M7.1 Challenging the Market Price: Cisco Systems, Inc.

M7.1 Challenging the Market Price: Cisco Systems, Inc. Price = $24 per share Forward P/E = $24/$1.42 = 16.9 Book value per share = $6.68 P/B = $24/6.68 = 3.59 B/P = 0.278 Introduction Part A of this case asks you to challenge the market price of $24 or, alternatively stated, to challenge the market s P/B ratio of 3.59. 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 $24 price. Of course, we might develop a full analysis to do this (as will be done in Chapters 8 16), but for now we are asked to challenge the price with the limited forecasts. Reverse engineering gives us the handle. This is done by asking two questions that correspond to parts A and B of the case: A. 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 2011 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. B. What is the expected return to buying Cisco at $24, and is this good enough? Before beginning the case, it is helpful to remind ourselves of the principles of fundamental analysis: 1. Don t mix what you know with speculation 2. Anchor a valuation of what you know 3. Beware of paying too much for growth The Questions

Part A The challenge to the market price is a challenge to the market s growth forecasts. To challenge those, we anchor on book value (which we know) and short-term forecasts (about which we are reasonably confident). To begin, establish the no-growth valuation based on these inputs. Separating value with no growth from value from speculative growth To proceed, one needs a required return. This is the investor s choice his or her hurdle rate. We will use a 10% rate here, but the analysis can be tested for sensitivity to this rate, made easier if the analysis is put into a spreadsheet. The pro forma to challenge the price is as follows. This pro forma identifies the no-growth value of $14.63 per share: 2009A 2010E 2011E EPS 1.42 1.61 DPS 0.00 0.00 BPS 6.68 8.10 9.71 Book rate of return 21.3% 19.9% Residual earnings (10% charge) 0.752 0.800 Growth in residual earnings 6.38% Growth in EPS 13.4% Value of Equity 0 ( ROCE1 r) B0 ( ROCE2 r) B1 B0 Value of Speculative Growth 1 r (1 r) r 0.752 0.800 $ 6.68 Value of Speculativ e Growth 1.10 1.10 0.10 = $6.68 + 0.684 + 7.27 + Value of Speculative Growth = $14.63 + Value of Speculative Growth As the stock is trading at $24, we have the value that the market is placing on speculative growth: $24-14.63 = $9.37. The market is asking us to pay $9.37 for growth. Do we want to pay this much? We now have the components of a building-block diagram like that in Figure 7.4:

Block (1), book value, we know for sure; block (2) we know with some certainty (let s say) it s been subject to analysis based on considerable information but block 3 is where we are most uncertain. This block is what we have to challenge. We do so by eliciting the market s growth forecast. Reverse engineering the market s growth forecast This is accomplished by solving for g in the residual earnings valuation model: Value of 0.752 0.800 Equity0 $24 $6.68 1.10 1.10 (1.10 g) The solution for g = 1.0563, or a 5.63% growth rate. So the market is forecasting that RE will grow at a 5.63% rate every year after 2011. Is that a reasonable forecast? Rather than applying a valuation model to transform one s own forecast to a value, we have applied the model in reverse engineering mode to extract the market s forecast. This is the way to handle valuation models. By resisting the temptation to plug a speculative growth rate into a model, we have heeded Graham s warning (in the chapter) about formulas out of higher mathematics, particularly the growth rate in those formulas. Rather, we have turned the model around as a tool to challenge the market speculation about growth of which he was so skeptical. The growth rate is the residual earnings growth rate, a little difficult to get our minds around. But we can convert this growth rate to an EPS growth rate by reverse engineering the residual earnings calculation:

As Residual Earnings t+1 = Earnings t+1 (r Book value t ), then Earnings t+1 = (Book value t r) + Residual Earnings t+1. Cisco s residual earnings two years-ahead (2011) is $0.800 per share, so the residual earnings forecasted for the third year ahead (2012) at a growth rate of 5.63 percent is $0.845. Thus, with a per-share book value of $9.71 forecasted for the end of 2011, the implicit forecast of EPS for 2012 is EPS 2012 = $(9.71 0.10) + 0.845 = $1.816 and the forecasted growth rate over the 2011 EPS of $1.61 is 12.8 percent. Similarly, the EPS for 2013 is forecast as follows: RE 2013 = RE 2012 g = 0.845 1.0563 = 0.893 BPS 2012 = BPS 2011 + EPS 2012 DPS 2013 = 9.71 + 1.816 0.0 = 11.526 EPS 2013 = (11.526 0.10) + 0.893 = 2.046 The forecasted EPS growth rate for 2013 = 2.046/1,816 1 = 12.6%. Extrapolating in the same way to subsequent years, one develops the earnings growth path that the market is forecasting, displayed below:

