trends when it comes to the amount of money a
company spends on warranties on products that they have previously sold. These costs
and the ways that they are accounted for can have a significant effect on every financial
statement that a company puts out. Since these are future costs that a company has to
estimate in order to come to a figure, the allowances for product returns and the cost of
37
warranties can become a significant source of accounting discrepancies if not handled
correctly. If allowances for these liabilities are underestimated, it would cause an
artificial inflation in net income, which could cause an incorrect valuation of the
company, and hence must be accounted for when doing accounting analysis.
Post Retirement Benefit Plans
While not directly specifically to any key success factor that Cisco may have,
outstanding benefit plans are of much importance when we look at Cisco goal of
reducing costs. While Cisco itself has no specific pension style plan to provide for
employees after retirement, their acquisition of Scientific-Atlanta forced them to assume
the liability of paying for the pensions of Scientific-Atlanta employees, since the
company had, “a defined benefit pension plan covering substantially all of its domestic
employees and defined benefit pension plans covering certain international employees, a
restoration retirement plan for certain domestic employees, and subsidized health care
and life insurance benefits for eligible retirees”(Cisco 2006 10-K). Since the costs of
these plans depend on numerous factors that are unknown to Cisco at this point, some
kind of estimation for the future costs has to be made. Because of the complexity in
anticipating factors such as future health care costs of employees, the proper discount
rate to use and the lifespan of Scientific-American employees, this figure is subject to
many different estimations created by management, and because of that is forecast
errors are likely in this figure. By underestimating any of these numbers, it would lead
to distortions that are unacceptable when attempting to do accounting analysis, so
special attention must be paid to these figures. While the amounts may not be material
compared to the overall size of other accounts in the financial statements (only $109
million in 2007 compared to over 21 billion in total liabilities), whether these accounts
are dealt with properly will give us insight into how Cisco handles flexibility in their
financial statements.
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Goodwill
Like the cost of pensions, the allocation of the costs of goodwill aren’t directly
linked to any key success factor, however in this case goodwill must be considered when
addressing principal accounting policies. This is true because goodwill makes up over
21% of total assets, which is a significant amount considering it is intangible and can be
written down whenever a company feels like it has lost value. Accounting for the
impairment (or lack of impairment) is increasingly important because Cisco has not
made any impairment to its goodwill since the fiscal year 2003. This may be
problematic because not properly impairing goodwill can lead to an overstatement of
total assets, again creating errors and suspicion about the basis for the figures in certain
financial statements.
Conclusion
Generally Accepted Accounting Practices have evolved to allow much flexibility
for companies in reporting financial information. This flexibility can be a blessing, by
allowing companies to quickly estimate future costs, however they can also be used to
hide problems that a company is having, to overstate earnings or assets, or to
understate future liabilities. To properly assess the accounting principals, we must keep
in mind that accounting numbers are human made and subject to errors. In continuing
with our accounting analysis, we will take these principal accounting policies and
evaluate if they are fairly stated or if changes will have to be made.
Potential Accounting Flexibility
Company financial statements are made available to provide a clear, dependable,
and significant information tool for not only the investors, but also stockholders,
analysts, and employees. These statements are mostly ignored by the average Joe and
naively seen as boring financial papers presented only because the SEC requires it.
Mostly, these same people all believe these statements are each calculated and recorded
in the exact same way. And while this should be how it is done, it is not. Financial
statements are a powerful instrument that can be manipulated and misrepresented for
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many purposes. Usually, when this occurs, they are used to boost performance which is
frequently tied into bonuses and rewards, for executives and mangers. Or more often,
they can also cover-up and disguise a company that is performing very poorly but this
will make it seem as everything is perfect. The SEC has tightened accounting standards
with the help from the Financial Accounting Standards Board (FASB) by implementing
the Generally Accepted Accounting Principles (GAAP) for all publicly traded companies to
follow. However, there will always be accounting flexibility company’s can exploit which
distorts actual numbers. Cisco relies fully on its management which assumes complete
responsibility for the assumptions and estimates it utilizes, within its accounting policies,
which complement the company’s key success factors, in its overall business accounting
strategy.
Research and Development
Research and Development otherwise known as R & D is the cornerstone of this
industry and the future of all the companies in it. There is an unwavering need to keep
the edge in the technology industry. Typical spending on R & D trends around less than
5%. High tech industries such as ours invest considerably larger amounts of capital.
Cisco spent $4.5 billion, a 14% R & D to revenue ratio, right at the industry average of
15%. And although the capital is used to generate future revenue, it is only possible
revenue and therefore must be expensed when incurred. Cisco follows this policy and
states and restates this very clearly. With the mergers and acquisitions of other
company’s In-process R & D costs are assumed and are expensed at the fair market
price. This is a typical area of concern since managers could overstate In-Process R & D
lowering the amount of goodwill, decreasing impairment charges at later times
Warranty Costs
Another earnings manipulated area is in an account very sensitive to estimates.
It is warranty costs, a liability that is also based on management estimates.
Underestimates could result in overstated Net Income, drawing possible investors which
could ultimately drive the stock price. However, Cisco’s estimates are projected at fair
value in line with GAAP guidelines and are generally not at risk to cause any financial
manipulations.
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Failing to Write Down Impairments
There is definitely accounting flexibility with the possibility of failing to write
down impairments in many areas. Cisco has an extremely large portion of assets
devoted to goodwill, roughly 23% of total assets, about 12.5 billion dollars. This opens
the possibility that it could delay impairment write-off, understating expenses and
overstating earnings. This same practice could be done with Cisco’s long-lived assets
and investments, especially with investments equaling about 18.5 billion.
Conclusion
Cisco allows a lot of human involvement with the use of so much estimation.
The managers have full accountability and have established their own internal controls
which the company is satisfied with. They express a great interest in the meaning of
integrity. But Cisco has definitely opened itself up for the possibility of some creative
accounting and in today’s world unethical temptation seems to be higher than ever.
Especially, we have seen the rise of top managers and executives, those who govern
themselves, become the greedy ones.
Actual Accounting Strategy
Cisco began its expansion strategy in the early 90’s acquiring numerous
companies to expand its product and service line. Cisco has taken an aggressive
accounting policy ever since. Its acquisition policy has been the basis for its growth.
These acquisitions have enabled Cisco to wear two masks in its accounting strategy.
While acquisitions swell revenue, goodwill, and research and development figures,
showing us aggressive financials, they also use write-offs and stock repurchases to
dilute earnings presenting a conservative side. Cisco does the same with disclosure as
well. With its lengthy 10-K, filled with discussions and explanations, we have the
appearance of a high-disclosure company. But, Cisco uses many pro-forma charts with
these explanations, which typically means the reporting is minimal, usually to satisfy
requirements for GAAP. So this would distinguish a low-disclosure company. These
policies combined can definitely cloud actual health and pricing.
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Identify Potential “Red Flags”
“Red Flags” are indicators within the financial statements or SEC filings that
questionable accounting is taking place. Unexplained rises or falls in sales figures that
raise an interest to dig a little deeper for an explanation. Upon initial analysis of our
statements a few inconsistencies arose.
Cisco has an unrelenting passion for acquiring new companies. They are always
looking to expand there product line and services. This endless pursuit of mergers and
acquisitions will always raise the”flags” or question when going over the financial
statements and knowing nothing about the company. But all major changes or
distortions in numbers and ratios can always be linked to a major acquisition. For
example, sales in 2007 jumped a peculiar 22%. This was due to the acquisition of
Scientific Atlanta in the previous year. Cisco is constantly merging and acquiring new
companies, sometimes as many as a dozen a year leading to short-term debt ratio and
inventory distortions which will always raise questions.
Undo Accounting Distortions
After analyzing the Cisco financials, there were some moderate discrepancies.
The distortions were from the lack of impairment to goodwill. Cisco is devoted to
expansion by mergers and acquisitions; it has been their cornerstone for growth. They
utilize all the newly acquired companies product lines and services and then show
commitment by putting its large research and development funds back into these
companies as well. Goodwill should be impaired by 20% per year for five years. We
have adjusted and restated our financials accordingly.
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QUALITY OF DISCLOSURE
Being able to communicate the worth of a company through the financial
statements is essential when creating a “window” for those outside the company to
view. The financial statements must convey the well being of the firm to the public in a
reasonable and accurate manner.
QUALITATIVE ANALYSIS OF DISCLOSURE
Analyst’s confidence or suspicion’s in a firm rely heavily on how well the
company can inform the public of internal happenings with truthful financial statements.
Being confident in the firms financial statements not only present a better public image,
but the can also open the door for future growth. The company must be as transparent
as possible without revealing valuable information that can be used by its competitors in
the industry to gain the upper hand.
Product Sales
Cisco does a terrific job in making their product sales information public, and
easy to read in the 2007 10-K. They are in a high tech industry that provides routers,
switches, and advanced technology such as video systems. Cisco also produces a
number of other products but the sales from those other products combined only
account for 7% of their total net sales. The percentages from the table below were
pulled directly from Cisco’s Management’s Discussion page from their 2007 10-K.
43
It is easy to see that during the last three years Cisco has really started to focus
on the expansion of producing their various advanced technology systems, and with that
growth we can see the steady decrease in net sales from the other departments that
drove the company sales for so long, routers and switches. This jump in advanced tech
sales is also contributed to the acquisition of Scientific-Atlanta, a company that
specializes in end-to-end video distribution and video integration systems. Cisco
purchased Scientific-Atlanta In February of 2006 in order to obtain a better market
percentage in the advanced tech field.
Breaking down sales in this manner is helpful to those investors on the outside
of the company because it allows them to see what drives the firms current business,
and it also may give them a very good snapshot of where the firm is headed.
Net Product Sales Percentages
2005 2006 2007 Routers 26% 25% 24% Switches 47% 45% 42% Advanced
Technologies 19% 24% 27%
Other 7% 6% 7%
44
Global Sales
A firms total sales are among the most important numbers that many investors
will look at. While it is not a directly related to a firm’s growth, it is a great place to start
when trying to assess a firm’s value and growth. Being able to break down total sales
into different parts of the world is a great indicator in being able to see where the profit
is coming from, and where a company should engage in more business.
NET SALES In Millions
2005 2006 2007 Unites Sates and Canada
$13,298 $15,785 $19,294
European Markets
$5,692 $6,079 $7,335
Emerging Markets
$1,805 $2,476 $3,447
Asia Pacific $2,486 $2,853 $3,551 Japan $1,520 $1,291 $1,295 TOTAL $24,801 $28,484 $34,922
Cisco is a firm based in the United States, so it would make sense that sales in
North America would be greater than in any other market around the world. As
mentioned earlier, the acquisition of Scientific-Atlanta helped boost global net sales in
2007 by $2,766,000. Of that, $2,035,000 came in the United States and Canada. Not
only have sales increased across the board, but the amount of sales in the emerging
markets has almost tripled in 2007 compared to 2005. This is no doubt attributed to
globalization; the world is getting smaller and the need to communicate through walls
and borders is growing. As we move further and further into the new millennium, the
barriers that kept people apart are fading, and Cisco is a very big reason why.
45
Conclusion
It is no secret that Cisco has made a living by buying out hundreds of smaller
companies during the last several years, and the disclosure of these company facts can
be found in several of the managerial discussion sections of all the 10-k’s that Cisco has
released. Every year it seems that the annual reports get longer and longer, however,
more recently they are doing a much better job at presenting information much clearer.
It is by far much easier to read than many of the reports that were releases several
years ago.
Quantitative Analysis of Disclosure
When looking at the quantitative quality of disclosure provided by
managers one must first understand the Generally Accepted Accounting Policies
(GAAP). GAAP allows managers to use flexibility in financial reporting. A manager
can use these principles to overstate sales, or understate expenses in order to
cause net income to be proportionately larger than reality. Due to the incentive
to bulk up financial statements analysts and investors must carefully analyze all
numbers contained within the financial statements of any company. Large
changes in any number from year to year on a financial statement should be
reviewed and confirmed.
In order to better understand the numbers presented in the financial
statements both selling and expense ratios must be calculated and scrutinized.
The selling ratios include net sales to cash from sales, accounts receivables,
inventory, unearned revenue, and warranty liabilities. To fully understand the
disclosure of profits/revenues produced by selling activities analysts must review
many years of financial information, here we will use 5 years or 6 in the case of
Cisco. Also included in this analysis are expense ratios between expenses, cash
46
flows, accruals, and asset turnover. These ratios can help to identify
manipulation of expense numbers that will either overstate/understate income or
selling activities. Analysts should catch potential “red flags” in the financial
information, that is any large increases or decreases in accounting numbers, as
this could show the use of fraudulent information or possibly inappropriate
accounting policies. Through the use of these ratios analysts should be able to
identify “red flags” and asses the quality of disclosure provided by companies.
Sales Manipulation Diagnostics
Sales performance is a key factor used to identify potential problems with
reported numbers in the financial information. Comparing these numbers over a
five year span will help to better understand whether the numbers reported in
the financial statements show red flags. Here we will look at Cisco, Inc. in
comparison to its highest competitors in order to pinpoint discrepancies in
financial statements within the company and across the entire industry. The
competitors used in this analysis include Nortel and Juniper. Sales diagnostics
show how well the company generates revenues from its sales, and make sure
that the sales generated are providing cash.
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Net Sales/Cash From Sales
The ratio of net sales to cash from sales is computed by subtracting
increases in accounts receivable from net sales and then dividing by net sales.
