Challenging the Market Price: Cisco Systems, Inc. Cisco Systems, Inc. (CSCO), manufactures and sells networking and communications cquipment for transporting data, voice, and video and provides services related to thet cquipment, Its products include routing and switching devices; home and office network- ing equipment; and Internet protocol, telephony, security, network management, and soft- ware services. The firm has grown organically but also working and software firms. Cisco's Web site is www.ciseo egn acquisition of other net- Cisco was a darling of the Internet boom, one of the few firms with concrete products. Indeed its products were impodecommunications. At one point, in early 2000, the firm ortant to the development of the infrastructure for the Inter- age and the expansion in traded with a Microsoft, and its shares traded at a P/E of over 130. With the bursting of the Internet bub- ble and the overcapacity net otal market capitalization of over half a trillion dollars, exceeding that of in telecommunications resulting from overinvestment by telecom- e and munications firms, Cisco's growth slowed. Faced with a sales slump, CEO John Chambers overhauled the management to streamline the company. By 2004 its revenue had recovered to the $22.0 billion level. Subsequently, Cisco's sales continued to grow, reaching $39.5 billion by 2008. The com- pany acquired the home networking company Linksys and cable set-top box maker Scientific Atlanta, along with WebEx web-conferencing software and Flip video cameras. However, sales then remained flat, standing at $36.2 billion in 2009. Profit margins declined and EPS in 2009 was $1.05, down from $1.35 in 2008. Rivals Motorola and Juniper Networks were gain- ing ground. Cisco's diversification, via acquisitions, into cable set-top boxes and videocon- ferencing equipment had not proved successful, with cable companies cutting back on orders for the cable boxes and customers using Skype or Google Talk to conference for no cost. Mr. Chambers began another shake-up of the company. At the beginning of 2010, Cisco was trading at $24 per share, or 3.6 times book value of $6.68 at the end of its July 2009 fiscal year. Analysts were forecasting a consensus estimate of $1.42 EPS for fiscal year 2010 and 1.61 for 2011. The forward P/E of 16.9 implies some growth expectations, and indeed the growth rate forecasted for 2011 EPS over 2010 is 13.4 percent. Cisco paid no dividends at the time. A. Bring all the tools in this chapter to an evaluation of whether Cisco's price is appropri- ate. You will not be able to resolve the issue without some detailed forecasting of Cisco's future earnings (which you should not attempt at this stage). Rather, using the analysts' forecasts for 2010 and 2011, quantify the earnings forecasts for subsequent years im- plicit in Cisco's $24 price. Identify the speculative components of Cisco's price using the building block approach. Figures 7.4 and 7.5 should be helpful to you. B. If, through diligent analysis, you concluded that Cisco's long-run residual earnings growth rate can be no more than 4 percent per year, what is the expected rate of return from buying Cisco at $24? C. What is the no-growth value for Cisco? What is the expected return from buying Cisco if no growth is expected? Calculate the expected return for different growth rates, in- cluding negative growth rates. Does this exercise give you a feeling for the range of pos- sible payoffs from buying Cisco
