Victor Selva

# Applying the Dividend Discount Model to Cisco Systems

March 17, 2014 | About:

Cisco Systems Inc. (NASDAQ:CSCO) is the world's largest supplier of high-performance computer networking systems. The firm continues strengthening its focus on corporate software and technology services, which we see as a main driver in the current years.

The firm is currently Zacks Rank # 3 Hold, and it also has a longer-term recommendation of “Neutral.” For investors looking for a Zacks Rank # 1 – Strong Buy, Netgear Inc. (NASDAQ:NTGR) and Silicom Limited (NASDAQ:SILC) could be better options.

So now let's take a look at the intrinsic value of this company and try to explain to investors the reasons why it is a good buy or not. In this article, we present a model that is by no means the be-all and end-all for valuation. The purpose is to force investors to evaluate different assumptions about growth and future prospects.

Valuation

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

Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).

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

Let´s estimate the inputs for modeling:

Required Rate of Return (r)

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

Assumptions:

Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%

Beta: β =1.27

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

rCSCO = RF + βCSCO [GGM ERP]

= 2.67% + 1.27 [11.43%]

= 17.19%

Dividend growth rate (g)

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

g = b x ROE

b = retention rate

ROE can be estimated using Dupont formula:

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

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

With the GGM formula and simple math:

The growth rates are:

 Year Value g(t) 1 g(1) 12.90% 2 g(2) 12.42% 3 g(3) 11.95% 4 g(4) 11.47% 5 g(5) 11.00%

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

Calculation of Intrinsic Value

 Year Concept Amount Present value 0 Div 0 1.20 1 Div 1 1.35 1.16 2 Div 2 1.52 1.11 3 Div 3 1.71 1.06 4 Div 4 1.90 1.01 5 Div 5 2.11 0.95 5 Terminal Value 37.83 17.12 Intrinsic value 22.41 Current share Price 21.52

Final Comment

When the stock price is lower than the intrinsic value, the stock is said to be undervalued and it makes sense to buy the stock. We have covered just one valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

Hedge fund gurus have also been active in the company. Gurus like Jean-Marie Eveillard (Trades, Portfolio), Tweedy Browne (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and Donald Yacktman (Trades, Portfolio) and the funds PRIMECAP Management (Trades, Portfolio) and First Pacific Advisors (Trades, Portfolio) have invested in it in fourth quarter 2013.

Disclosure: Victor Selva holds no position in any stocks mentioned.

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

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