The optimal ratio is 1:1, although this ratio is extremely difficult to achieve. All
companies strive to collect all sales in cash although this is impractical in today’s
world. Since many customers use credit to purchase products and services;
companies are obligated to create an account receivable to show cash that is
earned but not collected. A ratio of 1:1 would tell the readers of a company’s
financials that the revenues produced are supported by the cash cycle.
The computer technology industry makes most of their sales either in
retail stores or via the internet. Most large credit card companies take over the
liability of the sale immediately after the transaction is completed allowing
companies like Cisco to collect cash at the time of sale. The remainder of sales
made by Cisco are paid for in cash or placed on account.
Since Cisco’s Net Sales/Cash from Sales ratio is close to one, we can
conclude that the majority of Cisco’s sales are collected in cash. With most of
48
their sales collected in cash, Cisco does not take on the risk of doubtful accounts.
A doubtful account is an account in which the seller does not expect that the
buyer will make payment, causing the seller to suffer a loss. This ratio does not
throw any “red flags” about the validity of Cisco’s financials.
Net Sales/Net Accounts Receivable
Net sales to net accounts receivables is a ratio that shows how much of a
company’s sales are tied up in accounts receivables. The higher this ratio the
better, as the less money that is tied up in accounts receivables means more
money available for other liabilities and operating expenses. Any large decreases
in this ratio should be closely examined as a decrease shows that a company’s
accounts receivables are growing.
Looking at Cisco’s net sales to accounts receivable ratios for the past 6
years we notice that there are large drops between 2002-2004 and 2005-2006.
As this ratio continues to decline, Cisco’s sales are supported less and less by the
49
cash cycle. Also, as this ratio declines Cisco has more money tied up in account
receivables that could hinder their ability to meet liability requirements.
Net Sales/Inventory
The inventory turnover ratio evaluates a firm’s ability to turn inventory
into revenues. It should be noted that Juniper Networks holds no inventory. Over
the past 6 years Cisco’s inventory turnover has fluctuated between 21.624 and
26.416. Over the last 6 years Cisco has turned over their inventory 17.39 times
per year, or a little over a month between turnovers. The higher this ratio
becomes the shorter and shorter the cash to cash cycle becomes. On the other
hand its close competitor Nortel Network turns over their inventory 60 times per
year, showing that Nortel converts inventory to revenue at a rapid pace. As Cisco
approaches 2008 they will be able to move inventory more rapidly allowing the
number of days in the cash to cash cycle to diminish.
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Net Sales/Unearned Revenue
The net sales/unearned revenue ratio helps analysts discover
discrepancies in the reporting and accruing of unearned revenue. Spikes in this
ratio are most likely caused by a firm accruing unearned revenue before it is
actually earned. There are many reasons that a firm would want to accrue
revenue early, the main one being to increase profits. Also, any irregularities in
the ratio over time should be carefully examined as it may be a “red flag”.
Analyzing the above graph shows that Cisco has held a very consistent
sales/unearned revenue ratio. This indicates that Cisco has not over stated
revenue by recognizing revenues before they have been earned. On the other
hand, Juniper Networks has several potential “red flags” over the last 5 years.
The most likely cause of this inconsistency would come from Juniper overstating
revenues in order to boost net profits for the year.
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Net Sales/Warranty Liabilities
Juniper is the only one of the companies analyzed that has warranty
liabilities. The ratio of net sales to warranty liabilities shows how much of a
company’s sales come from warranty sales. The higher this ratio the lower the
percentage of sales that comes from warranty sales. Warranty sales are only
recorded as revenue after the warranty period has run out, causing this money
to be tied up in warranty obligations.
Net Sales/Warranty Liabilities Year 2002 2003 2004 2005 2006 JNPR 17.094 20.029 34.256 73.714 65.829
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The chart that follows shows the numbers used to develop the ratio graphs used
in the Sales Diagnostic Ratios portion of this report.
Sales Manipulation Diagnostic
CSCO 2002 2003 2004 2005 2006 2007Net Sales/Cash From Sales 0.981 1.013 1.022 1.016 1.04 1.02Net Sales/Accounts Receivable 17.12 13.97 12.08 11.92 8.624 8.755Net Sales/Inventory 21.49 21.62 18.26 19.12 20.78 26.42Net Sales/Unearned Revenue 6.018 6.222 6.25 6.435 6.462 6.478Net Sales/Warranty Liabilities none none none none none none
NT Net Sales/Cash From Sales 0.941 1.028 1.001 1.031 0.996 N/A Net Sales/Accounts Receivable 4.941 4.069 3.776 3.719 4.1 N/A Net Sales/Inventory 7.309 8.566 4.831 5.052 5.741 N/A Net Sales/Unearned Revenue none none none none none N/A Net Sales/Warranty Liabilities none none none none none N/A
JNPR Net Sales/Cash From Sales 0.941 0.999 1.09 1.041 0.991 N/A Net Sales/Accounts Receivable 7.013 9.104 7.144 7.673 9.253 N/A Net Sales/Inventory none none none none none N/A Net Sales/Unearned Revenue 11.89 11.88 8.403 9.69 7.385 N/A Net Sales/Warranty Liabilities 17.09 20.03 34.26 73.71 65.83 N/A
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Expense Manipulation Diagnostic
Examining expense manipulation diagnostics helps analysts to learn about
a company’s sales performance for a single period or a number of years, in this
case 6 years for Cisco and 5 years for its competitors. Analysts must compare
these ratios with firm’s closest competitors in order to confirm that the firm is
operating at or around the same level as all other firms in the industry. The data
that follows shows expense diagnostics for Cisco, Nortel, and Juniper.
Asset Turnover
Asset turnover is a measure of how productively a company uses its
assets. Asset turnover shows, “The amount of sales generated for every dollar's
worth of assets. It is calculated by dividing sales in dollars by assets in dollars”
(www.investopedia.com). Asset turnover tells a company how well they are using
54
their asset to produce revenue. Since 2002 Cisco’s asset turnover ratio has
grown, showing that for every dollar of assets that Cisco has it has generated
more and more profit between 2002 and 2005. Cisco shows slight signs of a
decreasing asset turnover since 2005, but looks to be leveling out. In comparison
to its competitors, Cisco’s asset turnover is right around what appears to be the
industry norm. Also, those companies with high asset turnover in most cases
have low profit margins, while the opposite goes for firms with low asset
turnover (www.investopedia.com).
Cisco’s asset turnover is relatively steady over the past 6 years, following
closely with its competitors in the industry. The peak on the graph was caused
because Cisco’s financials crashed during 2001, Richard McCaffrey said, “For a
year we watched Cisco's working capital management deteriorate”
(www.fool.com). During 2002-2004 Cisco worked on crawling back to their
normal asset turnover rate. In comparison with Nortel and Juniper, Cisco is for
the most part running with the market. Also, even with good will impaired Cisco
is still able to keep up with the growing communication technology industry.
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Cash Flow from Operating Activities/Operating Income
When looking at the CFFO/OI diagnostic the lower the number the more
cash is contributed from operating activities than either of the other two sources
of cash flow, investing and financing. Examining the graph above shows that
Cisco has held a stable CFFO/OI ratio for the past 5 years, although there was an
in discrepancy during 2002. This sudden spike shows that in 2002 there was a
large amount of cash flow from operating activities. Looking at the CFFO/OI
ratio, Cisco’s cash flows from operations are supported by their operating income
over the past 5 years.
56
Cash Flow from Operating Activities/Net Operating Assets
The Cash Flow from Operating Activities/Net Operating Assets ratio is
used to determine just how much cash flow is generated by all the companies
operating assets such as: plant, property, land, and equipment. A higher ratio
indicates a large amount of cash flows being generated by the fixed assets of the
company. Looking at the graph, Cisco has a very high ratio during 2002-2004 in
comparison with its main competitors. This high ratio shows that Cisco is using it
net operating assets efficiently in order to generate positive cash flows from
operating activities, though in more present years Cisco has moved toward the
industry standard for CFFO/Net Operating Assets ratio. Closer to present time,
Cisco’s CFFO/Net Operating Assets has lowered to nearly that of Juniper
Networks.
57
Pension Expense/SG&A
Cisco Systems Inc. does not incur a pension expense, therefore this
expense diagnostic cannot be used to help evaluate the disclosure of their
financial information. Only one of Cisco’s main competitors lists a pension
expense, Juniper Networks, but they have only incurred this expense in the last 3
years of operations. Juniper has held this ratio fairly constant for the last 3 years.
When analyzing the numbers lower is better, in Junipers case Pension expense
makes up a decent portion of its total expenses.
Juniper 2004 2005 2006 Pension Expense/SG&A 0.58 0.578 0.528
Other Employment Expenses/SG&A
Neither Cisco Inc. nor its competitors incur any other employment
expenses. All firms list no employment expenses other than selling &
administrative expenses. Due to the lack of these expenses the Other
Employment Expenses/SG&A diagnostic is irrelevant.
58
The chart that follows shows the numbers used to develop the ratio graphs used
in the Expense Diagnostic Ratios portion of this report.
Expense Manipulation Diagnostic
CSCO 2002 2003 2004 2005 2006 2007Asset Turnover 0.689 0.986 1.055 0.757 0.73 0.707CFFO/OI 2.257 1.073 1.132 1.02 1.129 1.172CFFO/Net Operating Assets 0.727 1.023 1.263 0.605 0.55 0.555Pension Expense/SG&A N/A N/A N/A N/A N/A N/A Other Employment Exp/SG&A N/A N/A N/A N/A N/A N/A
NT Asset Turnover 0.419 0.509 0.443 0.47 0.447 N/A CFFO/OI 0.25 1.889 0.621 0.066 0.881 N/A CFFO/Net Operating Assets 0.247 0.024 0.063 0.074 0.095 N/A Pension Expense/SG&A N/A N/A N/A N/A N/A N/A Other Employment Exp/SG&A N/A N/A N/A N/A N/A N/A
JNPR Asset Turnover 0.466 0.643 0.652 0.747 0.614 N/A CFFO/OI 0.016 3.123 2.286 1.458 0.757 N/A CFFO/Net Operating Assets 0.005 0.419 0.482 0.51 0.429 N/A Pension Expense/SG&A N/A N/A 0.58 0.578 0.528 N/A Other Employment Exp/SG&A N/A N/A N/A N/A N/A N/A
Conclusion
After examining both the sales and expense manipulations diagnostics,
Cisco’s ratios do not throw any “red flags”. Cisco has out-performed the industry
as a whole. The turnover rate of Cisco Systems is much higher than that of
Juniper or Nortel. While Cisco is at peak performance compared to the industry,
some of their expense diagnostics have been dropping over the past 2 years
which may signal a drop in value.
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Financial Analysis, Forecast Financials, and
Cost of Capital Estimation
Financial Analysis
Over the years, financial analysts have found several ways to evaluate
firms on a scale of overall health and profitability. For measures of the health of
a business, analysts use liquidity and efficiency ratios. Liquidity and efficiency
ratios include: current ratio, quick ratio, inventory turnover, accounts receivable
turnover, and working capital turnover. The second set of measures, the
profitability ratios, show how profitable a firm is and include: gross margin,
operating profit margin, net profit margin, asset turnover, return on assets, and
return on equity. The final set of ratio, the capital structure ratios, give insight
into how a company is structured, looking at the debt to equity ratio, times
interest earned, and the debt service margin. All of the financial analysis ratios
provide much needed information about a firm, and can be more helpful when
used to compare one firm to its industry.
Liquidity Ratio Analysis
The major purpose of liquidity ratio analysis is to judge the ability of a
firm to pay back its short-term obligations. It is an overall statement on the
capability to turn assets to cash quickly and easily. These are the fundamental
analysis ratios used by bankers, creditors, and suppliers to determine risk levels
of any given firm. These ratios are also an important tool for investors given
that liquidity ratio analysis can reveal weak points in the financial position of a
company. The most common and most important of these ratios is current ratio,
and quick ratio. These two ratios give an instant indication that a firm can
satisfy its immediate debt obligations or possibly tell us the company is fixing to
go under.
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Current Ratio
This is a balance sheet calculation that takes current assets and divides it
by current liabilities. It is a powerful interpreter of short-term liquidity or
revealer of possible cash crisis issues within a company. Mostly we look for a 2:1
ratio which states a strong position where assets outweigh liabilities. Anything
over 1:1 is typically acceptable but anything under 1 is typically a signal that a
company cannot meet its immediate obligations. Any company with a ratio over
2 is typically thought to be underutilizing its resources and may want to look into
other uses for capital.
Current Ratio
Cisco Cisco
Cisco Cisco Cisco
NortelNortel
Nortel
Nortel
Nortel
JuniperJuniper
JuniperJuniper
Juniper
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
FY2003 FY2004 FY2005 FY2006 FY2007
CiscoNortelJuniper
Cisco currently has over a 2:1 current ratio putting the company right in
line with an overall accepted strong position. This is a liquidity ratio so in terms
of cash this means that for every $1 Cisco owes they have over $2 in current
assets. With the ratio well over 2:1 they should have no difficulty satisfying their
short-term obligations. If, however, this ratio would continue to climb, Cisco
may need to find a use for its current assets.
Liquidity Analysis FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
Current Ratio 2.08 1.62 1.65 2.31 2.27 2.36
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Quick Ratio
This ratio is very similar to current only it excludes inventory from current
assets leaving us with a snapshot of how quickly a company can access cash for
any urgent claims or demands. Otherwise known as the “acid test,” This is really
the true measure of liquidity. Industry standards typically accept a 1:1 ratio.
Cisco is closer to 2:1 which means that if all revenues stopped, Cisco could still
easily meet its current obligations.
