Investment Analysis & Portfolio
Management
(EQUITY VALUATION)
CHAPTER 8
Part 2
FIN 611
MBA
SEMESTER – SUMMER, 2022
Discounted Cash Flow Valuation
The valuation of a financial asset requires two steps:
1. Identify the cash flows that the asset will generate.
2. Discount those cash flows to account for their riskiness.
This can be stated formulaically, where the value of a stock (or any other financial asset) is
represented by the following equation:
It can be restated to emphasize the importance of growth and the discount rate:
1st Equation simply states that the value is equal to the sum of
the present value of each of the cash flows. The cash flow is
represented by CF, and the discount rate is represented by k.
It is easier to value bonds, while valuing equity is more difficult.
The difficulty in valuing a stock does not make valuation any less important. In fact, it likely makes
valuation even more important. Investors are likely to use very different inputs (for the cash flows, the
growth rates, and the discount rates), and this will result in very different valuations. Differences in
opinion can create opportunities for investors to earn excess returns or (unfortunately) inferior returns.
Three approaches to discounted cash flow valuation
1. the free cash flow to equity (FCFE) approach,
2. the dividend discount model (DDM) approach, and
3. the free cash flow to the firm (FCFF) approach.
The FCFE and DDM methods are used to estimate the intrinsic value of the equity of a firm. The
FCFF method is used to value the entire firm (equity plus debt plus preferred stock).
The various numerators and denominators can be seen in the following table:
Method #1: The Dividend Discount Model
The simplest way to approach valuation is through the dividend discount model (DDM).
The DDM is the basis of all valuation.
It can be used to develop the intuition that will be necessary to understand the FCFE model.
An analyst can apply the constant growth assumption, no-growth assumption, or a multi-stage
growth assumption with the DDM
Key Ideas to remember1. Numerator of next year’s dividend
2. The discount rate is the Cost of equity {k=Risk free rate + Beta (Risk Premium)}
Dividend Discount Model (Constant Growth)
Imagine that an analyst is valuing a company that is expected to pay a dividend of
$1.05 next year. The dividend is expected to grow 5 percent per year, and the cost of
equity is 15 percent.
the value = $1.05/(.15 - .05) = $10 50 (Vo= D1/k-g)
Variations in numerators
It’s important to realize that the numerator could have been described in many other ways. The analyst could
have been told that next year’s earnings will be $1.50 and the payout ratio would be 70 percent. So the retention
or plowback ratio is 30 percent. The payout ratio plus the retention ratio must always add up to 100 percent.
Another way of framing this question would be to say that last year’s dividend was $1.00 per share and that
dividends are expected to grow 5 percent per year. Alternatively, you could have been told that last year’s
earnings were $1.43 and that earnings are expected to grow 5 percent per year forever, and the payout ratio is 70
percent.
The discount rate of 15 percent could be described in many ways. Most simplistically, you could be told that the
cost of equity is 15 percent. Or, you could be told that the risk-free rate is 7.8 percent, the beta is 1.2, and the
market risk premium is 6 percent. This would result in a calculation of 7.8% +1.2(6%) = 15%.
Another way that the 15 percent cost of equity could be described is to be told that the risk-free rate is 7.8
percent, the expected return from the market is 13.8 percent, and the beta is 1.2. This would lead to a cost of
equity calculation of 7.8% +1.2(13.8% - 7.8%) = 15%. In this way of describing the data, you are told the
expected return from the market (13.8 percent) and the risk-free rate (7.8 percent), and you use those two
numbers to calculate the risk premium of 6 percent.
Dividend Discount Model (No-Growth)
Imagine that you’re looking at a company that will earn $1.50 next year and has no
growth opportunities. The company has a cost of equity of 15 percent.
the value of the equity = $1.50/15% = $10
Present Value of the Growth Opportunity (PVGO) 1/3
The PVGO represents the portion of a stock’s intrinsic value (worth of an asset or True value) that is
attributable to the company’s growth.
When an analyst is valuing a stock that is expected to have some growth, it is important to know
how much of the intrinsic value is derived from growth.
