M5.1 Forecasting from Traded Price-to-Book Ratios: Cisco Systems Inc. Price = $21 Required equity return = 12% Forward P/E = $21/$0.89 = 23.60 Book value per share = $25,826/6,735 = $3.835 P/B = $21/3.835 = 5.48 Introduction Part A of this case asks you to challenge the market price of $21 or, alternatively stated, to challenge the current P/B ratio of 5.48. As a P/B ratio is based of expected residual earnings, this comes down to asking whether the P/B ratio is justified on the basis of residual earnings forecasts. Given that we have only two years of analysts forecasts, we do not have the complete set of forecasts to challenge the $21 price. Of course, we might develop a full analysis to do this (as will be done in Chapters 7 15), but for now we are asked to challenge the price with the limited forecasts. Reverse engineering gives us the handle: What are the forecasts implicit in the market price, and are these reasonable? This is done in three steps: 1. Calculate the implied residual earnings growth rate after 2006 that is implicit in the market price. 2. Translate the residual earnings growth rate into an eps growth rate 3. Ask whether, given our knowledge of Cisco and its operations, the implied eps growth rates are reasonable. The assembly of the building blocks of the valuation to separate the speculative part of the valuation also provides insights. Part B of the case is a check on analysts recommendations, first against their target price and, second, against their forecasts. Are the recommendations consistent with their target price and their forecasts for the stock? The Questions Part A: 1. Implied Residual Earnings Growth Rates With a required return on the equity of 12%, the pro forma for a price of $21 is as follows: 2004 2005 2006
Eps 0.89 1.02 Dps 0.00 0.00 Bps 3.835 4.725 5.745 Residual earnings (RE) 0.4298 0.4530 Discount factor 1.12 1.2544 PV of RE 0.3838 0.3611 Total PV to 2006 0.745 PV of CV 16.420 CV 20.597 Value of Equity 21.000 The present value (PV) of the continuing value (CV) is the plug between $21 and the other two components of the valuation: PV of CV = $21.00 3.835 0.745 = $16.42 The continuing value (at the end of 2006) is the future value of this number: CV = $16.42 1.2544 = $20.597 Given the analysts forecasts for 2005 and 2006 are reasonable, this is the continuing value that the market forecasts; that is, the market attributes $16.42 of the $21 price to value to be delivered after 2006. From this continuing value, we can impute the implied residual earnings growth rate after 2006: 0.4530 g CV = 20. 597 1.12 g So g = 1.0959. The market is forecasting a growth rate for residual earnings of 9.59% per year indefinitely. Keeping in mind the average GDP growth rate of 4% as a benchmark, this looks a bit high. Notice that we have anchored on the book value and the two years of analysts forecasts in order to challenge the speculation in the market price. We would have to revise our analysis (to anchor solely on the book value) if we were not confident in the integrity of the analysts forecasts. 2. Implied Eps growth rates It s difficult to think in terms of residual earnings growth rates, so convert the growth rate to eps growth rates using the formula to reverse engineer residual earnings: Earnings t = (B t-1 0.12) + RE t
EPS Growth Rate The following pro forma gives forecasts RE (growing at 9.59% after 2006) and converts the RE forecasts to eps forecasts in order to derive eps growth rates: 2005 2006 2007 2008 2009 2010 RE 0.430 0.453 0.496 0.544 0.596 0.653 Bps 4.725 5.745 6.930 8.306 9.899 11.740 Eps 0.89 1.02 1.185 1.376 1.593 1.841 Eps growth rate 14.61% 16.18% 16.12% 15.77% 15.57% 3. Evaluate Implied Growth Rates Are these growth rates reasonable? Well, we do not know enough about Cisco to make the evaluation here, but an analyst who is familiar with the company might well conclude that these rates are too high, too high, or too low. She might conclude: I just cannot see Cisco maintaining such high growth rates for such a long period of time. The following plot will help her: Plotting the market s implied Eps growth rates: 20.0% 19.0% BUY 18.0% 17.0% 16.0% 15.0% 14.0% 14.61% 16.18% 16.12% 15.77% 15.57% 13.0% 12.0% SELL 11.0% 10.0% 2006 2007 2008 2009 2010 If the analyst forecasts growth rates above the path implied by the market, she would say that Cisco was underpriced at $21. If the analyst forecasts growth rates below the path
Value Per Share implied by the market, she would say that Cisco was overpriced at $21. The path separates the BUY and SELL regions. To be confident in her assessment, she would model the eps path, using the full financial statement analysis and pro forma analysis that we will move on to in Chapters 7-15, and then compare her path to that implied by the market. Identifying the speculative component of the market price: the Building Blocks Refer to Figure 5.5 in the text. The speculative component is that which involves the more uncertain forecasts for the longer term. The building blocks are: 1. Block 1: Book value $3.84 2. Block 2: Value from two years of forecasts: 1 0.4530 Value in Block 2 = 0.4298 3.75 1.12 0.12 3. Block 3: Value in speculation about growth 13.41 21.00 The building blocks for Cisco: $21.00 Current Market Value $13.41 $7.59 $3.75 $3.84 Book Value (1) (2) Book Value Value from short-term forecasts (3) Value from long-term forecasts