Quick Ratio
Cisco Cisco
Cisco Cisco Cisco
NortelNortel
NortelNortel
Nortel
JuniperJuniper Juniper Juniper
Juniper
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
FY2003 FY2004 FY2005 FY2006 FY2007
CiscoNortelJuniper
Liquidity Analysis FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
Quick Ratio 1.64 1.19 1.21 1.92 1.87 1.97
Efficiency Ratio Analysis
Efficiency ratios are generally compared on a little bit larger time scale.
As opposed to liquidity ratios that are all about urgency, these are typically
compared over years to judge some of the operational aspects such as
collections. These ratios come from both the Balance Sheet and Income
Statement linking the financials. These ratios tend to give an idea of just how
fast a company can turn over inventory and then how quickly it can collect.
62
Inventory Turnover
This is a measurement of how quickly a firm is selling and replacing its
inventory directly adding to gross profit. We derive this ratio by taking Total
Inventory and divided it into Total Sales It is a gauge of a company’s inventory
management. The higher the ratio the better a company is utilizing its inventory
levels. If a company has a lower ratio it could be a sign of sales troubles.
Inventory Turnover
CiscoCisco
CiscoCisco
Cisco
Nortel Nortel
Nortel NortelNortel
0.00
1.00
2.00
3.00
4.00
5.006.00
7.00
8.00
9.00
10.00
FY2003 FY2004 FY2005 FY2006 FY2007
CiscoNortelJuniper
Cisco has had a gradual increase in inventory turnover each year which
shows that it constantly increasing its efficiency and productivity. In 2007 Cisco
ran 9.5:1 Inventory Turnover which means the company replenished its
inventory nine and a half time times last fiscal year. Judging competitor’s
turnover against your own is the only way to truly measure efficiency. Since
there is a lack of competitive ratios it is hard to compare Cisco to the industry
averages. One of Cisco’s chief competitors, Juniper, is not featured in this
section because it keeps no inventory on its balance sheet for cost management.
However, Cisco almost triples Nortel’s turn rate.
Efficiency Analysis FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
Inventory turnover 7.84 6.47 5.73 6.27 7.10 9.52
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Days Supply of Inventory
Cisco goes through its inventory about nine and a half times a year. Now
if we take the number of days in the year, (365) and divide it by inventory
turnover, (9.5) we will get the number of days it takes for Cisco to get through
its inventory. Cisco takes about 39 days, and if we compare that to Nortel which
is a bit over 100, we can claim that Cisco is much more efficient in moving its
product.
Days Supply of Inventory
CiscoCisco
CiscoCisco
CiscoCisco
Nortel Nortel
NortelNortel
Nortel
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
CiscoNortel
Accounts Receivable Turnover
This ratio gives us a general idea of a company’s effectiveness with
collections. Industry standards dictate that typically the higher the ratio the
better the companies credit issuance and debt collection policies. Accounts
Receivables divided by Credit Sales gives the Receivables Turnover, or the
number of times the company collects its Accounts per year. Then if we take
365 by that number we have the days it takes the average customer to pay.
Efficiency Analysis FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
Days Supply Inv 46.54 56.45 63.67 58.23 51.39 38.34
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Accounts Recievable Turnover
Cisco
CiscoCisco
Cisco Cisco
NortelNortel Nortel Nortel Nortel
Juniper
Juniper
Juniper Juniper
Juniper
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
FY2003 FY2004 FY2005 FY2006 FY2007
CiscoNortelJuniper
Days Supply of Recievables
CiscoCisco Cisco Cisco
Cisco Cisco
Nortel
NortelNortel Nortel
Nortel
Juniper
JuniperJuniper Juniper
Juniper
0.00
20.00
40.00
60.00
80.00
100.00
120.00
FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
CiscoNortelJuniper
Effective Analysis FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
Acc Rec. Turn 17.12 13.97 12.08 11.19 8.62 8.75
Effective Analysis FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
Days Supply Rec. 21.32 26.12 30.22 32.61 42.33 41.69
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Cisco collects its Accounts Receivables about nine times per year and it
takes the average customer about forty days to pay. Cisco has been gradually
losing effectiveness over the years while competition has gained.
Working Capital Turnover
This ratio determines how a company is utilizing its working capital for its
sales. The higher the ratio the more effective the company is. If you take
Current Assets and subtract Current Liabilities you get Working Capital. The
more Working Capital, the less financial pressure, and the more likely the
company is to sustain internal growth.
Working Capital Turnover
Cisco Cisco
Cisco Cisco Cisco
NortelNortel Nortel
Nortel
Nortel
Juniper Juniper Juniper Juniper Juniper
0.00
2.00
4.00
6.00
8.00
10.00
12.00
FY2003 FY2004 FY2005 FY2006 FY2007
CiscoNortelJuniper
Cisco has a dominating merger and acquisition policy. It is always looking
for the next company it is going to take over. This tends to put some negative
pressure on its capital usage but it a little distorted due to the cash and revenue
contributions of the purchased companies.
Effective Analysis FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
Work Cap Turnover 2.09 3.69 3.91 1.76 1.73 1.92
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Days Supply of Working Capital
Companies with quicker Inventory Turnover generally have less working
capital due to a quick ability to generate cash. Those companies that have
larger, expensive inventories, which is most likely going to be financed, tends to
keep Working Capital around longer.
Days Supply of Working Capital
Cisco
Cisco Cisco
Cisco CiscoCisco
NortelNortel
Nortel
Nortel
Nortel
Juniper
JuniperJuniper
Juniper
Juniper
0.00
50.00
100.00
150.00
200.00
250.00
300.00
350.00
FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
CiscoNortelJuniper
As this industry’s technology develops so too do the products.
Merchandise can sometimes become obsolete in shorter periods of time then it
took to develop. Inventories, along with their life-cycles, become harder to
predict and this drives a much more volatile analysis.
Conclusion
Cisco is readily identifiable as a genuinely liquid company. It leads its
industry in quick and current liquidity. The lack of competition makes it hard to
benchmark the industry standard, but it appears Cisco to be much more efficient.
Effective Analysis FY2002 FY2003 FY2004 FY2005 FY2006 FY2007
Days Sup Work Cap 174.79 99.01 93.38 206.95 211.38 190.39
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Cisco deals in a great deal of mergers and takeovers, so Cisco’s effective use of
capital will be slightly skewed which has let some of its competitors catch up
from an effective standpoint.
Profitability Analysis
Profitability analysis uses six ratios to help better analyze a company’s
ability to make a profit. The profitability analysis ratios include: gross profit
margin, operating profit margin, asset turnover, return on assets (ROA), and
return on equity (ROE). The first three of these ratios can be used in measuring
how efficiently a firm’s sales are producing profit. Asset turnover measures the
productivity of a firms assets, while ROA an ROE measure the returns on assets
and equity respectably.
Gross Profit Margin
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The gross profit margin can be found by dividing a company’s gross profit
(sales minus cost of goods sold) by total sales. This ratio shows if a firm is
financially sound, measuring how much profit is provided by each dollar of
revenue (sales). The higher this ratio the more profit a firm generates per dollar
of sales.
Cisco’s gross profit margin has declined slightly over the past 5 years,
although it has returned to its starting ratio of 0.64 from 2002. Over the past
few years Cisco has kept a pretty good gross profit margin, receiving a minimum
of $0.64 per dollar of sales over the last 6 years. While its close competitor
Juniper has kept a gross profit margin very close to the same as Cisco, Nortel
Networks received at it max only $0.43 per dollar of sales. Which is only about
2/3 that of Cisco’s lowest gross profit margin. Due to its high gross profit margin,
Cisco will have plenty of extra earning to allocate toward paying its expenses and
for putting into savings and investments.
Operating Profit Margin
69
The operating profit margin is a measure of the firm’s ability to pay for its
fixed costs after paying for its variable and selling costs. To find operating profit
margin take the firms operating income and divide it by total revenue (sales). A
higher operating profit margin is preferred because the firm will then have ample
amounts of money to devote to the payment on fixed costs. Of its competitors,
Cisco is the only one to have a consistent operating profit margin over the past 5
years (6 for Cisco). Cisco’s operating margin has increased significantly over its
starting margin of 0.15. Cisco is currently operating under a 0.25 operating profit
margin which leaves plenty of revenues to allocate toward fixed costs. On the
other hand, Cisco’s competitors have had a rough few years and Juniper’s
margin is still falling, at $-0.43 in 2006. While Nortel Networks operating profit
margin has increased over the past year, allowing them to still end up having
excess revenue to cover their fixed costs in 2006. Cisco is by far a top performer
in its industry, developing operating margins that far surpass all other firms in its
industry.
Net Profit Margin
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The net profit margin shows how much of every dollar of sales a firm will
keep as income before taxes. As with the other 3 profit margin ratios, a higher
number is best. The higher a company’s net profit margin, the higher that
company’s net income will be in comparison to sales. While the net profit margin
doesn’t give very much insight as to how an individual company is doing, when
compared with its competitors or other firms in the industry analysts can see
how well a company is doing in comparison.
Cisco’s net profit margin has seen little change over the past 5 years,
holding at about 0.20. That means that for every dollar of sales Cisco made
$0.20 of net income before tax. Even though Cisco has efficiently used its
revenues, competitors such as Nortel and Juniper have found themselves with
little or even negative earnings.
Asset Turnover
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Asset turnover is a measure of how productively a company uses its
assets. Asset turnover shows, “The amount of sales generated for every dollar's
worth of assets. It is calculated by dividing sales in dollars by assets in dollars”
(www.investopedia.com). Asset turnover tells a company how well they are using
their asset to produce revenue. Since 2002 Cisco’s asset turnover ratio has
grown, showing that for every dollar of assets that Cisco has it has generated
more and more profit between 2002 and 2005. Cisco shows slight signs of a
decreasing asset turnover since 2005, but looks to be leveling out. In comparison
to its competitors, Cisco’s asset turnover is right around what appears to be the
industry norm.
Return on Assets
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Return on assets, similar to return on equity discussed in the latter
section, is a measure of how much profit is generated for each dollar of assets.
This helps to shows how profitable a company really has the potential to
become. The higher this ratio, the more efficiently a company is at using its
assets in churning a profit. The decrease in ROA in 2006 came from a large
increase in selling expenses during the year. The results in 2007 for Cisco’s ROA
stemmed from an increase in sales revenue, which in turn increased net income
by slightly fewer than 2 billion dollars. Compared to the industry, Cisco has done
a very healthy job of producing profits through the use of firm assets. Juniper
has held consistent with the other profitability ratios losing money after 2005.
Return on Equity
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The return on equity is similar to return on assets, but it measures the
productivity of a firm’s equity. It is noticeable that this number is smaller than
the return on assets; this is because assets are equal to liabilities (debt) plus
equity. Cisco’s return on equity has been very steady over the past 6 year,
holding close to the industry. Nortel is an outlier here, in 2005, because the firm
suffered a loss of 2.61 billion dollars.
Conclusion
Following the profitability analysis we find that Cisco has had steady
ratios. Compared to its competitors, Cisco is a far more profitable firm in most
cases. Although Cisco had a few small falls in their ratios after 2005, they are still
able to produce net profits of $0.21 per dollar of sales. Cisco’s competitors max
net profit margins combined, Nortel (0.04) and Juniper (0.17), equal to 0.21.
Overall Cisco has shown industry high profitability over the past 6 years.
Capital Structure Analysis
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Capital structure ratios are used to compare a company’s debt obligations
to its available equity. The three capital structure ratios include: debt to equity,
times interest earned, and the debt service margin. These ratios tell us whether
a company prefers debt financing or equity financing, or even how much of a
company’s operating income is spent to pay off interest. The industry analysis
follows.
Debt to Equity Ratio
The debt to equity ratio is found by dividing a firm’s total debt by its total
equity. “The debt-to-capital ratio gives users an idea of a company's financial
structure, or how it is financing its operations, along with some insight into its
financial strength” (www.investopedia.com). Although Cisco’s competitor Nortel
has shown to finance most of their assets with debt, having a debt to equity ratio
in 2005 of 21.74, Cisco had an average ratio of 0.50. With an average ratio of
0.50, Cisco has approximately double the amount of equity financing as it does
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debt financing. This shows that Cisco prefers equity financing to debt financing,
although in previous years (i.e. 2006 and 2007) Cisco’s debt financing use has
grown.
Times Interest Earned
Times interest earned is a ratio that shows how much of a firms operating
income goes toward paying off its interest expense. The ratio is found by
dividing operating income by interest expense. Cisco has not recorded any
interest expense on its financials until 2006. Of Cisco’s operating income in 2006,
for every $47.27 of operating income one dollar went toward paying off interest
expense. In recent years Cisco’s competitor Juniper has become unable to pay
off its interest expense due to negative operating earnings. Overall Cisco has had
very low and even zero interest expense compared to its operating income.
Debt Service Margin
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Of the three companies used in this valuation Nortel Networks in 2002
was the only one of the firms to have notes payable. The debt service margin
ratio is a measure of how operating cash flow went toward each dollar of notes
payable. Since none of the analyzed firms have notes payable this ratio is
irrelevant to the valuation of Cisco Systems Inc.
Conclusion
Although Cisco did not accrue any interest expense or notes payable in
the past 6 years, we can gain information about the firm from the debt to equity
ratio. Since the debt to equity ratio is the only ratio that has any weight on
valuing Cisco, it is important to notice that Cisco uses approximately twice the
amount of equity financing as they do debt financing. Overall the capital
structure ratios do not give a good insight into Cisco’s credibility, while they do
show how the rest of the industry is doing.