In order to calculate the PVGO, we will use the constant growth model and no-growth model.
If you consider the company that is expected to earn $1.50 next year and will retain 30 percent of its
earnings, we have already seen that this stock should be worth $10.50. In order to calculate the value
of the growth, we can ask how much the stock would be worth if the company did not grow. If the
company did not grow, the company could pay out all of its earnings. This means that the stock
would be worth $10. This was the no-growth calculation that was done above. This means that the
value of the growth is $10.50 - $10.00 = 50 cents. In other words, approximately 5 percent of the
stock’s value comes from growth.
Present Value of the Growth Opportunity (PVGO) 2/3
It is also interesting to think about why the 5 percent growth in this example adds only 5 percent to the value of
this stock. The answer is based on the idea that value is created when a firm earns more than its cost of capital.
In this case, we know that the firm has a cost of equity of 15 percent. Given the analyst’s assumptions of 5
percent growth and that the company has to plowback 30 percent of its earnings, we can use the sustainable
growth rate equation to back out the company’s return on equity assumption.
Sustainable Growth Rate (g) = Return on Equity * RR (Retention rate or sometimes it is called as plowback
ratio)
5% = ROE * 30%
ROE = 5%/30% = 16.67%
This means that the return on equity is 16.67 percent. Since the company earns more on its equity (16.67 percent)
than the cost of equity (15 percent), the growth creates value. But the spread between the ROE and the cost of
equity is small, and this is why the 5 percent growth assumption has not created even more value.
Present Value of the Growth Opportunity (PVGO) 3/3
the PVGO is calculated in three steps:
1. Calculate the intrinsic value of the stock. This is frequently done using the constant growth DDM. But, it
could be done using a two-stage model or any other way.
2. Calculate the no-growth value of the stock. This assumes that the company could pay out 100 percent of its
Year 1 earnings. In other words, if the company is not going to grow, the company does not need to retain any
earnings. We often think about this no-growth value as the value of the assets-in-place.
3. Calculate the PVGO by subtracting the no-growth value from the intrinsic value. For example, if a stock has
an intrinsic value of $15, but it would be worth $10 if the company never grows again, the value of the growth
is $5.
Computation of PVGO
Imagine that a company is going to earn $2 per share next year, and it should be able to pay out 25 percent of
those earnings in the form of a dividend. (The remaining 75 percent of earnings needs to be retained in order to
finance growth.) The company is expected to grow 4 percent per year and has a cost of equity of 12 percent. To
calculate the present value of the growth opportunity:
Step 1: Calculate the intrinsic value of the stock: V0 = ($2 X .25)/(.12-.04) = $6.25
Step 2: Calculate the no-growth value of the stock: V0 = $2/.12 = $16.67
Step 3: Calculate the present value of the growth opportunity: PVGO = $6.25 - $16.67 = -10.42
In this case, growth is destroying value.
Again, the sustainable growth rate equation, the ROE can be calculated.
Growth = ROE * RR, = 4% = ROE * 75%. = ROE = 4%/75% = 5.33%.
This company is earning 5.33 percent on capital that costs 12 percent. It is destroying value.
Dividend Discount Model (Two-Stage)
let’s imagine that an analyst expects a company to pay a $1 dividend next year and that this dividend will grow10 percent per
year for two more years. After Year 3, the dividend will grow 4 percent per year. The cost of equity is 14 percent. The value of
the stock can be calculated by discounting:
The value of the dividends in Years 1–3. These dividends will be $1.00, $1.10, and $1.21. They must be discounted at 14
percent for one year, two years, and three years, respectively. The present value of these three dividends is $2.54.
The value of the dividends in years 4 through perpetuity. Dividend 4 will = (dividend 3) * (1 + growth rate) = $1.21 *1.04 =
$1.258. Since we know dividend four, we can calculate the value of the stock at the end of Year 3. V3 = $1.258/(.14 - .04) =
$12.58. This was simply the constant growth model. This $12.58 must be discounted for three years at 14 percent. The value
of this is $12.58/ (1.14)^3 = $8.49
Adding the present value of the dividends plus the present value of the terminal value equals $2.54 + $8.49 = $11.03.