A considerable portion of the market price involves speculation about growth in the long term (Block 3). At this point, the analyst asks whether this speculation is justified. Maybe the market is pricing events beyond the forecast horizon or other factors, other than immediate eps growth, that are pertinent to the value. The analyst (and the student) asks: what is the market anticipating that I do not anticipate; what do others know that is not factored into my forecasts? What is the market speculating about to give Cisco such a high Block 3 value? Is the firm on a takeover list? (Unlikely for Cisco) Does it have new strategic plans? Is it ripe for breakup? (Unlikely for Cisco) Having posed these questions, the analyst furthers his research to check on the answers before being confident in his BUY/HOLD/SELL recommendation. Note: We have proceeded with a CAPM required return of 12%. CAPM technology is quite imprecise, so we must be sensitive to this. We do this by asking if our assessment will change if the required return is different. A sensitivity analysis for a 10% cost of capital follows: 2004 2005 2006 Eps 0.89 1.02 Dps 0.00 0.00 Bps 3.835 4.725 5.745 Residual earnings (RE) 0.5065 0.5475 (Using a 10% required return) Discount factor 1.10 1.21 PV of RE 0.4605 0.4525 Total PV to 2006 0.913 PV of CV 16.252 CV 19.665 Value of Equity 21.000 0.5475 g CV = 19. 665 1.10 g So g = 1.0702, or a 7.02% growth rate. Proceed from here, as before. A 7.02% growth rate is lower, of course, but still high relative to the GDP growth rate. You can now prepare a similar plot to that above with this 7.02% growth rate (and also a building block diagram).
Part B: This part of the case conducts two tests to challenge the integrity analysts recommendation (to buy, hold or sell Cisco). Is the recommendation consistent with their analysis? First, is the recommendation consistent with the target price? If one bought Cisco at $21 at the beginning of 2005 and accepted 12% as the required return, a target price of $23.52 at the end of 2005 would yield the required (normal) return: $21 1.12 = $23.52 (there are no dividends). So, a target price of $24 would be a (marginal) buy. (Of course, analysts may have a lower required return, which would make a $24 target price a solid BUY). Analysts were indeed recommending a BUY at the time (on average). Second, is the recommendation consistent with analysts forecasts? To start, work with analysts 2006 forecast. Their forecast for growth in residual earnings for 2006 (from the pro forma above) is Growth rate for RE 2006 = 0.4530/0.4298 = 1.054 (a 5.4%growth rate). This is considerably below the market s implied growth rate of 9.59% for subsequent years. Now work with analysts 5-year growth rate. Analysts see a growth rate for eps of 14.5% after 2006 and, on the basis of that forecast, recommend a BUY. But the plot above puts a growth rate of 14.5% in the SELL region: the implicit market forecast is greater than this. The recommendation is inconsistent with analysts forecast. There are two provisos to these conclusions. First, analysts may see higher growth after their 5-year forecast horizon (2010), and are basing their recommendation on this. Second, analysts may indeed see the lower growth in the future, but may anticipate that the market price will (irrationally) increase: the price will move away from fundamentals. In making a call on the target price, they are predicting prices, not values. One further point should be noted. There is a possibility that the market is pricing based on analysts consensus forecasts and both a wrong! Indeed, there are claims that mispricing is led by analysts (poor) forecasting, as in the bubble. If we do not trust analysts forecasts, there is no avoiding developing our own. Chapters 7-19 of the book are designed to do this. Note that, by the end of Cisco s 2005 fiscal year, the stock price had dropped to $19.
Part C: Calculate the expected return from buying the stock at $21 by reverse engineering for the specified growth rate of 6%. The formula 5.7a in the chapter does this: Expected return Earnings Price 1 B 1 ( g 1) P $0.89 1 0.183 6% = 9.14% $21 This is less that the required return of 12%, so SELL. For a two-year analyst forecast, the formula is not so simple. Solve for X in the residual earnings formula for a two-year forecasting horizon: 0.89 ( X 3.835) 1.02 ( X 4.725) 1.06 21 $3.835 1. X 1. X (1. X 1.06) $ 2 X = 9.15% (You best do this with trial and error, starting with the expected return from the formula for the one-year-ahead forecast.)