IGR/SGR Analysis
The Internal Growth Rate (IGR) and Sustainable Growth Rate (SGR) are
ratios that show investors and analysts whether a company will continue to be
profitable. If a company has no sustainable growth then they will eventually
become unprofitable. Similarly, if a company has no internal growth then they
will have to begin financing operating activities with debt, which in effect will
cause the company to become unprofitable.
Internal Growth Rate (IGR)
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Internal Growth Rate (IGR) tells a company how much it can increase its
assets with only using internal financing, i.e. no debt financing. Companies are
constantly trying to expand their asset base, but to do so with debt financing
costs the company large amounts of interest. Firms want to try and expand their
asset base using only internal financing which mainly comes from operating
activities. Cisco has sustained an internal growth rate higher than that of its
competitors for the past 6 years. Cisco’s average IGR over the past 6 years has
been 0.68, or a 68% IGR. The industry average internal growth rate is not far
below that of Cisco with a 5 year average of 0.45, or 45% IGR. Cisco again
shows that they are the top of the networking industry with a very high internal
growth rate.
Sustainable Growth Rate (SGR)
A firm’s sustainable growth rate is the amount of growth that a company
can sustain without any additional debt financing. This ratio says that if a firm
surpasses its sustainable amount of growth, then in the long run the firm will
need to borrow money through debt financing to continue growing at that rate.
In comparison with its competitors, Cisco’s SGR is always higher than the
industry. This is because the computation of SGR uses a company’s IGR. It
would be impossible for a company to have more sustainable growth than
internal growth.
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The average sustainable growth rate for the industry over the past 5 years
has been mostly negative growth. Though the industry has fought through
negative sustainable growth over the past 5 years, Cisco is still able to have a
SGR on average of 0.18.
Financial Statement Forecasting
The first step to valuing any company is to establish the value of future cash
flows in periods to come. The first step of this is achieved by financial statement
forecasting. While it is a very simple task to accomplish, the figures obtained from it will
be central in our future valuation of Cisco Systems. In our valuations, we computed
various financial statements figures, using previous data from 10-K’s to guide us in the
right direction. Although we cannot know for sure what kind of growth we will have in
our financials, by using past 10-K data, we can take an educated guess. It is important
to note that while it may have been possible to forecast every line item on every
individual financial statement, doing so would have not been prudent and would have
filled this report with unclear and unnecessary data. Instead, we sought to forecast
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items that were both of significance to our future valuations and that had a clear historic
trend to follow. Our main metric for forecasting the income statement, the balance
sheet and the statement of cash flows is year to year growth, because it provided us
with the steadiest and most reliable metric for charting future figures. One challenge
that forecasting Cisco presented was the lack of an industry standard to use to forecast
growth figures. Since 2002, Cisco has had the least volatility in its financial statements
compared to its competitors. Many of them have had wild growth years followed by
terrible downturns, making their financial statements less useful when attempting to
forecast future growth. Because of this, we used past Cisco data as the main source of
future forecasting information.
Income Statement Analysis
Forecasting the income statement proved to be the easiest of the 3 statements
to forecast, because it was the statement with the most line items that had historic
trends in a certain direction, which made predicting a steady and stable growth rate
much easier. Even with that, there was much volatility in the earlier years of our historic
data. It was because of this that we decided to weigh our historic data with more
emphasis on the two years previous to where we would start forecasting. By doing this,
we could use more recent trends to figure out a realistic growth rate. In we forecast
each financial statement two ways; first we forecast the actual figures in dollar terms,
then we forecast the statements as a percentage of some total from the financial
statement. In the case of the Income statement, we forecast using Total Net Sales as
the base from which all other lines were a percentage of. These two methods for
forecasting tell us not only how much each line item is growing in absolute terms, but
relative to other items on the financial statement.
Looking at Total Net Sales over the last 3 years, we see a significant and steady
upward trend. From over 24 billion in 2005 to 34 billion in 2007, this shows us their
strength and power as a leading player in the networking/telecommunications industry.
In order to ensure that the growth rate for future periods didn’t overstate the sales
growth, a more modest growth rate of 15% was chosen. When forecast out 10 years, it
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gave a total for Net Sales of $118 Billion, almost triple the current figures. However,
this rapid growth will be coupled with increased costs of doing business as well, with the
cost of selling going up 17% and Research and Development costs increasing 6%
annually. Looking at the common size income statement, we see each of these will
become a significant portion of the total sales over the next 10 years.
Another key income statement line to keep in mind is the total operating income,
which is “A measure of a company's earning power from ongoing operations, equal to
earnings before deduction of interest payments and income taxes”(investorwords.com).
Strong and steady growth in operating income suggests that the company is maintaining
its operations successfully, which is a strong barometer of future success. Since 2002
operating income for Cisco has grown by leaps and bounds, quiet a feat considering the
downturn in the economy at the beginning of the decade. The last few recent years
have provided some volatility to Cisco’s operating income, with a down year in 2006,
followed by some of the largest growth in operating income since 2002 in 2007.
Because of this volatility, we decided to scale back the expected growth in operating
income to 18%. While that is still a quiet a bit of growth, it seems easily achievable
considering Cisco’s recent growth.
Finally when looking at the income statement we come to the bottom line, or
net income. Since net income is highly interrelated to other financial statements
(especially the Statement of Cash Flows) forecasting it correctly is absolutely crucial to
the success of our valuation. Looking at common sized balance sheet it seems that over
the past 5 years that net income has steadily been about 20% of total sales, giving us a
good indicator of what future net income will be. Looking at it forecast out 10 years, we
see net income about tripling what it was in 2007, which would be in line with our other
forecasted figures, which also increased about threefold.
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Balance Sheet Analysis
In creating a forecast for the next ten years for the balance sheet, the common
size balance sheet became extremely important. The main things that we were looking
to get out of this analysis was the changes in the mix of assets that the company held
and a how over the last five years have they been funding the purchase of those assets.
This information, along with the growth that occurred over the last five years was the
main way we came to our figures for future growth.
When analyzing the balance sheet, it was easiest to split it up into assets,
liabilities and shareholders equity (the way the balance sheet is naturally divided).
When looking at assets, we notice a few pronounced trends. First, in the current assets,
we see a large spike in current investments, from just over $3 billion (or 8% of total
assets) to over $18 billion (or 34% of total assets). This represents a tremendous shift
in the allocation of assets in Cisco. The increase in short term investments has
corresponded with a sharp decrease in cash and cash equivalents over the last 5 years,
showing instead of idly holding cash as a significant source of their assets they have
moved that into more productive ventures. When looking at the amount of assets held
current versus long term assets, we see the biggest shift in the way Cisco allocated its
assets, and a trend that may very well continue into the future. Over the last 5 years,
short term assets (mostly due to the increase in short term investments) have increased
by over 13%, while long term assets have fallen by the same amount. The decrease in
long term assets is mostly due to the fact that between 2004 and 2005 Cisco went from
holding 34% of its total assets in long term investments to holding no long term assets.
This represents a major shift in the way assets are used by Cisco.
On the other side of the balance sheet, there is less to comment about. Most of
the figures have stayed relatively constant over the last five years, making forecasting
key line items relatively easy. The largest change in the liabilities section is an increase
in long term debt during 2006 through 2007(to 29% of total liabilities in 2007). These
were the first years when the company took on long term debt. Not coincidentally, the
increase in long term debt corresponded with a decrease in total shareholders equity,
giving the impression that the issue of that debt was to buyback a certain percentage of
outstanding shares. However, it looks as if the increase to debt was just a one time
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event, and liabilities and shareholders equity levels are likely to stay constant over the
coming years. One last thing to note about the forecast financial statements in the
retained earnings section under the stockholders equity section of the balance sheet.
Retained earnings is calculated by taking the beginning balance of retained earnings,
adding in net income and subtracting out any dividends that will be paid. Because we
are forecasting net income (a net positive to retained earnings) but we are not
forecasting out dividends (a net negative to retained earnings) the forecast figure is
unreliable for use in any calculations, because it is not possible that Cisco will not pay
out any dividends over the next 10 years with the amount of forecasted growth to net
income.
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Statement of Cash Flow Analysis
The statement of Cash Flows is by far the hardest of the three major financial
statements to forecast. Not only is it full of erroneous information that is practically
impossible to forecast (such as cash flows from investing and financing activities), but
much of the data shifts wildly from positives to negatives, year to year, making any
future predictions worthless. When looking at key items to forecast, only a few lines
were even stable enough to garner a decent forecast. Of the most importance is net
cash provided by operating income, because it shows that the core activities of the
business are doing well (or poorly) if there is a large number, or conversely a negative
number. To verify that our estimation of cash provided by operating income, we
decided to use the CFFO/OI measure to make sure there were no discrepancies between
the statements. According to our diagnostic ratio, Cash Flow from Operations (CFFO)
should be growing at a slightly faster rate then Operating Income (because the ratio is
1.17 in 2007). Looking at the figures, it seems that CFFO are growing slightly faster
then Operating Income, showing that the figures used on the statement of cash flows
are consistent with figures used in the income statement. Even in the years where
Cisco was less profitable as a company (2002, 2003, 2004), there cash from operating
activities improved steadily, and has continued to grow at an extremely fast pace (about
24% per year). This steady growth tells us that it is safe to use that figure to forecast
future growth in cash flows from operating activities, giving us a strong barometer of
the ability for Cisco to succeed in the future.
Forecasting the cash provided (or used by) investing section was more
problematic. Because of the rapid swings in investments that Cisco had been making,
accurately predicting the future of Cisco’s investing policy will be unlikely. However, we
can note that over the past two years a small, linear decline in the amount invested (in
years 2006 and 2007). Because of the lack of metric to help us forecast, we decided to
forecast using a small growth rate, to stay conservative in our estimates.
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Conclusion
While we cannot be certain about the direction of Cisco Systems (because of a lack of
reliable competitors to create comparisons), we can say that they are headed in a good
direction. With strong steady growth of net income, operating income and net cash provided
by operating activities, it is reasonable to suspect the next 10 years will be good for Cisco.
Couple that with the thoughtful reallocation of resources from cash to short term investments
and you can see hints of a winning strategy for the company.
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Analysis of Valuations
With a strong background in a companies industry, how it handles its accounting
practices and financial information, we can now proceed with our valuation of Cisco Systems.
We will be using several different valuation techniques in order to get the most complete
picture of the true value of the company. Some are based on financial theory, while others are
based on accounting principals. The first method that we will be using is the method of
comparables, which uses industry averages in order to determine the price for a certain
company in that industry. Following the comparables valuation will be several intrinsic models
that will help us to find a suitable valuation for Cisco.
Method of Comparables
Price
Forward P/E $145.69
Trailing P/E $197.93
P/B $20.37
Dividend Yield N/A
P.E.G $41.18
P/EBITDA $39.16
P/FCF N/A
EV/EBITDA $35.32
Since companies who occupy the same industry often have similar characteristics and
may tend to have comparable financial patterns, it may be a good idea to look at valuing Cisco
compared to other companies in the Networking and Communications industry. The method of
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comparables (also known as ratio valuation) is precisely the way we can do that, by using
industry averages for several different metrics to determine the share price for Cisco. We took
the data from the 10-K of Cisco in 2007 (and made changes where applicable, such as adding
growth rates in) and from the Yahoo Finance website (www.finance.yahoo.com) for Cisco’s
competitors. The figures we came up with after doing our calculations are presented above,
however it is important to note that these numbers shouldn’t be seen as a definitive answer to
Cisco’s true value for a few reasons. First, because of the relative lack of real comparable
companies in the industry, some of the numbers have been skewed to the point where they are
unusable. This is compounded when certain companies in the industry have negative values for
key ratios, making them impossible to use. Finally, since the method of comparables isn’t
based in theory, it has lower predictive power as compared to the other intrinsic valuations,
making its predictions less accurate. What follows is the method of comparables for several
different ratios.
Forward Price to Earnings
PPS EPS P/E Industry Average
CSCO Share Price
CSCO 32.18 0.97 33.16 150.15 145.69
JNPR 34.71 -1.63 -21.25
NT 15.68 0.10 150.15
This first method took our PPS as of November 1st 2007 and the earnings per share that
we forecasted on year out to give us our price/earnings ratio. We did the same thing with the
industry (using data from Yahoo finance) and took the average of those numbers to get the
industry average. The reason the industry average is so much higher then Cisco’s P/E ratio is
because we weren’t able to use Juniper in the average due to a negative P/E ratio, leaving only
Nortel to make up the industry. To get the expected share price for Cisco, we took the industry
P/E average and multiplied it by Cisco’s EPS to get a share price of $145.69. Because of the
high industry average, this number is suspect, and shouldn’t be considered in the actual
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valuation decision. However, if this number was correct, it would indicate that Cisco is highly
undervalued and that investors should buys.
Trailing Price to Earnings
PPS EPS P/E Industry Average
CSCO Share Price
CSCO 32.18 0.81 39.79 244.74 197.93
JNPR 34.71 -1.92 -18.09
NT 15.68 0.06 244.74
Trailing Price to Earnings is computed in a similar manner as Forward Price to Earnings;
however, the main difference is the Earnings Per Share (EPS) that is used in the calculation.
When calculating your P/E ratio you use the EPS that were reported on the last available 10-K
statement, without forecasting growth into the future. As happened the last time, because EPS
was negative for Juniper, we had to exclude it from the industry average, creating a very large
skew in the computed share price for this valuation model. After multiplying the EPS for Cisco
with the industry average, we came out with a per share price of $197.93. Like the last
method, because of the skew in industry average, we are unlikely to use this in the final
valuation, but if we did it would indicate that Cisco is highly undervalued.