Again, the analyst could examine how much of this $11.03 comes from growth. If the company never grew again, it could pay
out all of next year’s $1 of earnings. This would make the no-growth value equal to $1/.14 = $7.14. This means that the PVGO
$11.03-$7.14 = $3.89
Method #2: Free Cash Flow to Equity
In order to make the dividend discount model useful in all situations. Instead of using actual dividends paid, what
you are actually valuing is the amount of dividends that could be paid. This is the free cash flow to equity
(FCFE).
To begin, FCFE is defined (measured) as follows:
Net Income
+ Depreciation expense
- Capital expenditures
- Change in working capital
- Principal debt repayments
+ New debt issues
The goal is to determine the free cash flow that is available to the stockholders after payments to all other capital
suppliers and after providing for the continued growth of the firm. This model is a more general version of the
dividend discount model.
Method #2: Free Cash Flow to Equity
Imagine that you are the sole shareholder in a company. After running the business, reinvesting in the business (investing in
more long-term assets as well as investing in net working capital), making any interest payments, and possibly making
principal payments (or borrowing more), there is $10 million remaining. The company could send you a $10 million dividend
check. If the company planned on doing that, it would be easy for you to apply the dividend discount model and obtain an
accurate valuation.
But what happens if the company doesn’t pay any dividend? It retains all $10 million. If the dividend is zero, does that mean
that the company is worthless?
Obviously, the company is not worthless. As the sole shareholder, you are still $10 million better off. Instead of receiving a $10
million dividend check, you are the owner of a company that is holding $10 million for you.
The key takeaway is that we are valuing the $10 million of free cash flow that belongs to the equity holder—whether it is paid
to the shareholder in the form of a dividend or the company holds the money for the shareholder.
G = ROE * RR
As an example of the sustainable growth rate, consider a company has an ROE of 10 percent. This means that a company is
generating 10 percent more equity. If the company retains 60 percent of these earnings, the company can grow 6 percent. This
is simply 10% X 60% = 6%.
Method #2: Free Cash Flow to Equity
The sustainable growth rate equation makes two assumptions:
1. The firm will keep the capital structure the same. This means that the debt has to increase by the same
percentage amount as the equity.
2. The firm is not becoming any more or less efficient. This means that the firm needs the asset turnover ratio
(Sales/Assets) to stay constant.
Traditional sustainable growth model
The company is generating 10 percent more equity; this is
what the return on equity represents. But, since the firm is
only retaining 60 percent of its earnings, this means that
the equity will grow 6 percent. Since we assume that the
firm wants its capital structure to remain constant, this
means the firm will issue 6 percent more debt. With 6
percent more capital, the firm will have a 6 percent
increase in assets that can be used to generate 6 percent
more growth.
Method #2: Free Cash Flow to Equity
Analysts also estimate how efficient and profitable the company will be, as well as how the capital
structure may change. These estimates are all captured in the estimate for the return
How to calculate the free cash flow to equity?
In order to use the FCFE model, an analyst needs to make the following forecasts:
1. Sales growth
2. Profit margin
3. Return on equity
4. Cost of equity
Method #2: Free Cash Flow to Equity
We will value CSCO at the end of 2016. We will proceed by identifying the four forecasts we need
to make.
1. Sales growth. At the end of 2016, CSCO had sales per share of $9.78. Sales are expected to grow
by approximately 4 percent per year for the next five years. After that, we are forecasting slightly
lower growth (3.75 percent) into perpetuity. This growth rate is more consistent with our current
forecast of the long-term nominal growth rate of the economy.
2. Profit margin. The company’s profit margin is approximately 24 percent. Profit margin represents
the net income divided by the sales. In other words, for every dollar of sales, CSCO generates 24
cents of net income.
3. Return on equity. You expect that CSCO will have a return on equity of 20 percent.
4. Cost of equity. You have estimated CSCO’s cost of equity as 9.5 percent.
Calculation of value of CSCO
Next year’s sales should be $10.17. (This is $9.78 * 1.04; in other words, we grew this past year’s sales at the 4
percent growth rate.)