If the analyst forecasts growth rates above the path implied by the market, she would say that Cisco was underpriced at $24. If the analyst forecasts growth rates below the path implied by the market, she would say that Cisco was overpriced at $24. 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 8-16. Those chapters provide the analysis to get a better handle on growth. In the absence of that analysis, the analyst can look at growth up to the forecast horizon as an indication of the firm s ability to deliver subsequent growth. The residual earnings growth rate forecasted for Cisco in 2011 is 6.4 percent in the pro forma above, contrasting with the longterm rate of 5.63 percent inferred from the market price. For speculation, she may then turn to softer inputs than the accounting. She understands, first and foremost, that a good knowledge of the business is prerequisite for grappling with the issue. She understands that exceptionally high growth rates are not likely to eventuate unless the firm has a strong sustainable competitive advantage. She understands that technological advantage can be eroded away. She is reminded that the implied residual earnings growth rate of 9.3 percent in the $77 price for Cisco in 2000 looked absurd to anyone who understood business, and proved to be so. She dissented from technology analysts of the time who advised buy Cisco at any price. While remaining skeptical of prices, the investor also maintains respect. She understands that she cannot be the sole possessor of knowledge and is wary of the dangers of self-deception and overconfidence. So she allows the market price to challenge her: What do others know that I do not know? Is the market speculating about a takeover? Am I missing something? Or is it the case that I cannot justify the growth expectations in the market price? The game is against other investors and the consensus view is to be acknowledged and understood. She may conclude that animal spirits are moving the crowd (and prices), but may also conclude that there are rational

explanations for the current price that she has not anticipated. This is the discussion in negotiating with Mr. Market. In deploying accounting as the anchor to challenge speculation, one must be realistic about whether the accounting has much to say. For a bio-tech start up with no product or FDA approval, reporting losses and even negative book value, the accounting is not the place to start. That is how it should be: this firm is a pure speculative play and (non-speculative) accounting should not have much to say. Better to get a degree in biochemistry than to study the financial statements. We have much to add in the matter of evaluating growth. Indeed the next four chapters will be preoccupied with the question of how much to pay for growth. This chapter is just the set-up. Note: We have proceeded with a required return of 10%. We must be sensitive to this estimate. We do so by asking if our assessment will change if the required return is different. Part B The second way to challenge the market is to ask whether the expected return from buying at the current market price is reasonable. The weighted average expected return formula is the tool. Forward ROCE = $1.42/$6.68 = 21.26% B/P = $6.68/$24 = 0.278 Long-term growth rate = 4% ER = [B/P ROCE 1 ] + [(1 B/P) (g-1)] = [0.278 21.26%] + [0.731 4%] = 8.83% So, if one cannot see growth in excess of 4%, the most one can expect to earn is a return of 8.83%. If one sees a 4% growth rate as achievable, that return might be OK. But as it is a return to best outcome, then one might be doubtful at buying at $24 there is a good chance of getting less. And, if one s required return is the 10% we used above, then this is not a stock to buy. Part C This part of the case experiments with different growth rates. If asks the question: What is the expected return for different growth scenarios. This is given by a growth-return profile that we will return to later in the book. This profile gives the expected return for given growth rates using the weighted average expected return formula: Growth Return -3% 3.72%