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Price to Book
PPS BPS P/B Industry Average
CSCO Share Price
CSCO 32.18 4.56 7.05 2.89 20.37
JNPR 34.71 10.16 3.42
NT 15.68 6.65 2.36
The Price to Book (P/B) method uses the share price on November 1, 2007 and the book
value of equity per share to obtain a share price. We obtained the book value per share for our
competitors from Yahoo Finance. After computing a P/B ratio for both Cisco and its
competitors, we took the average of the competitors to get an industry average of 2.89. To get
the share price, we multiplied that industry average by Cisco’s BPS to get a per share price of
$20.37. Out of all values that we have calculated up to this point, this one is the more reliable,
because we were able to get a true industry average. According to the P/B ratio, Cisco would
be slightly overvalued using this metric.
Dividend Yield
Because none of the companies in this industry pay dividends or have paid dividends in
the past, we are unable to compute this method of comparable for Cisco. If were we’re to
compute this ratio, we would do it the same way that we had for the last ratios.
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Price Earnings Growth
PPS EPS PEG Industry Average
CSCO Share Price
CSCO 32.18 0.81 2.65 3.39 41.18
JNPR - - 1.69
NT - - 5.09
The Price Earnings Growth Ratio is similar to the P/E ratio; it takes the same figures
used in trailing EPS and uses them again. I obtained the PEG ratios for the industry on Yahoo
Finance. After multiplying the industry average PEG with the growth rate for Cisco I then
multiplied it by Cisco’s EPS we came to a per share price of $41.18. Under this valuation
method, Cisco is undervalued versus its current share price.
Price to EBITDA
PPS EBITDA(per
share) Price/EBITDA Industry Average
CSCO Share Price
CSCO 32.18 1.66 19.44 23.65 39.16
JNPR 34.71 0.99 34.92
NT 15.68 1.27 12.39
In this method we use the PPS along with EBITDA (Earnings before Interest, Taxes,
Depreciation and Amortization). Because the EBITDA figures were so large, we put them in a
per share basis to get figures that were easy to work with. The EBITDA figures for Cisco came
from the 2007 10-K, while the figures from the industry came from Yahoo Finance. After
computing an industry average in a similar fashion to the other methods of comparable, we
came up with an industry average of 23.65. After multiplying that number by Cisco’s EBITDA
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per share, we came to a per share price of $39.16, suggesting that Cisco is currently slightly
undervalued.
Price to Free Cash Flow
The Price to Free Cash Flow method of Comparables is calculated by taking the Price Per
Share and dividing it by Free Cash Flow (FCF) per share. FCF is calculated as Cash Flow from
Operations plus or minus Cash Flow from Investing (depending on whether investing activities
generated a cash inflow or outflow). Because of the large amount of investing activities done
by Cisco, (primarily through acquisitions of other companies) it has a negative FCF for share,
making the Price to Free Cash Flow ratio negative. This is problematic because we aren’t able
to use negative Cash Flow figures when computing this ratio, meaning we are unable to
calculate the share price based on this ratio.
Enterprise Value/EBITDA
EV Per Share EBITDA(per
share) EV/EBITDA Industry Average
CSCO Share Price
CSCO 24.49 1.66 14.79 21.33 35.32
JNPR 26.78 0.99 26.94
NT 19.91 1.27 15.73
The final method of comparable we will calculate for Cisco is the Enterprise
Value/EBITDA. Enterprise value is equal to the market value of equity plus the book value of
liabilities minus cash and financial investments. We used the same EBITDA figures that were
used in the Price to EBITDA valuation, while computing Cisco’s EV per share using recent 10-K
data. We found the enterprise value per share for Juniper and Nortel on Yahoo Finance. After
finding an industry average of 21.33, we computed a per share price for Cisco of 35.32,
signifying that Cisco is slightly undervalued.
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Conclusion
Using methods of comparables should never be the soul source of your decision to buy
or sell a company. Because of the volatile nature of industry averages, and the lack of theory
to support the ratios, it makes this method of valuation unreliable at best and misleading in the
worst cases. However, after analyzing the data we see that the method of comparables seems
to indicate that Cisco is slightly undervalued compared to the current per share price.
Cost of Capital
Cost of Equity
We used the CAPM model to get our estimation of the cost of equity, Ke. The
CAPM model consists of finding a risk-free rate, the expected market return, and our
company’s beta. The risk-free rate and the expected market return were found by
visiting the St. Louis Federal Reserve website and using the Treasury bill rates for each
of the periods needed in order to find the expected market return and the risk-free rate.
When it came to finding the beta of our company, we had to run a series of regressions
using the S&P 500 index prices, Cisco’s prices, and the Treasury bill rates.
Our regressions were run using the 72, 60, 48, 36, and 24 month periods in
order to try and get as close of an estimate as possible. For each of these periods we
used the St Louis Federal Reserve t-bill rates for the 3-month, 1-year, 2-year, 5-year, 7-
year, and 10-year rates. We use these different periods and t-bill rates because over
different time periods and rates Beta can vary. Without running regressions for all these
periods it would be hard to tell which of the Betas found should be used to calculate Ke.
After analyzing our regression, we found that the 10 year, 72 month regression yielded
the highest adjusted R-squared of 39.54 percent. The adjusted R-squared is a number
that will give us our highest degree of explanatory power, and our company beta of
1.81. The published beta, for Cisco systems shown on Yahoo Finance, 1.1 is below that
which we have determined to be Cisco’s estimated beta. When using the CAPM to
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calculate Ke, the published beta will show a much lower estimate of the cost of capital.
We calculated our cost of capital for each of our maturity periods using a risk-free rate
of 4% which was derived from the St Louis Federal Reserve, and a market premium of
6.8%. After plugging all of our factors into the CAPM model, our cost of capital, Ke, was
16.31%.
Regression Analysis
3 Month Constant Maturity Series Maturity Ke
Months Beta t-Stat
R^2
Adjusted 3 Month 0.1848
72 1.810584 6.868346475 0.394064477 1 Year 0.1847
60 1.744287 5.057754132 0.294096901 2 Year 0.1844
48 1.379059 3.205056509 0.164776859 5 Year 0.1849
36 1.07116 2.260354121 0.105069924 7 Year 0.1851
24 0.99773 1.506842099 0.052350355 10 Year 0.1852
1 Year Constant Maturity Series
Months Beta t-Stat
R^2
Adjusted
72 1.809309 6.877546546 0.394717744
60 1.746612 5.076316558 0.295682088
48 1.383718 3.222862317 0.166472199
36 1.074397 2.270844994 0.106156368
24 0.997808 1.508311132 0.052523268
2 Year Constant Maturity Series
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Months Beta t-Stat
R^2
Adjusted
72 1.804605 6.848136437 0.392627556
60 1.741597 5.024179517 0.291226415
48 1.375147 3.183019876 0.162682215
36 1.063338 2.235979572 0.102555005
24 0.993868 1.500848087 0.051645919
5 Year Constant Maturity Series
Months Beta t-Stat
R^2
Adjusted
72 1.811089 6.871938403 0.394319592
60 1.751437 5.057322892 0.294060058
48 1.389734 3.22674114 0.166841842
36 1.076268 2.27063637 0.10613474
24 0.999184 1.509405614 0.052652164
7 Year Constant Maturity Series
Months Beta t-Stat
R^2
Adjusted
72 1.81375 6.882230694 0.395050143
60 1.755123 5.070930827 0.295222295
48 1.39652 3.245864719 0.168665963
36 1.082477 2.285076503 0.107633991
24 1.002119 1.513069471 0.053084075
10 Year Constant Maturity Series
98
Months Beta t-Stat
R^2
Adjusted
72 1.81513 6.888210039 0.395474252
60 1.757787 5.079658147 0.295967311
48 1.402779 3.26420597 0.170418034
36 1.087699 2.297735269 0.108951943
24 1.004392 1.515554577 0.053377401
Cost of Debt
In order for us to calculate our cost of debt, we needed to take all of the single
lines of liabilities and divided them by total liabilities to get a weight and multiply them
by the several interest tax rates that were derived from Cisco’s 10-K and by using the St
Louis Federal Reserve’s three-month nonfinancial commercial paper rate of 4.59% for
all of the current liabilities. For our long-term debt we used the rates given in Cisco’s
10-K in order to get an average weight for the long term debt, the deferred revenue,
and the other long term liabilities. For the long term debt and the other long term
liabilities we used a 5.25% rate because Cisco’s fixed rate notes had an interest rate of
5.25%.
After we divide out all of our liabilities and multiply them by their respective
interest rates, we take the sum of all the answers in order to find the cost of debt. In
this case Cisco’s before tax cost of debt is 4.82%. The after tax cost of debt is 4.82%
times 1 minus the corporate tax rate, in this case Cisco’s corporate tax rate is 35% and
the after tax rate is 3.13%
Weighted Average Cost of Capital
99
Now that we have a cost of equity and a cost of debt, we can plug them into the
after tax weighted average cost of capital. We will use the before tax cost of debt of
4.82%, and the 18.52% cost of capital in the the after tax weighted average cost of
capital and get a 12.22%WACC. The before tax weighted average cost of capital is the
equation without the 1 minus the corporate tax rate, in this case Cisco’s before tax
WACC is 42.95%.
Intrinsic Valuations
For the following valuations the following legend will be used.
Under Valued >$44.22Fairly Valued 32.68<x<44.22Over Valued <$32.68
The use of intrinsic valuations to value a firm gives a much more accurate result
than the standard comparables that we see in the market at large today. One of the
main reasons for this is that the person doing the intrinsic valuations must add
something of themselves into the equation. These personal decisions include the
choice of Ke, WACC, and IGR/SGR. While there are formulas to calculate each of these
numbers, the answers obtained must be critically reviewed to ascertain how feasible
and valid they are. You must also take into consideration the industry standards and
market standards. Once all of these considerations have been assessed and tempered
with the evaluator’s personal goals and risk levels, can the final evaluation numbers be
chosen. For the evaluation of Cisco, we will be using the Discounted Free Cash Flows
model (DFCF), the Residual Income model (RI), the Long Run Residual Income Model
(LR RI), and the Abnormal Earning Growth model (AEG). Cisco does not currently pay
dividends, therefore it is impossible to use dividend based valuation models.
Discounted Free Cash Flows
100
The DFCF takes into the account the differences between Cash Flow from
Operations (CFFO) and Cash Flows from Investing (CFFI), discounted back to present
value dollars. In the case of Cisco, the PV of the perpetuity is over 4 times the PV of
the forecasted future cash flows. For this reason, we must conclude that the DFCF
model for Cisco is based on more hopes and dreams than reality. Unfortunately the
land of hopes and dreams is where the value of the computer/technology industry
seems to lie most of the time.
0 0.02 0.04 0.06 0.08 0.10.15 $25.80 $28.25 $31.59 $36.41 $43.99 $57.640.14 $29.34 $32.44 $36.78 $43.30 $54.15 $75.860.13 $33.53 $37.51 $43.26 $52.29 $68.55 $106.48
WACC BT 0.1222 $37.36 $42.24 $49.50 $61.43 $84.66 $149.760.11 $44.62 $51.49 $62.29 $81.72 $127.08 $353.840.1 $52.09 $61.40 $76.91 $107.94 $201.03 NA
Under Valued >$44.22Fairly Valued 32.68<x<44.22Over Valued <$32.68
Actual Price Per Share (November 1, 2007): $32.18
Annual Growth RatesSensitivity Analysis
To begin calculating the DFCF, you must take the forecasted CFFO and subtract
the CFFI for each year in your forecast. Then these free cash flows must be discounted
back to present value using your WACC (BT). The forecasted years plus the PV of the
terminal perpetuity gives us the value of the firm. By subtracting the BV of liabilities
from the value of the firm, dividing by the number of outstanding shares, and adjusting
for time, we achieve a share price prices based on the DFCF. As a benchmark for the
sensitivity analysis, we used the calculated WACC and a zero growth rate. This gave us
a DFCF share valuation of 37.36. By systematically adjusting the growth rate and
WACC we established the preceding table of share prices based on the different
combinations of growth and WACC. Due to the huge range of price valuations, 25.80 –
353.84, we conclude that this method is very sensitive to minute changes in the growth
rate and WACC.
101
Based solely on this model, an analyst might conclude that the stock price is
fairly valued to under-valued. This supports the ratio analysis performed earlier.
However, based on the overall volatility of the industry it would be irresponsible not to
view the other valuation models before coming to a final conclusion.
Residual Income
The Residual Income valuation model (RI) is based on forecasted earnings
instead of perpetuities, making it a more accurate view than some of the other
valuation models. As implied in the name, the RI model uses residual income
discounted back to present values to calculate the value of the firm. Residual income is
calculated by subtracting Normal Income from Net income. The Normal Income is
calculated by multiplying BE x Ke. Normally we would have to also account for
dividends, but Cisco does not currently pay dividends.
g0 0.05 0.1 0.15
Ke 0.12 $14.62 $18.26 $40.10 N/A0.14 $10.94 $12.48 $17.87 N/A
0.1631 $8.05 $8.58 $9.94 21.650.18 $6.53 $6.72 $7.13 $8.90
0.2 $5.17 $5.15 $5.10 $4.96
Sensitivity Analysis
Compared to the trading price of 32.18 this valuation model and sensitivity
analysis shows that Cisco is extremely overvalued. Even pushing the growth rate and
Ke to the extremes makes it difficult to come close to the current price.