This growth rate continues throughout the first five years. After Year 5, growth slows slightly to 3.75 percent.
We used that slower growth rate to calculate sales in 2022. The 2022 sales number is going to help us to
calculate our terminal value (as of the end of 2021).
After calculating sales, we forecast earnings. We do this by multiplying the profit margin by our sales number.
Next year’s earnings should be $2.44. (This is $10.17 * 24%; in other words, for every dollar of sales, the
company has 24 cents of earnings.)
The next step is probably the most important: We need to calculate how much of those earnings actually reflect
free cash flow to equity holders. The FCFE is what we are valuing. We are going to do this for the next five
years and then we will do this again for Year 6 (2022) for the terminal value. We need to do a second
calculation for the terminal value because estimates have changed.
Calculation of value of CSCO
In order to calculate the FCFE, we are going to use the sustainable growth rate equation (as described above).
We have estimated growth (for the next five years) to be 4 percent.
 We have also estimated that Cisco will have an ROE of 20 percent. From here, we can calculate how much
of earnings must be plowed back and how much can be paid out as free cash flow.
 An ROE of 20 percent means that Cisco is generating 20 percent more equity each year. But, if the company
is only growing at 4 percent per year, and assuming that the company wants to maintain its capital structure
(that is, keep their debt-to-equity ratio constant), it will only need 4 percent more equity (and 4 percent more
debt). So, using the sustainable growth rate equation, we can solve for the retention rate. This means 4% =
20% * RR.
 The retention rate must equal 20 percent. This means that we have to plow back 20 percent of earnings, and
we can pay out 80 percent of earnings. So, in Year 1, the free cash flow to the equity holder is 80 percent of
the $2.44 of earnings. This comes out to $1.95. We’ll also apply that 80 percent payout to Years 2 through 5
(2018–2021).
Calculation of value of CSCO
Now that we have the FCFE for the first five years, we need to calculate the terminal value. Think of this as the
intrinsic value of the stock at the end of Year 5. We will calculate this value using the continuous growth model.
We’ll need the free cash flow in the terminal year (2022) in order to calculate the terminal value.
 In order to calculate the free cash flow in 2022, we grow the prior year’s sales by 3.75 percent (the
sustainable growth rate). Then we apply the 24 percent profit margin to these sales to reach earnings per
share of $2.96. Since the growth rate has changed (from 4 percent to 3.75 percent), we must recalculate the
payout by using the SGR equation, 3.75% = 20% * RR. The retention rate now equals 19 percent, and that
means we can pay out 81 percent of earnings. Notice that the change in growth rate was slight, and the result
was that the payout ratio also changed by only a slight amount (80 percent to 81 percent). This allows us to
calculate the FCFE for the terminal year as $2.41.
 In order to calculate the terminal value, we use FCFE6/(k – g), or $2.41/(9.5% - 3.75%). The result is $41.87.
Again, this is the terminal value. Think of this as our estimate for what the stock will be worth in five years.
Calculation of value of CSCO
Now that we have all of our cash flows and the terminal value, all we need to do is discount them and sum
them. We discount them by using the cost of equity. Again, since we have cash flows that belong to the equity
holders, we discount them at the cost of equity (in order to arrive at the value of the equity).
 We discount $1.95 at 9.5 percent for one year, $2.03 at 9.5 percent for two years, and so on. Be careful with
Year 5: We are discounting both the $2.28 cash flow and the $41.87 terminal value. We discount their
combined value ($44.15) for five years. When we add all of these values together, the intrinsic value of the
stock is $34.66.
 At the end of 2016, CSCO was trading at $30.22. So, this valuation shows CSCO to be slightly undervalued
by the market.
 You should also notice that this model would be considered to be a two-stage model.
Calculation of value of CSCO
Let’s also apply the concept of PVGO. Our FCFE model calculated a value of $34.66. What would CSCO be
worth if the company never grew again? We would assume that CSCO would be able to pay out all of its
earnings if it never grew again after Year 1.
