DuPont Analysis, Forecasting with the Parsimonious Method and Estimating Share Value of Cisco Systems Inc Using the DCF Model Cisco Systems, Inc. is a multinational information technology company headquartered in San Jose, California, that produces and sells networking hardware, telecommunications equipment and other high-technology services. Cisco Systems was founded in December 1984 by Leonard Bosack and Sandy Lerner, two Stanford University computer scientists, who pioneered the concept of a local area network (LAN). In 1990, Cisco Systems went public with a market capitalization of $224 million. By 2000, Cisco had become the most valuable company in the world with a more than $500 billion market capitalization. The stock was initially listed on the NASDAQ in 1990, and then was added to the Dow Jones Industrial Average on June 8, 2009. Cisco is currently included in the S&P 500 Index, the Russell 1000 Index, NASDAQ-100 Index and the Russell 1000 Growth Stock Index. As Figure 1 shows, the stock price of Cisco Systems peaked in 1999-2000 before the burst of internet bubble. However, its stock price has been fluctuating in the range of $10-$30 since 2001. Figure 1. Stock Price of Cisco Systems Inc. 90 80 70 60 50 40 30 20 10 0 1/1/1991 1/1/1992 1/1/1993 1/1/1994 1/1/1995 1/1/1996 1/1/1997 1/1/1998 1/1/1999 1/1/2000 1/1/2001 1/1/2002 1/1/2003 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011 1/1/2012 1/1/2013 1/1/2014 1/1/2015 Following are the income statement and balance sheet for Cisco Systems for the year ended July 30, 2016. July 25, 2015 $37,750 11,411 49,161 15,377 4,103 19,480 29,681 Cisco Systems Inc. Consolidated Statements of Income Years Ended December ($ millions) July 30, 2016 Revenue Product $37,254 Service 11,993 Total revenue 49,247 Cost of sales Product 14,161 Service 4,126 Total cost of sales 18,287 Gross margin 30,960 Operating expenses Research and development 6,296 Sales and marketing 9,619 General and administrative 1,814 Amortization of purchased intangible assets 303 Restructuring and other charges 268 Total operating expenses 18,300 Operating income 12,660 Interest income 1,005 Interest expense (676) Other income (loss), net (69) Interest and other income (loss), net 260 Income before provision for income taxes 12,920 Provision for income taxes 2,181 Net income $10,739 6,207 9,821 2,040 359 484 18,911 10,770 769 (566) 228 431 11,201 2,220 $8,981 July 30, 2016 July 25, 2015 $7,631 58,125 $6,877 53,539 5,344 5,847 Cisco Systems Inc. Consolidated Balance Sheets In millions, except par value Assets Current assets Cash and cash equivalents Investments Accounts receivable, net of allowance for doubtful accounts of $249 at July 30, 2016 and $302 at July 25, 2015 Inventories Financing receivables, net Other current assets Total current assets Property and equipment, net Financing receivables, net Goodwill Purchased intangible assets, net Deferred tax assets Other assets Total assets 1,217 4,272 1.627 78,719 3,506 4,158 26,625 2,501 4,299 1.844 $121,652 1,627 4,491 1,490 73,368 3,332 3,858 24,469 2,376 4,454 1.516 $113,373 Liabilities Current liabilities Short-term debt Accounts payable Income taxes payable Accrued compensation Deferred revenue Other current liabilities Total current liabilities Long-term debt Income taxes payable Deferred revenue Other long-term liabilities Total liabilities $4,160 1,056 517 2,951 10,155 6,072 $3,897 1,104 62 3,049 9,824 5,476 24,911 24,483 925 6,317 1.431 58,067 23,412 21,457 1,876 5,359 1,562 53,666 July 30, 2016 July 25, 2015 Cisco Systems Inc. Consolidated Balance Sheets In millions, except par value Cisco shareholders' equity Preferred stock, no par value: 5 shaes authorized; none issued and outstanding Common stock and additional paid-in capital, $0.001 par value: 20,000 shares authorized; 5,029 and 5,085 shares issued and outstanding at July 30, 2016 and July 25, 2015, respectively Retained earnings Accumulated other comprehensive income (loss) Total Cisco shareholders' equity Noncontrolling interests Total equity 44,516 43,592 19,396 (326) 63,586 (1) 16,045 61 59,698 9 63.585 59,707 Total liabilities and equity $121,652 $113,373 Required (a) compute the return on assets (ROA) and return on equity (ROE) for 2016 (b) Complete the DuPont disaggregation of return on equity (ROE) for 2016. Analyze the DuPont financial ratios