Long Run Residual Income
The LR RI is based on the assumption that stock price and valuation can be seen
as nothing more than a simple perpetuity. This perpetuity is based on the use of Ke, g,
102
and ROE. By varying two of these values, we can get a broader perspective of the
sensitivity and accuracy of this model.
ROE 0.180 0.05 0.1 0.15 0.2
Ke 0.13 $7.20 $8.45 $13.86 $0.00 $1.490.14 $6.68 $7.51 $10.40 $0.00 $1.73
0.163 $5.74 $5.98 $6.59 $11.91 $2.820.18 $5.20 $5.20 $5.20 $5.20 $5.20
0.2 $4.68 $4.51 $4.16 $3.12 $0.00
g 0.150.14 0.16 0.18 0.2 0.22
Ke 0.13 $2.60 $0.00 $0.00 $0.00 $0.000.14 $5.20 $0.00 $0.00 $0.00 $0.00
0.163 $0.00 $3.97 $11.91 $19.84 $27.780.18 $0.00 $1.73 $5.20 $8.67 $12.13
0.2 $0.00 $1.04 $3.12 $5.20 $7.28
Ke 0.16310 0.05 0.1 0.15 0.2
g 0 0.00 1.59 3.19 4.78 6.380.05 0.00 0.00 2.30 4.60 6.90
0.1 0.00 0.00 0.00 4.12 8.240.15 0.00 0.00 0.00 0.00 19.84
0.2 28.18 21.13 14.09 7.04 0.00
Sensitivity AnalysisROE
Sensitivity Analysisg
Sensitivity AnalysisROE
As seen in the above sensitivity analysis, there are only two instances where the
stock is fairly valued. Both of these instances occur at the extremes of the spectrum.
103
Abnormal Earnings Growth Model
The AEG model is probably the most comprehensive valuation model seen at the
present time. It is based off of accounting numbers and forecasting of those numbers
to ascertain the value of the company. While many financial analysts do not like using
these numbers, based on the past problem because the accounting numbers were
never converted to market values, changes in GAAP have allowed accountants to mark
many portions to market value. These new standards make the book value much closer
to market value than we have seen in the past. Using the assumption that the financial
now show a much more current view of the company’s assets, we can make much
more accurate forecasts.
g-0.1 -0.2 -0.3 -0.4
Ke 0.12 17.17$ 16.37$ 15.96$ 15.70$ 0.14 12.25$ 11.87$ 11.66$ 11.53$
0.1631 8.60$ 8.45$ 8.36$ 8.31$ 0.18 6.76$ 6.70$ 5.17$ 5.17$
0.2 5.17$ 5.17$ 5.17$ 5.17$
Based on our full sensitivity analysis of Cisco we can see that it once again shows up as
an overvalued stock. Just to put things into full perspective, it took a -0.1 growth rate
and a Ke of .0875 to bring the estimated value within 15% of the observed value of
32.18.
Looking over the results from the various forms of intrinsic valuing it is concluded
that Cisco is overvalued. Unfortunately this is usually the case with technology firms.
Many investors seem to put large amounts of value into future possible innovations
instead of past performances and intrinsic values.
104
Credit Analysis
We have evaluated Cisco Systems through the use of the Altman Z-score model,
which uses several weighted ratios in order to determine Cisco’s bankruptcy score.
Once the Z-score has been found, it can be used to determine the risk of bankruptcy for
a firm. The model says that for any firm with a Z-score less than 1.81 there is a high
probability of bankruptcy. Firms earning a Z-score between 1.81 to 2.67 are do not
have a high risk of bankruptcy but should be closely monitored. A score of 3 or more
shows that the firm is healthy and should have no problems with bankruptcy. There is
one problem with the Altman Z-score, because it uses the history of a company
investors will find it challenging to use this model on newer firms. The Z-score for Cisco
Systems and the formula used to find z-scores follows:
2002 2003 2004 2005 2006 2007
Z-Score 3.214 3.211 3.116 3.217 2.336 2.446 Z-Score GW Impaired 3.149 3.136 3.041 3.128 2.198 2.297
Z-Score = 1.2(Working Capital/Total Assets) + 1.4(Retained Earnings/Total Assets) + 3.3(Earnings before Interest and Taxes/Total Assets) + .6(Market Value of Equity/Book Value of Debt) + 1.0(Sales/Total Assets)
Cisco’s current Z-score is 2.446, which shows that Cisco is currently at a low risk
of bankruptcy and should be closely monitored by its investors. Over the past 6 years,
Cisco’s Z-score has ranged from 3.149, an acceptable Z-score, to 2.198 in 2006.
Although they experienced a drop in Z-score between 2005 and 2006, Cisco appears to
be moving back toward a Z-score of 3.
105
Analyst Recommendation
The final results of our analysis show us that the Cisco Company is highly over
valued. We have come to this conclusion based on financial analysis of this firm and
other firms of the industry. During the process of analysis and evaluation we have
reviewed the previous 5 years worth of data from the 10-k filing of Cisco, Juniper, and
Nortel.
This research has shown us that Cisco has performed on par with others in the
industry as far as sales, COGS, and revenues. The computer networking industry is
constantly growing and changing as newer and faster technologies become available.
This makes it difficult to fully value a firm in this industry. With the constant change
and growth, also comes constant mergers and acquisitions. The mergers and
acquisitions cause an unreal amount of goodwill added to the income statement of
these firms, inflating their value over time. With technology and information being seen
at the future of the world, people tend to place extra value in the knowledge and
innovations to come than in performance and assets. While it would be nice to consider
the minds of your technicians as an asset, it is too subjective to truly value.
The main thing that can be said for this set of valuations is that throughout the
entire process, we felt that even though there was a huge amount of useless data in
the 10-k’s, the overall disclosure and accuracy was good. This allowed us to focus
more on valuing the firm than working to determine if there were some underlying
financial issues. We chose very aggressive sales growth percentages to truly reflect the
industry and past performance. With this in mind, we do not believe that this growth is
fully sustainable in the long run. Even with these aggressive measures we have
determined the firm is overvalued, and should be placed on a sell rating. Since our
target analysis date, the stock has fallen almost $10 per share, further reflecting the
accuracy of our analysis. Taking into account that this is a technology stock, it can be
seen that our valuation is conservative, but we feel that in the end no stock is worth 4
times its estimated value using the RI, LR RI, and AEG models.
106
Appendix
2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007CSCO 2.082 1.617 1.648 2.314 2.270 2.364 CSCO 7.84 6.47 5.73 6.27 7.10 9.52NT 1.50 1.71 1.49 1.12 1.48 N/A NT 4.72 4.92 2.83 3.00 3.51 N/AJNPR 2.81 2.60 2.81 3.01 3.30 N/A JNPR N/A N/A N/A N/A N/A N/A
Days Supply of Inventory2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007
CSCO 1.64 1.19 1.21 1.92 1.87 1.97 CSCO 46.54 56.45 63.67 58.23 51.39 38.34NT 0.97 1.30 1.04 0.71 0.93 N/A NT 77.39 74.22 128.89 121.84 104.02 N/AJNPR 2.71 2.49 2.60 2.71 3.00 N/A JNPR N/A N/A N/A N/A N/A N/A
Working Capital Turnover2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007
CSCO 17.12 13.97 12.08 11.19 8.62 8.75 CSCO 2.09 3.69 3.91 1.76 1.73 1.92NT 4.94 4.07 3.78 3.72 4.10 N/A NT 3.54 2.89 3.25 10.51 3.57 N/AJNPR 7.01 9.10 7.14 7.67 9.25 N/A JNPR 1.25 1.65 1.47 1.64 1.31 N/A
2002 2003 2004 2005 2006 2007CSCO 21.32 26.12 30.22 32.61 42.33 41.69NT 73.88 89.70 96.66 98.15 89.03 N/AJNPR 52.05 40.09 51.09 47.57 39.45 N/A
Inventory Turnover
Accounts Receivable Turnover
Days Supply of Receivables
Liquidity Ratios
Current Ratio
Quick Ratio
107
2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007CSCO 0.635 0.701 0.686 0.672 0.658 0.640 CSCO 0.050 0.096 0.124 0.169 0.129 0.137NT 0.355 0.426 0.414 0.407 0.389 N/A NT -0.177 0.026 -0.014 -0.144 0.001 N/AJNPR 0.578 0.633 0.689 0.684 0.673 N/A JNPR -0.046 0.017 0.018 0.043 -0.136 N/A
Return on Equity2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007
CSCO 0.154 0.259 0.285 0.299 0.246 0.247 CSCO 0.066 0.128 0.170 0.248 0.233 0.233NT -0.279 0.004 -0.031 -0.260 0.024 N/A NT -0.981 0.110 -0.068 -3.421 0.025 N/AJNPR -0.232 0.081 0.144 0.214 -0.433 N/A JNPR -0.084 0.026 0.021 0.057 -0.164 N/A
2002 2003 2004 2005 2006 2007CSCO 0.100 0.190 0.200 0.231 0.196 0.210NT -0.272 0.043 -0.026 -0.248 0.002 N/AJNPR -0.219 0.057 0.096 0.170 -0.435 N/A
2002 2003 2004 2005 2006 2007CSCO 0.500 0.509 0.619 0.732 0.658 0.655NT 0.649 0.614 0.533 0.579 0.602 N/AJNPR 0.209 0.291 0.191 0.252 0.313 N/A
Asset Turnover
Operating Profit Margin
Profitability Ratios
Gross Profit Margin Return on Assets
Net Profit Margin
108
Capital Structure Ratios
Debt to Equity Ratio
2002 2003 2004 2005 2006 2007
CSCO 0.318 0.324 0.375 0.462 0.811 0.694
NT 4.349 3.049 3.711 21.742 15.236 N/A
JNPR 0.828 0.543 0.168 0.154 0.205 N/A
Times Interest Earned
2002 2003 2004 2005 2006 2007
CSCO N/A N/A N/A N/A 47.27 22.87
NT (11.29) 0.22 (1.48) (12.47) 0.79 N/A
JNPR (2.27) 1.46 32.00 110.25 (277.93) N/A
Debt Service Margin
2002 2003 2004 2005 2006 2007
CSCO N/A N/A N/A N/A N/A N/A
NT 2.83 N/A N/A N/A N/A N/A
JNPR -0.219 N/A N/A N/A N/A N/A
109
Method of Comparables
PPS EPS
Forecast EPS DPS BPS EV FCF
CSCO 32.18 0.97 0.81 N/A 4.56 24.49 -0.11
JNPR 34.71 -1.63 -1.92 N/A 10.16 26.78 1.51
NT 15.68 0.1 0.06 N/A 6.65 19.91 0
P/E P/E
(Trailing) (Forward) P/B D/P P.E.G EBITDA P/EBITDA P/FCF EV/EBITDA
(Per
Share)
CSCO 39.79 33.16 7.05 N/A 2.65 1.66 19.44 -29.51 14.79
JNPR -18.09 -21.25 3.42 N/A 1.69 0.99 34.92 2.3 26.94
NT 244.74 150.15 2.46 N/A 5.09 1.27 12.39 0 15.73
Price Comparables Trailing Forward
P/E 197.93 145.69
P/B 20.47
D/P N/A
PEG 41.18
P/EBITDA 39.16
P/FCF N/A
EV/EBITDA 35.32
3 Month Regression
110
SUMMARY OUTPUT 72 months
Regression StatisticsMultiple R 0.634506722R Square 0.40259878Adjusted R Square 0.394064477Standard Error 0.077228062Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.281355019 0.281355019 47.1741833 2.16858E-09Residual 70 0.417492153 0.005964174Total 71 0.698847172
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.007624151 0.009151295 0.833122591 0.407609271 -0.010627532 0.025875834 -0.01062753 0.02587583X Variable 1 1.810583957 0.263612787 6.868346475 2.16858E-09 1.284824838 2.336343076 1.284824838 2.33634308 SUMMARY OUTPUT 60 months
Regression StatisticsMultiple R 0.553228127R Square 0.30606136Adjusted R Square 0.294096901Standard Error 0.0694007Observations 60
ANOVAdf SS MS F ignificance F
Regression 1 0.123209196 0.123209196 25.58088 4.56E-06Residual 58 0.279354512 0.004816457Total 59 0.402563708
Coefficients Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.008684495 0.009303353 0.933480169 0.354442 -0.00994 0.027307 -0.00994 0.027307X Variable 1 1.744287298 0.344873881 5.057754132 4.56E-06 1.053947 2.434627 1.053947 2.434627
SUMMARY OUTPUT 48 months
Regression StatisticsMultiple R 0.427255853R Square 0.182547564Adjusted R Square 0.164776859Standard Error 0.063067876Observations 48
ANOVAdf SS MS F ignificance F
Regression 1 0.040859006 0.040859006 10.27239 0.002456Residual 46 0.182967622 0.003977557Total 47 0.223826628