 This means the value would be $2.44/.095 =$25.68. Since we believe the company is worth $34.66 but it
would be worth only $25.68 if it never grew again, the PVGO is $8.98. This is almost 25 percent of the
intrinsic value comes from our estimate of future growth.
 One other interesting thing to think about is that in June 2016 (right after the Brexit vote), CSCO’s stock was
trading for less than $28. An investor would have been able to buy the stock at a significant discount to
intrinsic value—hardly paying for the expected growth.
Method #3: Free Cash Flow to Firm
This method is often referred to by the generic term of discounted cash flow (DCF) or the weighted average cost
of capital (WACC) approach
The FCFF uses different cash flows, a different discount rate, and results in a different value:
1. The free cash flow in the FCFF model is the cash flow that is available to distribute to all providers of capital
(shareholders and debtholders) after estimating the cash flow generated from running the business and reinvesting in the
business (that is, investing in long-term assets and net working capital). The key difference is that the FCFE uses cash
flow after the debtholders were already paid. The FCFF does not subtract payments to debtholders; instead, the cash flow
that is left over is what can be distributed to shareholders and debtholders. The equation for the FCFF is:
EBIT (1 - Tax Rate) + Depreciation Expense - Capital Expenditures - Change in Working Capital - Change in Other Assets
2. Since the cash flows in the FCFF model belong to all providers of capital, the discount rate must incorporate all the
different costs of capital. In other words, the discount rate must include the cost of equity, the cost of debt, and the cost
of preferred stock (if the firm has issued preferred stock). This discount rate is known as the weighted average cost of
capital (WACC).
3. The resulting value of this calculation is the value of the firm. In other words, if you discount the cash flows that are
available to all the providers of capital, you are going to calculate a value that belongs to all the providers of capital. We
can loosely refer to this value as the calculated enterprise value.
Steps in Calculating Free Cash Flow to the Firm
1. Forecast the sales. Analysts often forecast somewhere between 3 and 10 years of sales and then use a terminal year forecast. It is
most common to forecast 5 years. Reasons used to defend this are that the analyst is trying to capture an entire business cycle and
is trying to avoid making specific forecasts that are too far out in time.
2. Forecast the operating profits. By operating profits, we are referring to the earnings before interest and taxes (EBIT). You can
think about operating profits as how profitable the operations are before considering the capital structure (which impacts interest
expense) and taxes (which are also impacted by capital structure because interest is deductible). Realize that when the analyst
forecasts operating profits, this is going to force her to think about gross margins as well as selling, general, and administrative
expenses (SG&A)
3. Forecast the taxes as a percentage of the operating profit. Multiply the effective tax rate (the average tax rate that the firm pays)
by the EBIT (the operating profit). This may strike you as odd because you know that you normally subtract interest from EBIT
and then calculate taxes (and subtracting interest lowers the tax bill). But remember, if you subtracted interest, that would mean
that you have already paid the debtholders. Instead, we are trying to calculate how much cash is available for the debtholders (and
equityholders). Subtracting interest is only done if you are trying to calculate the FCFE, not the FCFF.
4. Calculate the net operating profit after taxes (NOPAT). This is simply the EBIT minus the taxes that would be paid on that
amount of EBIT. Again, you might recognize that the taxes you calculate in this step are higher than they would have been if you
had deducted interest before calculating taxes. In other words, we did not capture the fact that the taxable income should have been
lowered by deducting interest. (The benefit of the deductibility of interest will be captured later. When we calculate the discount
rate [the WACC], we will use the after-tax cost of debt. This lower rate results in a higher value.)
Steps in Calculating Free Cash Flow to the Firm
15. Add back depreciation. We add back depreciation because we are calculating the free cash flow. Depreciation is not a cash
flow. It’s an accounting entry to lower the book value of assets. We capture the cash flow when the plant and equipment was
purchased, not when it is depreciated. After adding depreciation back to NOPAT, this is often referred to as operating cash flow. It
represents the cash generated by the day-to-day business.