and discuss how Cisco Systems Inc. can achieve a high ROE. (c) Compute net operating assets (NOA) for 2016. (d) Compute net operating profit after tax (NOPAT) for 2016, assuming a federal and state statutory tax rate of 37%. (Round your answer to the nearest whole number.) (e) Forecast Cisco's sales, NOPAT, and NOA for years 2017 through 2020 and the terminal period using the following assumptions: Sales growth 2017 2% Sales growth 2018-2020 3% Terminal growth 1% Net operating profit margin 2016 rate rounded to three decimal places Net operating asset turnover 2016 rate rounded to three decimal places Assume a discount rate (WACC) of 12%, common shares outstanding of 5,029 million, and net nonoperating obligations (NNO) of $(37,113) million (NNO is negative which means that Cisco has net nonoperating investments). (f) Estimate the value of a share of Cisco common stock as of July 30, 2016 using the discounted cash flow (DCF) model and sales, NOPAT and NOA forecast in (e); (g) If Cisco's top management were optimistic about CISCO's market growth opportunities and revised their sales growth rates up by 5%, please forecast Cisco's sales, NOPAT, and NOA for years 2017 through 2020 and the terminal period using the following assumptions: 7% 8% Sales growth 2017 Sales growth 2018-2020 Terminal growth Net operating profit margin Net operating asset turnover 1% 2016 rate rounded to three decimal places 2016 rate rounded to three decimal places (h) Estimate the value of a share of Cisco common stock as of July 30, 2016 using the discounted cash flow (DCF) model and the sales forecast in (g); Note, we still assume a discount rate (WACC) of 12%, common shares outstanding of 5,029 million, and net nonoperating obligations (NNO) of $(37,113) million. (1) Cisco stock closed at $31.47 on September 8, 2016, the date the Form 10-K was filed with the SEC. How does your DCF valuation estimates compare with this closing price? What do you believe are some reasons for the difference? What investment decision is suggested from your results? (1) Are there other equity valuation models? Please discuss the advantages and disadvantages of different equity valuation models. DuPont Analysis, Forecasting with the Parsimonious Method and Estimating Share Value of Cisco Systems Inc Using the DCF Model Cisco Systems, Inc. is a multinational information technology company headquartered in San Jose, California, that produces and sells networking hardware, telecommunications equipment and other high-technology services. Cisco Systems was founded in December 1984 by Leonard Bosack and Sandy Lerner, two Stanford University computer scientists, who pioneered the concept of a local area network (LAN). In 1990, Cisco Systems went public with a market capitalization of $224 million. By 2000, Cisco had become the most valuable company in the world with a more than $500 billion market capitalization. The stock was initially listed on the NASDAQ in 1990, and then was added to the Dow Jones Industrial Average on June 8, 2009. Cisco is currently included in the S&P 500 Index, the Russell 1000 Index, NASDAQ-100 Index and the Russell 1000 Growth Stock Index. As Figure 1 shows, the stock price of Cisco Systems peaked in 1999-2000 before the burst of internet bubble. However, its stock price has been fluctuating in the range of $10-$30 since 2001. Figure 1. Stock Price of Cisco Systems Inc. 90 80 70 60 50 40 30 20 10 0 1/1/1991 1/1/1992 1/1/1993 1/1/1994 1/1/1995 1/1/1996 1/1/1997 1/1/1998 1/1/1999 1/1/2000 1/1/2001 1/1/2002 1/1/2003 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011 1/1/2012 1/1/2013 1/1/2014 1/1/2015 Following are the income statement and balance sheet for Cisco Systems for the year ended July 30, 2016. July 25, 2015 $37,750 11,411 49,161 15,377 4,103 19,480 29,681 Cisco Systems Inc. Consolidated Statements of Income Years Ended December ($ millions) July 30, 2016 Revenue Product $37,254 Service 11,993 Total revenue 49,247 Cost of sales Product 14,161 Service 4,126 Total cost of sales 18,287 Gross margin 30,960 Operating expenses Research and development 6,296 Sales and marketing 9,619 General and administrative 1,814 Amortization of purchased intangible assets 303 Restructuring and other charges 268 Total operating expenses 18,300 Operating income 12,660 Interest income 1,005 Interest expense (676) Other income (loss), net (69) Interest and other income (loss), net 260 Income before provision for income taxes 12,920 Provision for income taxes 2,181 Net income $10,739 6,207 9,821 2,040 359 484 18,911 10,770 769 (566) 228 431 11,201 2,220 $8,981 July 30, 2016 July 25, 2015 $7,631 58,125 $6,877 53,539 5,344 5,847 Cisco Systems Inc. Consolidated Balance Sheets In millions, except par value Assets Current assets Cash and cash equivalents Investments Accounts receivable, net of allowance for doubtful accounts of $249 at July 30, 2016 and $302 at July 25, 2015 Inventories Financing receivables, net Other current assets Total current assets Property and equipment, net Financing receivables, net Goodwill Purchased intangible assets, net Deferred tax assets Other assets Total assets 1,217 4,272 1.627 78,719 3,506 4,158 26,625 2,501 4,299 1.844 $121,652 1,627 4,491 1,490 73,368 3,332 3,858 24,469 2,376 4,454 1.516 $113,373 Liabilities Current liabilities Short-term debt Accounts payable Income taxes payable Accrued compensation Deferred revenue Other current liabilities Total current liabilities Long-term debt Income taxes payable Deferred revenue Other long-term liabilities Total liabilities $4,160 1,056 517 2,951 10,155 6,072 $3,897 1,104 62 3,049 9,824 5,476 24,911 24,483 925 6,317 1.431 58,067 23,412 21,457 1,876 5,359 1,562 53,666 July 30, 2016 July 25, 2015 Cisco Systems Inc. Consolidated Balance Sheets In millions, except par value Cisco shareholders' equity Preferred stock, no par value: 5 shaes authorized; none issued and outstanding Common stock and additional paid-in capital, $0.001 par value: 20,000 shares authorized; 5,029 and 5,085 shares issued and outstanding at July 30, 2016 and July 25, 2015, respectively Retained earnings Accumulated other comprehensive income (loss) Total Cisco shareholders' equity Noncontrolling interests Total equity 44,516 43,592 19,396 (326) 63,586 (1) 16,045 61 59,698 9 63.585 59,707 Total liabilities and equity $121,652 $113,373 Required (a) compute the return on assets (ROA) and return on equity (ROE) for 2016 (b) Complete the DuPont disaggregation of return on equity (ROE) for 2016. Analyze the DuPont financial ratios and discuss how Cisco Systems Inc. can achieve a high ROE. (c) Compute net operating assets (NOA) for 2016. (d) Compute net operating profit after tax (NOPAT) for 2016, assuming a federal and state statutory tax rate of 37%. (Round your answer to the nearest whole number.) (e) Forecast Cisco's sales, NOPAT, and NOA for years 2017 through 2020 and the terminal period using the following assumptions: Sales growth 2017 2% Sales growth 2018-2020 3% Terminal growth 1% Net operating profit margin 2016 rate rounded to three decimal places Net operating asset turnover 2016 rate rounded to three decimal places Assume a discount rate (WACC) of 12%, common shares outstanding of 5,029 million, and net nonoperating obligations (NNO) of $(37,113) million (NNO is negative which means that Cisco has net nonoperating investments). (f) Estimate the value of a share of Cisco common stock as of July 30, 2016 using the discounted cash flow (DCF) model and sales, NOPAT and NOA forecast in (e); (g) If Cisco's top management were optimistic about CISCO's market growth opportunities and revised their sales growth rates up by 5%, please forecast Cisco's sales, NOPAT, and NOA for years 2017 through 2020 and the terminal period using the following assumptions: 7% 8% Sales growth 2017 Sales growth 2018-2020 Terminal growth Net operating profit margin Net operating asset turnover 1% 2016 rate rounded to three decimal places 2016 rate rounded to three decimal places (h) Estimate the value of a share of Cisco common stock as of July 30, 2016 using the discounted cash flow (DCF) model and the sales forecast in (g); Note, we still assume a discount rate (WACC) of 12%, common shares outstanding of 5,029 million, and net nonoperating obligations (NNO) of $(37,113) million. (1) Cisco stock closed at $31.47 on September 8, 2016, the date the Form 10-K was filed with the SEC. How does your DCF valuation estimates compare with this closing price? What do you believe are some reasons for the difference? What investment decision is suggested from your results? (1) Are there other equity valuation models? Please discuss the advantages and disadvantages of different equity valuation models