Coefficients Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.004156442 0.009410674 0.441673136 0.660795 -0.01479 0.023099 -0.01479 0.023099X Variable 1 1.379058626 0.430275916 3.205056509 0.002456 0.512958 2.245159 0.512958 2.245159
3 Month Regression
111
SUMMARY OUTPUT 36 month
Regression StatisticsMultiple R 0.361441R Square 0.130639Adjusted R 0.10507Standard E 0.060666Observatio 36
ANOVAdf SS MS F ignificance F
Regression 1 0.018804 0.018804 5.109201 0.030317Residual 34 0.125131 0.00368Total 35 0.143935
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.011027 0.010454 1.054835 0.298939 -0.01022 0.032272 -0.01022 0.032272X Variable 1.07116 0.47389 2.260354 0.030317 0.108099 2.034221 0.108099 2.034221
SUMMARY OUTPUT 24 month
Regression StatisticsMultiple R 0.305864R Square 0.093553Adjusted R 0.05235Standard E 0.06498Observatio 24
ANOVAdf SS MS F ignificance F
Regression 1 0.009587 0.009587 2.270573 0.146077Residual 22 0.092894 0.004222Total 23 0.102481
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.022245 0.013979 1.591267 0.125818 -0.00675 0.051235 -0.00675 0.051235X Variable 0.99773 0.662133 1.506842 0.146077 -0.37545 2.370911 -0.37545 2.370911
1 Year Regression
112
SUMMARY OUTPUT 72 months
Regression StatisticsMultiple R 0.635014R Square 0.403243Adjusted R 0.394718Standard E 0.077186Observatio 72
ANOVAdf SS MS F ignificance F
Regression 1 0.281805 0.281805 47.30065 2.09E-09Residual 70 0.417042 0.005958Total 71 0.698847
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.008044 0.00914 0.880056 0.381841 -0.01019 0.026273 -0.01019 0.026273X Variable 1.809309 0.263075 6.877547 2.09E-09 1.284623 2.333995 1.284623 2.333995
SUMMARY OUTPUT 60 months
Regression StatisticsMultiple R 0.554635R Square 0.30762Adjusted R 0.295682Standard E 0.069323Observatio 60
ANOVAdf SS MS F ignificance F
Regression 1 0.123837 0.123837 25.76899 4.26E-06Residual 58 0.278727 0.004806Total 59 0.402564
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.009032 0.009273 0.974004 0.3341 -0.00953 0.027594 -0.00953 0.027594X Variable 1.746612 0.344071 5.076317 4.26E-06 1.057879 2.435344 1.057879 2.435344
SUMMARY OUTPUT 48 months
Regression StatisticsMultiple R 0.429193R Square 0.184207Adjusted R 0.166472Standard E 0.063004Observatio 48
ANOVAdf SS MS F ignificance F
Regression 1 0.04123 0.04123 10.38684 0.002335Residual 46 0.182596 0.003969Total 47 0.223827
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.004444 0.009376 0.473921 0.637798 -0.01443 0.023317 -0.01443 0.023317X Variable 1.383718 0.429344 3.222862 0.002335 0.519492 2.247943 0.519492 2.247943
1 Year Regression
113
SUMMARY OUTPUT 36 month
Regression StatisticsMultiple R 0.362898R Square 0.131695Adjusted R 0.106156Standard E 0.060629Observatio 36
ANOVAdf SS MS F ignificance F
Regression 1 0.018955 0.018955 5.156737 0.029607Residual 34 0.124979 0.003676Total 35 0.143935
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.011191 0.010427 1.073268 0.29071 -0.01 0.032381 -0.01 0.032381X Variable 1.074397 0.473127 2.270845 0.029607 0.112888 2.035906 0.112888 2.035906
SUMMARY OUTPUT 24 month
Regression StatisticsMultiple R 0.306134R Square 0.093718Adjusted R 0.052523Standard E 0.064974Observatio 24
ANOVAdf SS MS F ignificance F
Regression 1 0.009604 0.009604 2.275002 0.145703Residual 22 0.092877 0.004222Total 23 0.102481
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.022324 0.01396 1.599101 0.124062 -0.00663 0.051275 -0.00663 0.051275X Variable 0.997808 0.66154 1.508311 0.145703 -0.37414 2.369757 -0.37414 2.369757
2 Year Regression
114
SUMMARY OUTPUT 72 months
Regression StatisticsMultiple R 0.633389R Square 0.401182Adjusted R 0.392628Standard E 0.07732Observatio 72
ANOVAdf SS MS F ignificance F
Regression 1 0.280365 0.280365 46.89697 2.36E-09Residual 70 0.418482 0.005978Total 71 0.698847
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.008781 0.009146 0.960113 0.340303 -0.00946 0.027023 -0.00946 0.027023X Variable 1.804605 0.263518 6.848136 2.36E-09 1.279036 2.330175 1.279036 2.330175
SUMMARY OUTPUT 60 months
Regression StatisticsMultiple R 0.550672R Square 0.30324Adjusted R 0.291226Standard E 0.069542Observatio 60
ANOVAdf SS MS F ignificance F
Regression 1 0.122073 0.122073 25.24238 5.15E-06Residual 58 0.28049 0.004836Total 59 0.402564
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.009452 0.009285 1.017928 0.31294 -0.00913 0.028038 -0.00913 0.028038X Variable 1.741597 0.346643 5.02418 5.15E-06 1.047716 2.435478 1.047716 2.435478
SUMMARY OUTPUT 48 months
Regression StatisticsMultiple R 0.42485R Square 0.180497Adjusted R 0.162682Standard E 0.063147Observatio 48
ANOVAdf SS MS F ignificance F
Regression 1 0.0404 0.0404 10.13162 0.002614Residual 46 0.183426 0.003988Total 47 0.223827
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.004586 0.009392 0.488256 0.627688 -0.01432 0.023492 -0.01432 0.023492X Variable 1.375147 0.432026 3.18302 0.002614 0.505524 2.24477 0.505524 2.24477
2 Year Regression
115
SUMMARY OUTPUT 36 month
Regression StatisticsMultiple R 0.358045R Square 0.128196Adjusted R 0.102555Standard E 0.060751Observatio 36
ANOVAdf SS MS F ignificance F
Regression 1 0.018452 0.018452 4.999605 0.032024Residual 34 0.125483 0.003691Total 35 0.143935
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.011335 0.010441 1.085677 0.28526 -0.00988 0.032553 -0.00988 0.032553X Variable 1.063338 0.475558 2.23598 0.032024 0.096888 2.029788 0.096888 2.029788
SUMMARY OUTPUT 24 month
Regression StatisticsMultiple R 0.30476R Square 0.092879Adjusted R 0.051646Standard E 0.065004Observatio 24
ANOVAdf SS MS F ignificance F
Regression 1 0.009518 0.009518 2.252545 0.147611Residual 22 0.092963 0.004226Total 23 0.102481
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.022642 0.013908 1.628006 0.117762 -0.0062 0.051485 -0.0062 0.051485X Variable 0.993868 0.662204 1.500848 0.147611 -0.37946 2.367196 -0.37946 2.367196
5 Year Regression
116
SUMMARY OUTPUT 72 months
Regression StatisticsMultiple R 0.634705R Square 0.40285Adjusted R 0.39432Standard E 0.077212Observatio 72
ANOVAdf SS MS F ignificance F
Regression 1 0.281531 0.281531 47.22354 2.14E-09Residual 70 0.417316 0.005962Total 71 0.698847
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.009862 0.009121 1.081186 0.283325 -0.00833 0.028053 -0.00833 0.028053X Variable 1.811089 0.263549 6.871938 2.14E-09 1.285458 2.33672 1.285458 2.33672
SUMMARY OUTPUT 60 months
Regression StatisticsMultiple R 0.553195R Square 0.306025Adjusted R 0.29406Standard E 0.069403Observatio 60
ANOVAdf SS MS F ignificance F
Regression 1 0.123195 0.123195 25.57651 4.56E-06Residual 58 0.279369 0.004817Total 59 0.402564
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.010589 0.009209 1.149815 0.254939 -0.00785 0.029024 -0.00785 0.029024X Variable 1.751437 0.346317 5.057323 4.56E-06 1.058208 2.444666 1.058208 2.444666
SUMMARY OUTPUT 48 months
Regression StatisticsMultiple R 0.429614R Square 0.184569Adjusted R 0.166842Standard E 0.06299Observatio 48
ANOVAdf SS MS F ignificance F
Regression 1 0.041311 0.041311 10.41186 0.002309Residual 46 0.182515 0.003968Total 47 0.223827
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.005382 0.009307 0.578239 0.565923 -0.01335 0.024116 -0.01335 0.024116X Variable 1.389734 0.430693 3.226741 0.002309 0.522795 2.256674 0.522795 2.256674
5 Year Regression
117
SUMMARY OUTPUT 36 month
Regression StatisticsMultiple R 0.362869R Square 0.131674Adjusted R 0.106135Standard E 0.06063Observatio 36
ANOVAdf SS MS F ignificance F
Regression 1 0.018952 0.018952 5.15579 0.029621Residual 34 0.124982 0.003676Total 35 0.143935
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.011778 0.010366 1.136164 0.263833 -0.00929 0.032844 -0.00929 0.032844X Variable 1.076268 0.473994 2.270636 0.029621 0.112996 2.03954 0.112996 2.03954
SUMMARY OUTPUT 24 month
Regression StatisticsMultiple R 0.306335R Square 0.093841Adjusted R 0.052652Standard E 0.06497Observatio 24
ANOVAdf SS MS F ignificance F
Regression 1 0.009617 0.009617 2.278305 0.145424Residual 22 0.092864 0.004221Total 23 0.102481
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.022828 0.013858 1.647288 0.11371 -0.00591 0.051567 -0.00591 0.051567X Variable 0.999184 0.661972 1.509406 0.145424 -0.37366 2.372029 -0.37366 2.372029
7 Year Regression
118
SUMMARY OUTPUT 72 months
Regression StatisticsMultiple R 0.635272R Square 0.403571Adjusted R 0.39505Standard E 0.077165Observatio 72
ANOVAdf SS MS F ignificance F
Regression 1 0.282034 0.282034 47.3651 2.05E-09Residual 70 0.416813 0.005954Total 71 0.698847
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.010352 0.009111 1.136258 0.259724 -0.00782 0.028524 -0.00782 0.028524X Variable 1.81375 0.263541 6.882231 2.05E-09 1.288134 2.339366 1.288134 2.339366
SUMMARY OUTPUT 60 months
Regression StatisticsMultiple R 0.554227R Square 0.307168Adjusted R 0.295222Standard E 0.069345Observatio 60
ANOVAdf SS MS F ignificance F
Regression 1 0.123655 0.123655 25.71434 4.34E-06Residual 58 0.278909 0.004809Total 59 0.402564
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.011105 0.009178 1.209985 0.231193 -0.00727 0.029477 -0.00727 0.029477X Variable 1.755123 0.346115 5.070931 4.34E-06 1.0623 2.447947 1.0623 2.447947
SUMMARY OUTPUT 48 months
Regression StatisticsMultiple R 0.431687R Square 0.186354Adjusted R 0.168666Standard E 0.062921Observatio 48
ANOVAdf SS MS F ignificance F
Regression 1 0.041711 0.041711 10.53564 0.002187Residual 46 0.182116 0.003959Total 47 0.223827
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.005754 0.009271 0.620614 0.537917 -0.01291 0.024416 -0.01291 0.024416X Variable 1.39652 0.430246 3.245865 0.002187 0.53048 2.26256 0.53048 2.26256
7 Year Regression
119
SUMMARY OUTPUT 36 month
Regression StatisticsMultiple R 0.36487R Square 0.13313Adjusted R 0.107634Standard E 0.060579Observatio 36
ANOVAdf SS MS F ignificance F
Regression 1 0.019162 0.019162 5.221575 0.028669Residual 34 0.124773 0.00367Total 35 0.143935
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.011996 0.010334 1.16081 0.253805 -0.00901 0.032997 -0.00901 0.032997X Variable 1.082477 0.473716 2.285077 0.028669 0.119771 2.045183 0.119771 2.045183
SUMMARY OUTPUT 24 month
Regression StatisticsMultiple R 0.307009R Square 0.094254Adjusted R 0.053084Standard E 0.064955Observatio 24
ANOVAdf SS MS F ignificance F
Regression 1 0.009659 0.009659 2.289379 0.144496Residual 22 0.092822 0.004219Total 23 0.102481
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.022955 0.013828 1.660045 0.111094 -0.00572 0.051632 -0.00572 0.051632X Variable 1.002119 0.662309 1.513069 0.144496 -0.37143 2.375664 -0.37143 2.375664
10 Year Regression
120
SUMMARY OUTPUT 72 months
Regression StatisticsMultiple R 0.635601R Square 0.403989Adjusted R 0.395474Standard E 0.077138Observatio 72
ANOVAdf SS MS F ignificance F
Regression 1 0.282326 0.282326 47.44744 2E-09Residual 70 0.416521 0.00595Total 71 0.698847