6. Subtract the capital expenditures. This is a difficult number for analysts to estimate. Capital expenditures are often done in a
stair-step fashion, but that is not something that an outside investor can easily forecast. The best way to estimate capital
expenditures is to examine the relationship between net PP&E (property, plant, and equipment) and revenue. You are effectively
trying to calculate how much PP&E is needed in order to generate a dollar of revenue. Of course, after understanding this
relationship, the analyst will need to determine whether the company is becoming more or less efficient. You can see an example
of this in Exhibit 8.10. In this exhibit, the assumption is that property, plant, and equipment is approximately 13.5 percent as large
as revenue. As a result, if an analyst creates a model with revenue growing $100, the PP&E should grow $13.50.
7. Subtract the investment in additional net working capital (NWC). NWC represents current assets minus current liabilities. You
can think of this as your net investment in short-term assets. The most significant short-term assets are cash, accounts receivable,
and inventory. The most significant short-term liability is accounts payable. The simplest approach is very similar to how we
projected capital expenditures. Examine the historic relationship between NWC and revenue. Ask if there is anything that you
expect to change going forward. There is one extra subtlety when using this methodology: the cash that you use in calculating the
NWC is only the cash needed for operations; you should exclude the excess cash. Obviously, as an outside analyst, it’s very
difficult to determine how much cash is needed to run a business and how much is simply extra. (This topic is described below
during the discussion of enterprise value.)
Steps in Calculating Free Cash Flow to the Firm
Steps in Calculating Free Cash Flow to the Firm
Calculate the free cash flow to the firm
This is the operating cash flow less the capital expenditures less the additional investment in net working capital.
This is what is left over and can be distributed to the providers of capital after running the business, reinvesting in
the long-term assets (capital expenditures) and the net short-term assets (net working capital).
Calculate the free cash flow to the firm
Imagine that you perform a FCFF analysis. After discounting the cash flows, they add up to $100 billion. You want to value the
equity. You know that the firm has $3 billion of excess cash (more cash than is needed to run the business), a $1 billion nonoperating asset (a group of buildings and real estate that are not yet being used), and a pension plan that is underfunded by $2.5
billion (i.e., the fund has $3.5 billion of assets and the present value of the obligation is $6 billion). The firm also has $20 billion
of debt. The firm has 2 billion shares outstanding. What is the value per share?
Here are the assumptions that we will use:
Sales for the year that just ended: $48.9 billion
Sales growth for next five years: 4 percent
Sales growth after Year 5: 3.75 percent
Operating margins 33 percent
Tax rate 22 percent
Net margins 24 percent
Debt $25 billion
Pre-tax cost of debt 4 54 percent
Number of shares outstanding 5 billion
Book value of equity: $61.05 billion
Book value of assets: $86.05
ROA (calculated as NOPAT1/Equity0): 15.21 percent
Percentage of NOPAT that must be reinvested (calculated as growth rate/ROA):
Reinvestment rate Years 1–5: 26.29 percent
Reinvestment rate after Year 5: 24.65 percent
Market value of equity: $150 billion
Market value of debt: $25 billion
Cost of Equity 9 5 percent WACC (6/7)(9.5%) + (1/7)(4.54%)(1-.22) = 8.65%
Relative Valuation
While discounted cash flow analysis attempts to calculate the intrinsic value of a company, relative
valuation attempts to value a company by comparing it to similar companies or the overall market or the
stock’s own trading history. DCF is often described as the best way to determine absolute value while
relative valuation describes what others seem willing to pay.
When analysts use multiples, they are typically used in one of the following ways:
1. Comparing multiples to comparable companies (that is, is the stock expensive or cheap relative to peer
companies).
2. Comparing a stock multiple to the market multiple (that is, is the stock expensive or cheap relative to the market).
This is particularly valuable in normalizing multiples. In other words, if interest rates are low, stock multiples tend
to be higher. This approach effectively strips out the fact that market multiples are high or low and simply looks at
whether this stock is trading at a high or low multiple relative to the market.
3. Comparing a stock’s multiple to its historic multiple (that is, is the stock expensive relative to how it has traded
historically). Be careful if using this approach. As companies mature, their growth rate slows and multiples contract.
