z - CSCO priced to fundamentals? You've got to be kidding!
Don't even try to price the company that way.
Firstly, it's a great company. If you go back through the last 5 years of 10-K you see revenues growing 49%, earnings growing 39% and the evil dilution by which the company grows and employees are enriched only growing by 5.3%
We also have "pro-forma" EPS at about 139% of GAAP EPS.
Many many posts extolling how this is the reason for its current price.
Let's model these fundamentals going forwards unabated for the next little while. At $0.53 per share, we may have to go forward a few years... but it's worthwhile. Because, everyone seems to be betting a bundle on it.
Using FY 2000 10-K figures and 49% Rev growth, 39% earnings growth and 5.3% dilution, my numbers got a bit, um, "indigestible" after 10 years. So I had to tone the growth rate down to a modest 25%, 20% and 2.6% respectively for the next 5 years, and then settle into behavior more fitting a respectable company at the top of the corporate rankings (12%, 9.5% and 1.3%). Still a bit hard to swallow, but here goes:
Rev in B$, pro-forma EPS in $0.01 (pennies)
2000 2005 2010 2015 2020 2025 2030
Rev 19 140 1030 3089 5514 9302 16602
pf EPS 53 208 808 1694 2500 3551 5238
<EDIT> Sorry the table messed up, but font went too teeny when i tried fixed and it's late.
I'm not even going to bother commenting about the validity or implications of this as a projection just yet. That's later. Nor will I dwell at all on whether earnings should be measured by GAAP or pro-forma.
No, I will merely accept this model at face value, noting only that the remarkable similarity between CSCO's reported pro-forma earnings and a calculation of free cash flow serves to simplify the calculating.
The "fundamental" economic value of a share is the sum of the discounted free cash flows per share over some period of time. We need to pick the time period, and the discount rate.
For time, I choose 30 years. For three reasons. Firstly, because I feel a certain empathy for the "L" in "LTBH", the time frame should be long. But not unlimited (reason number 2): 30 years ago in 1970, popular wisdom was that computers were going to change the world and the way the world did business, and that IBM being the undisputed computer Gorilla (they didn't use those terms of course, but same meaning) would rule supreme. Swap "Internet" for "computer" and "CSCO" for "IBM" and ponder the risk of choosing a time frame too far beyond the horizon.
And finally the third reasons is, I'm not willing to use a shorter period of time, because then someone will cry foul and flame my bias as that of a malicious bear because I didn't include tail-end revenue where the fruit of growth is to be harvested. By all means, let's harvest that growth. At this point, I would rather be criticized for being biased towards a higher price.
For discount rate, I choose 15%: 6% money risk (T-bill rate) + 5% business risk (mostly their customers of course) and 4% technology risk. These factors are extremely low for high-tech. Very very low compared to what CSCO itself uses when discounting the new technologies it so carefully harvests.
Using my detailed spreadsheet, the sum of the annual pro-forma earnings per share over the next 30 years discounted at 15% gives me....
.. drum roll please...
... $41.95 in constant dollars.
Ooooh.
In other words, people are willing to pay more for a slice than the company can be reasonably expected to generate "per slice" over the next thirty years!!
Perhaps the model is flawed. Someone with even a modest complement of functioning neurons would soon realize it's flawed big time. They'd realize that before the 30 years are up, this model projects CSCO attracting more revenue than the US government attracts (and spends) annually - by a factor of about 8!!!
It's flawed alright. It's flawed in the wrong direction.
There's a way better chance (approaching certainty) that CSCO gets no more than half as big, in no less than twice the time.
Which makes $10 a closer approximation of the the highest possible "fair" price one should pay today based on economic "fundamentals". With still a factor of two or so of doubt.
This doesn't argue that I should use a lower discount rate, but what the heck. Maybe my discount rate is way too steep. Let's try 9% and then divide by four: we get $25.
What about all that cash from options? Doesn't get us close (on 10B shares, $25 is off by about 200 B$) - even if they stay above water as price regresses to economic mean.
No, my zealous friend, this company is not priced according to fundamentals. It, and the rest of the high-priced growth are priced about as high as the market will bear.
Now, if you want to compare it relative to other stocks in the still-high-flying high-tech sector, then we can agree on all kinds of relative pricing theories which show that it's fairly priced...
... but that leaves me with a creepy cold feeling about the whole market right about now...
But then, how silly anyone should be, thinking that the stock market should be based on anything approximating economic fundamentals!
Fear and greed, supply and demand. These are the things of price today. No mistake about it. But those who are long?
If everything regresses to the mean, you can expect to get a better return from a T-bill from here on in.
John. |