-2% 4.49% -1% 5.18% No-Growth: 0% 5.91% 1% 6.64% 2% 7.37% 4% 8.83% 6% 10.30% 8% 11.76% One can run thought experiments with this profile. If you (as a conservative investor) refuse to pay for any growth, you ll get 5.91%, and if you will not pay for more than 4% growth, you ll get 8.83%. But the profile also gives the upside and downside. You may be conservative and be satisfied with a return of 5.91% with no growth, but the profile tells you there is also some prospect you ll do better than that if growth materializes. And it also gives the downside: the lower returns for negative growth indicate how much you can be damaged. To complete your investment decision making, you will need to get a feel for the probabilities of achieving the different growth outcomes. That can only be down with further analysis, with which much of the rest of the book is concerned. Growth and Risk: Turning it Around One can ask what is the expected return for different growth rates, as we have just done. But one can also ask what is the market s forecast of growth for a different required return. Suppose we set the required return = 12%. Then the reverse engineering exercise in Part A is based on the following pro forma: The pro forma 2009A 2010E 2011E EPS 1.42 1.61 DPS 0.00 0.00 BPS 6.68 8.10 9.71 Book rate of return 21.3% 19.9% Residual earnings (12% charge) 0.618 0.638 Reverse engineering from the market price of $24 to the growth rate:

Value of Equity 0 $24 $6.68 0.618 1.12 0.638 1.12 (1.12 g) The solution: g = 1.0860 (an 8.6% growth rate) The forecast of EPS growth for 2012 = 15.4% (following the procedures to get from the RE growth rate to the EPS growth rate. You will note that both the implied RE growth rate and the EPS growth rate are higher than that for a required return of 10%. You require more growth to buy at $24 if your required return is 12% This is growth and risk in action: More risk (and a higher required return), you require higher earnings growth to cover your risk. Handling the Required Return: the Margin of Safety We do not know the required return, but here is a way to handle it. Put in a required return that is higher than your hurdle rate you are building in a margin of safety. If, at the current market price, you see reasonable or achievable growth (that you can justify), then you are buying it with a margin of safety. Part D The lesson from Cisco s decline in price from $71 in early 2000 to $15 by August 2011: Growth that was priced in at $71 (and a P/E of 130) can disappear. Growth gets competed away, even for a great company like Cisco of earlier years. Growth is challenged by competition and technological change. Few firms have durable competitive advantage. Buying growth is risky, so require a higher return. A Modification for Estimating the Implied Growth Path from the Market Price The implied RE growth rate with a required return on 10% in Part A of the case was 5.63%. That is the RE growth rate forecasted for 2012 to the very long term. However, it might be the case that, rather than forecasting a constant growth rate, we might see growth at a higher level in the near term, declining to a lower rate in the long term (as competition sets in and the firm becomes more like the average firm). Indeed, we see in the pro forma that Cisco is projected (by analysts) to have a 6.36% growth rate in 2011.

A reasonable forecast of growth is the very long term is the GDP growth rate the average rate for the economy and all firms in the economy. To capture the gradual decline to this rate, we can apply weights to the 2011 growth rate for Cisco (6.38%) and the 4% long-term rate, with weights than add to 1.0. If those weights are (0.8, 0.2), then Growth rate for 2012 = (0.8 6.38%) + (0.2 4.0%) = 5.90% (and so on, recursively for years after 2012). The 2012 growth rate iss lower than the 6.38 percent for 2011 because it is on a path to decline to 4 percent inn the long run. Applying the weights to subsequent years, the forecasted growth rate for 2013 is 5.53 percent, declining to 4 percent eventually, and 4.4 percent within 10 years. So we establish a fade rate for growth. This path yieldss a valuation of $20.33. The path is plotted below and compared to a path with weights of (0.9, 0.1). The (0.9, 0.1) weighting sees the growth rate nearing 4 percent considerably further inn the future, reaching 4.44 percent in 20 years, and yields a valuation of $21.14. As before, these residual earnings growth paths can be converted to EPS growth paths, as above. While the weights are somewhat arbitrary, they focus our thinking: How long do I expect Cisco to maintain a growth rate superior to the economy as a whole?

One can also turn the exercise around to challenge the market price: rather than inferring one long-term growth rate from the market price, as before, infer the weights that the market is applying to forecast the decline in growth rates from the short-term rate of 6.38 percent to the long-term anchor of 4 percent. The weights that yield the market price of $24 are (0.98, 0.02), indicating that the market expects reversion of the growth rate to 4 percent far in the distant future, indeed reaching 4.4 percent 100 years hence. This growth path is also plotted in figure above. Is this growth path a reasonable one given one s knowledge of the company? See Penman, Accounting for Value, Chapter 3 for more.