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.010678 0.009105 1.172747 0.244873 -0.00748 0.028837 -0.00748 0.028837X Variable 1.81513 0.263513 6.88821 2E-09 1.289571 2.340689 1.289571 2.340689
SUMMARY OUTPUT 60 months
Regression StatisticsMultiple R 0.554887R Square 0.3079Adjusted R 0.295967Standard E 0.069309Observatio 60
ANOVAdf SS MS F ignificance F
Regression 1 0.123949 0.123949 25.80293 4.21E-06Residual 58 0.278614 0.004804Total 59 0.402564
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.011425 0.009159 1.247397 0.217265 -0.00691 0.029758 -0.00691 0.029758X Variable 1.757787 0.346044 5.079658 4.21E-06 1.065104 2.45047 1.065104 2.45047
SUMMARY OUTPUT 48 months
Regression StatisticsMultiple R 0.433669R Square 0.188069Adjusted R 0.170418Standard E 0.062855Observatio 48
ANOVAdf SS MS F ignificance F
Regression 1 0.042095 0.042095 10.65504 0.002075Residual 46 0.181732 0.003951Total 47 0.223827
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.005938 0.009249 0.642056 0.524024 -0.01268 0.024555 -0.01268 0.024555X Variable 1.402779 0.429746 3.264206 0.002075 0.537745 2.267813 0.537745 2.267813
10 Year Regression
121
SUMMARY OUTPUT 36 month
Regression StatisticsMultiple R 0.36662R Square 0.13441Adjusted R 0.108952Standard E 0.060534Observatio 36
ANOVAdf SS MS F ignificance F
Regression 1 0.019346 0.019346 5.279587 0.027856Residual 34 0.124589 0.003664Total 35 0.143935
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.012043 0.01032 1.167012 0.251326 -0.00893 0.033015 -0.00893 0.033015X Variable 1.087699 0.473379 2.297735 0.027856 0.125678 2.04972 0.125678 2.04972
SUMMARY OUTPUT 24 month
Regression StatisticsMultiple R 0.307465R Square 0.094535Adjusted R 0.053377Standard E 0.064945Observatio 24
ANOVAdf SS MS F ignificance F
Regression 1 0.009688 0.009688 2.296906 0.143869Residual 22 0.092793 0.004218Total 23 0.102481
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.022919 0.013831 1.657041 0.111705 -0.00577 0.051602 -0.00577 0.051602X Variable 1.004392 0.662722 1.515555 0.143869 -0.37001 2.378793 -0.37001 2.378793
122
Discounted Free Cash Flows Model
* In Millions of Dollars 0 1 2 3 4 5 6 7 8 9 102007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Cash Flow from Operations 7,680.00 9,523.20 11,808.77 14,642.87 18,157.16 22,514.88 27,918.45 34,618.88 42,927.41 53,229.99 66,005.19 Cash Provided (Used) by Investing Activities (8,342.00) (8,008.32) (7,687.99) (7,380.47) (7,085.25) (6,801.84) (6,529.77) (6,268.57) (6,017.83) (5,777.12) (5,546.03) Free Cash Flow (to firm) -662 1,515 4,121 7,262 11,072 15,713 21,389 28,350 36,910 47,453 60,459Present Value Factor (12.22% WACC) 0.8911068 0.79407125 0.70760225 0.63054915 0.5618866 0.50070095 0.446178 0.3975922 0.3542971 0.3157166Present Value of Free Cash Flows $1,349.92 $3,272.19 $5,138.89 $6,981.39 $8,828.95 $10,709.34 $12,649.28 $14,674.96 $16,812.42 $19,087.96Total Present Value of Annual Cash Flows 99,505Continuing (Terminal) Value (assume no growth) 494,756Present Value of Continuing (Terminal) Value 156,203Value of the Firm (July 2007) 255,708Book Value of Debt and Preferred Stock $21,850 0 0.02 0.04 0.06 0.08 0.1Value of Equity (July 2007) 233,858 0.15 $25.80 $28.25 $31.59 $36.41 $43.99 $57.64Estimated Value per Share 37.36 0.14 $29.34 $32.44 $36.78 $43.30 $54.15 $75.86Time Consistant Share Price 38.45 0.13 $33.53 $37.51 $43.26 $52.29 $68.55 $106.48WACC 12.22% WACC BT 0.1222 $37.36 $42.24 $49.50 $61.43 $84.66 $149.76Growth 0.00% 0.11 $44.62 $51.49 $62.29 $81.72 $127.08 $353.84
0.1 $52.09 $61.40 $76.91 $107.94 $201.03 NACurrent Price Per Share(November 1, 2007) 32.18Number of Shares Outstanding 6260 *Millions of Shares Under Valued >$44.22Total Value of Shares Outstanding 201446.80 *Millions of Dollars Fairly Valued 32.68<x<44.22
Over Valued <$32.68Actual Price Per Share (November 1, 2007): $32.18
Annual Growth RatesSensitivity Analysis
123
change In RI (0.00) 0.00 0.00 0.00 (0.00) 0.00 (0.00) 0.001 2 3 4 5 6 7 8 9 perp
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Beginning BE 31,480.00$ 37,370.80$ 44,439.76$ 52,922.51$ 63,101.81$ 75,316.98$ 89,975.17$ 107,565.01$ 128,672.81$ Total Net Income 5,890.80 7,068.96 8,482.75 10,179.30 12,215.16 14,658.20 17,589.83 21,107.80 25,329.36 Dividends per share $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00Ending BE 31,480.00$ 37370.80 44439.76 52922.51 63101.81 75316.98 89975.17 107565.01 128672.81 154002.17Ke 0.2"Normal" Income 6296.00 7474.16 8887.95 10584.50 12620.36 15063.40 17995.03 21513.00 25734.56Residual Income (RI) (405.20) (405.20) (405.20) (405.20) (405.20) (405.20) (405.20) (405.20) (405.20) (405.20)Discount Factor 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194Present Value of RI (337.67) (281.39) (234.49) (195.41) (162.84) (135.70) (113.08) (94.24) (78.53)
ROE 0.187 0.189 0.191 0.192 0.194 0.195 0.195 0.196 0.197BV Equity 31,480.00$ gr 1.1% 0.9% 0.8% 0.6% 0.5% 0.5% 0.4% 0.3% 0.193Total PV of RI (1,633.35)$ Continuation (Terminal) Value (4052.00)PV of Terminal Value (785.30)$ gEstimated Value 29,061.35$ 0 0.05 0.1 0.15time consistent implied price 30,882.29$ Ke 0.12 $14.62 $18.26 $40.10 N/AEstimated value per share $4.80 0.14 $10.94 $12.48 $17.87 N/ATime consistant price per share $5.10 0.1631 $8.05 $8.58 $9.94 21.65Actual Price per share 0.18 $6.53 $6.72 $7.13 $8.90Growth 0.1 0.2 $5.17 $5.15 $5.10 $4.96Ke 0.2Number of shares 6055
Forecast Years
Sensitivity Analysis
124
BookEquity 31480Ke 0.1631 ROE 0.18ROE 0.18 0.1 0 0.05 0.1 0.15 0.2g 0.15 Ke 0.13 $7.20 $8.45 $13.86 $0.00 $1.49
0.14 $6.68 $7.51 $10.40 $0.00 $1.730.1631 $5.74 $5.98 $6.59 $11.91 $2.82
PPS 72091.6031 0.18 $5.20 $5.20 $5.20 $5.20 $5.2011.91$ 0.2 $4.68 $4.51 $4.16 $3.12 $0.00
g 0.150.14 0.16 0.18 0.2 0.22
Ke 0.13 $2.60 $0.00 $0.00 $0.00 $0.000.14 $5.20 $0.00 $0.00 $0.00 $0.00
0.1631 $0.00 $3.97 $11.91 $19.84 $27.780.18 $0.00 $1.73 $5.20 $8.67 $12.13
0.2 $0.00 $1.04 $3.12 $5.20 $7.28
Ke 0.16310 0.05 0.1 0.15 0.2
g 0 0.00 1.59 3.19 4.78 6.380.05 0.00 0.00 2.30 4.60 6.90
0.1 0.00 0.00 0.00 4.12 8.240.15 0.00 0.00 0.00 0.00 19.84
0.2 28.18 21.13 14.09 7.04 0.00
Sensitivity AnalysisROE
Sensitivity Analysisg
Sensitivity AnalysisROE
125
1 2 3 4 5 6 7 8 9Forecast Years
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Total Net Income 5,890.80 7,068.96 8,482.75 10,179.30 12,215.16 14,658.20 17,589.83 21,107.80 25,329.36 DPS $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00DPS invested at 17% (Drip) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00Cum-Dividend Earnings 7,068.96 8,482.75 10,179.30 12,215.16 14,658.20 17,589.83 21,107.80 25,329.36 Normal Earnings $6,715.512 $8,058.614 $9,670.337 $11,604.405 $13,925.286 $16,710.343 $20,052.411 $24,062.894Abnormal Earning Growth (AEG) $353.448 $424.138 $508.965 $610.758 $732.910 $879.492 $1,055.390 $1,266.468 $728.946
PV Factor 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351PV of AEG $310.04 $326.36 $343.54 $361.62 $380.65 $400.68 $421.77 $443.97Residual Income Check Figure ($0.00) $0.00 $0.00 $0.00 ($0.00) $0.00 ($0.00) $0.00
Core Earnings 5,890.80 Total PV of AEG $2,988.64Continuing (Terminal) Value $1,656.70PV of Terminal Value $580.77Total PV of AEG $3,569.41Total Average EPS Perp (t+1) $9,460.21Capitalization Rate (perpetuity) 0.14
Intrinsic Value Per Share (6/30/07) $11.16time consistent implied price $11.66Nov 1, 2007 observed price 32.18Ke 0.14 gg -0.3 -0.1 -0.2 -0.3 -0.4Outstanding Shares 7/1/07 6055 Ke 0.12 17.17$ 16.37$ 15.96$ 15.70$ Actual Price per share $32.18 0.14 12.25$ 11.87$ 11.66$ 11.53$
0.1631 8.60$ 8.45$ 8.36$ 8.31$ 0.18 6.76$ 6.70$ 5.17$ 5.17$ 0.2 5.17$ 5.17$ 5.17$ 5.17$
Sensitivity Analysis
Altman’s Z-Score
126
2002 2002 Weighted 2002 GW 2002 GWW 2003 2003 Weighted 2003 GW 2003 GWWTotal Assets 37795 37082 37107 36298EBITDA 2919 2206 4882 4073Net Sales 18915 18915 18878 18878Market Vale of Equity 28656 28656 28029 28029Total Liabilities 9124 9124 9068 9068Current Assets 17433 17433 13415 13415Current Liabilities 8375 8375 8294 8294Retained Earnings 7733 7020 6559 5750.4Working Capital 9058 9058 5121 5121
EBIT/Total Assets 0.077232 0.254867046 0.05949 0.1963163 0.131565 0.43416606 0.11221 0.3702931Net Sales/ Total Assets 0.500463 0.500463024 0.510086 0.5100858 0.508745 0.508744981 0.520084 0.5200838MVE/Total Liabilities 3.140728 1.884436651 3.140728 1.8844367 3.090979 1.854587561 3.090979 1.8545876Working Capital/TA 0.239661 0.287593597 0.244269 0.2931233 0.138006 0.165607567 0.141082 0.1692986RE/TA 0.204604 0.286445297 0.18931 0.2650342 0.176759 0.247462743 0.158422 0.2217907
Altman Z-Score 3.214 3.149 3.211 3.136
2004 2004 Weighted 2004 GW 2004 GWW 2005 2005 Weighted 2005 GW 2005 GWWTotal Assets 35594 34754 33883 32824EBITDA 6269 5452 7416 6357Net Sales 22045 22045 24801 24801Market Vale of Equity 25826 25826 23174 23174Total Liabilities 9678 9678 10699 10699Current Assets 14343 14343 22010 22010Current Liabilities 8703 8703 9511 9511Retained Earnings 3164 2324.4 506 -553Working Capital 5640 5640 12499 12499
EBIT/Total Assets 0.176125 0.581213126 0.156874 0.5176843 0.218871 0.722273707 0.193669 0.6391086Net Sales/ Total Assets 0.619346 0.619345957 0.634315 0.6343155 0.73196 0.73195998 0.755575 0.7555752MVE/Total Liabilities 2.668527 1.601115933 2.668527 1.6011159 2.165997 1.299598093 2.165997 1.2995981Working Capital/TA 0.158454 0.190144406 0.162283 0.1947402 0.368887 0.442664463 0.380788 0.4569461RE/TA 0.088891 0.124447941 0.066882 0.0936341 0.014934 0.02090724 -0.01685 -0.0235864
Altman Z-Score 3.116267363 3.04149 3.217403482 3.1276416
2006 2006 Weighted 2006 GW 2006 GWW 2007 2007 Weighted 2007 GW 2007 GWWTotal Assets 43315 41470 53340 50916EBITDA 6996 5151 8621 6197Net Sales 28484 28484 34922 34922Market Vale of Equity 23912 23912 31480 31480Total Liabilities 19397 19397 21850 21850Current Assets 25676 25676 31574 31574Current Liabilities 11313 11313 13358 13358Retained Earnings 231 -1614.4 -617 -3041.2Working Capital 14363 14363 18216 18216
EBIT/Total Assets 0.161514 0.532997807 0.12421 0.4098939 0.161624 0.533357705 0.12171 0.4016439Net Sales/ Total Assets 0.657601 0.657601293 0.686858 0.686858 0.654706 0.654705662 0.685875 0.6858748MVE/Total Liabilities 1.232768 0.739660772 1.232768 0.7396608 1.440732 0.864439359 1.440732 0.8644394Working Capital/TA 0.331594 0.397912963 0.346347 0.4156161 0.341507 0.409808774 0.357766 0.4293189RE/TA 0.005333 0.007466236 -0.03893 -0.0545011 -0.01157 -0.016194226 -0.05973 -0.0836217
Altman Z-Score 2.335639071 2.1975277 2.446117275 2.2976552
References
127
1. Cisco Systems Website: www.cisco.com
2007 Annual Report
2002 10k -2007 10k
2. Juniper Networks Website: www.juniper.net
2006 Annual Report
2002 10k -2006 10k
3. Nortel Networks Website: www.nortel.com
2006 Annual Report
2002 10k -2006 10k
4. Wikipedia: www.wikipedia.com
5. Investopedia: www.investopedia.com
6. Fool: www.fool.com
7. Yahoo Finance: www.finance.yahoo.com
8. Linksys: www.lynksis.com
9. Strategy Business: www.strategy-business.com
10.Investor Words: www.investorwords.com
11. Google Finance: http://finance.google.com/finance?tab=we