4. Comparing a stock’s multiple to recent transactions (that is, what would the stock be worth if it were acquired).
Implementing Relative Valuation
There are three steps to follow when implementing relative valuation analysis.
Step 1: Find Comparable Companies
The analyst can think about factors that make the business similar or different. The most common approach is to ask how they are
different from a business risk perspective and financial risk perspective.
Business risk analysis searches for differences between companies regarding growth rates, expected term of high growth,
products, market share, cyclicality, distributions, cost structures, and management experience.
Financial risk often assesses differences in leverage, size, potential liabilities, interest coverage, and beta.
Step 2: Determine the Appropriate Multiple
There are two common ways to do this. The first approach is simply to understand what multiples other analysts
use. While this may seem like “cheating,” it’s always important to know how other analysts think about a
stock. The second approach is to try to determine what underlying metric seems to move a stock. In other words,
you might try to regress a stock’s performance against sales, or earnings, or book value. If stock prices seem highly
correlated with earnings, use a price–earnings multiple. If a stock’s price seems to be more correlated with sales or
book value, use the price–sales multiple or the price–book value multiple.
Step 3: Apply the Multiple
As expressed above, it is incorrect to simply compare multiples and decide that one stock should be purchased because it is
trading at a lower multiple. An analyst must understand the fundamentals that drive multiples.
A multiple measures some aspect of a company's financial well-being, determined by dividing one metric by another metric. They
are often based on a metric such as EBITDA (earnings before interest, taxes, depreciation, and amortization).
Relative Valuation with CSCO
In order to perform a relative valuation analysis for Cisco (CSCO), we will use Juniper Networks as
Cisco’s primary competitor. In reality, Juniper is Cisco’s main competitor in Internet routing. We will
perform this analysis in order to answer the question concerning which of these two stocks is more
attractive.
It’s important to analyze the nature of the businesses and
whether the companies are truly similar. The easiest thing to
notice is that Cisco is substantially larger than Juniper, with a
market cap of $170 billion versus $10 billion. The size
difference likely makes Cisco less volatile (resulting in a
lower cost of equity and a higher multiple). Intuitively, we
might expect the smaller company (Juniper) to have higher
growth expectations, but both companies are expected to
grow at similar rates.
It’s interesting to notice that the companies look similar from several perspectives. Their debt to-equity ratio
looks relatively similar on a book-value basis as well as a market-value basis. They have relatively similar
returns on equity, despite the fact that they have very different profit margins. As already mentioned, the capital
structures are similar. It turns out that Juniper has a higher asset turnover (Sales/Assets) than Cisco, and this
brings their returns on equity closer together.
Relative Valuation with CSCO
From a fundamental perspective:
Cisco’s forward price–earnings ratio = P/Eo = Payout ratio/k-g = 0.78/(0.089-0.046) =18.14. Similarly,
Juniper = 0.76/(0.095 -0.046) =15.51.
Cisco is currently trading at 14.25 times forward earnings while Juniper is trading at 16 times forward
earnings.
From this perspective, Cisco appears cheap relative to its fundamental value, while Juniper is trading
just above its fundamental multiple.
Cisco’s trailing price–book = P/BVo = ROE*Payout ratio / k-g = (0.21 * 0.78) / (0.089-0.046) = 3.81
Juniper’s trailing price–book = P/BVo = ROE*Payout ratio / k-g = (0.19 * 0.76) / (0.095-0.046) = 2.95
Cisco is currently trading at 2.71 times book value and appears cheap. Juniper also appears cheap, as it is
trading at 2.16 times book value.
Cisco’s Price–Sales = P/S1 = Profit margin * Payout ratio / k-g = (0.21 * 0.78)/(0.089-0.046) = 4.53
Juniper’s Price-Sales = P/S1 = Profit margin * Payout ratio / k-g = (0.13 * 0.76)/(0.095-0.046) = 2.02
This multiple makes Cisco appear cheap, as the company is selling at 3.54 times next year’s sales. Juniper
is trading at fair value using this multiple, as their forward price–sales multiple is 2.01.
Relative Valuation
Discussion?