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Forecasting Expected Cash Flow
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pany s most current quarterly report and earnings release. Many companies post these reports on their corporate Web sites. The SEC site is also a great central repository of quarterly and annual corporate information. The most recent quarterly report gives a good indication of the revenue and earnings prospects of the company. Analysts cover these quarterly report filings and earnings releases. A negative surprise almost always results in a steep drop in a stock s price. A positive surprise often results in a jump in the stock s price. Why are there such significant reactions to relatively small surprises in earnings Recall that a stock s value is based in large part upon expected future cash flows. If growth rates drop or NOPMs decline, when analysts and investors plug these lower numbers into a discounted cash flow pricing model, the resulting change in intrinsic value can be significant. To keep this example simple, we focus now on Cisco s Annual Report and save using quarterly data and earnings surprises until the valuations in 8. What are Wall Street analysts saying about Cisco s expected future growth rates On August 14, 2002, we checked out analyst estimates for Cisco by going to the Yahoo Finance Web site (http://finance.yahoo.com/). Yahoo Finance uses research data provided by Thomson Financial Network/First Call, which polled the 40 analysts that follow Cisco and found that 13 analysts rate Cisco a strong buy, 17 rate Cisco a buy, and 10 rank Cisco as a hold. The consensus estimate for a long-term (five-year) growth in earnings is 20 percent per year. We also checked Zack s (www.zacks.com/) Web site for detailed analyst estimates on Cisco and found a consensus 5-year growth estimate of 20.05 percent. To us, a 20-percent growth estimate smacks of optimism, but we use it to develop the high-side estimate of Cisco s intrinsic stock value. Let s assume that we like Cisco s Internet strategy and believe that greater revenue growth will follow as it peddles its routers, servers and software around the globe. For simplicity, and to be consistent with analyst estimates, we use a constant revenue growth rate of 20 percent, an aggressive assumption in light of Cisco s past three years of revenue growth from 55 percent to 17 percent to 15 percent not a positive trend. We also introduce some more conservative assumptions by playing a what-if 5-percent growth scenario, consistent with the high end of the growth of the U.S. economy.
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STREETSMART GUIDE TO VALUING A STOCK
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Excess Return Period: Our Recommendation
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Even if the company is a great company worthy of a 10-year excess return period, we often also check how the company s intrinsic stock value should react if the demand for the company s product contracts and its excess return period is reduced. When we re valuing a company using the ValuePro 2002 software, we can easily see how reducing a company s excess return period from 10 to 7 to 5 years affects intrinsic value. In certain situations, reducing the excess return period results in an increase in stock value. This occurs when a company currently is earning less than its WACC on its new investment. Playing what-if games with the company s excess return period allows you to see how its cash flows truly affect stock value.
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Cisco s Excess Return Period
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Recall the 1-5-7-10 Rule from 4. We think Cisco is a great company worthy of a 10-year excess return period. Why The length of the excess return period should correspond to the time period over which the investor expects the corporation s business strategy to be successful. This means that the strategy will generate free cash flow it will earn a rate of return on new investment in excess of the company s WACC. Business strategies based on patent protection, superior marketing channels, or valuable brand names should have a relatively longer-term excess return period. Cisco has terrific products, great brand name recognition, and efficient marketing channels. However, competitors seem to be making inroads into the markets that Cisco has dominated for years. Intense competition in the Internet hardware markets has resulted in shrinking profit margins and lower sales growth. Still, we think Cisco is well positioned in its industry, and we use a 10-year excess return period as we go through the rest of the cash flow analysis.
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