The story of Cisco
Also known as the story about valuation disillusion
The largest company in the world today, measured by its ‘Market Capitalisation’ (value of the company’s stock on the market, number of shares x share price) is Apple. I have no idea what the future of Apple or its stock will be, or how long it is going to stay the largest ‘market cap’ on the planet. But as a granddaddy-investor I can tell you a story about Cisco during the internet stock market bubble. Cisco was the largest ‘Market Cap’ in March 2000. Cisco was the Apple of twenty years ago. And it is a perfect example to consider valuations.
Cisco until 2000
It would be easy to say ‘Cisco was obviously in a bubble! look at how the stock price exploded!’. But although it was priced royally, the price could be justified. The company was growing extremely fast in the 90’s, at 30 % to 50% annually. Revenues doubled every two years. It showed this growth for the complete decade 1991 – 2000. Expected earnings for 2000 were 1.5 $/share, and at 50% growth a PE ratio of 40 is OK. So you could calculate:
Correct Intrinsic Value = (Price/ Earnings) x Earnings = 40 x 1.5 = 60 $ per share
And that was where the price was in March 2000. It went briefly to a highest price of 80.
Fast forward one year
Then the internet mania ended. In less than a year, our darling Cisco went from $ 80 to $ 13 ( = – 85 % !!). And this was not a short dip! The price stayed between 10 and 30 for 16 years! Even today, 20 years later, it is at 44, roughly half the share price it was in 2000. What happened?
Cisco was still the excellent, high quality company it was before, with top engineers and top quality equipment. It continued to do acquisitions and it kept launching innovative products. It did not turn from a princes into a frog overnight.
The problem is growth. Cisco suddenly did not promise growth any more. The company struggled to keep even the same revenues: from 22 billion in 2001 it went to 19 billion in 2003. Profits turned into losses. The entire inventory was written down. And a company without the prospect of growth is not priced at a PE of 40, but rather at 10. If you hoped in 2001 that Cisco would recover and see growth again, you could have estimated a PE of 15 as appropriate.
And profits went down too, if there were any profits at all. They went to 0.3 $ in 2001 and negative in 2002. In case of extreme downturns or negative earnings investors tend to estimate an appropriate number. Let’s estimate earnings at $ 0.8, then you get a share price of:
Price = (Price / Earnings) x Earnings = 15 x 0.8 = 12 $
The remarkable lesson here is not that a huge overpricing came down, but the valuation model re-priced Cisco because both the P/E (reflecting quality and growth) AND Earnings go down, so you get a doubly whammy, resulting in a – 85 % price decrease.
|Year||Price/ Earnings||Earnings||P = P/E x E||Share price|
|2000||40||1.5||60 $||80 $ (peak)|
|2001||15||0.8||12 $||13 $|
Value investors use parameters such as earnings, cash flow, book value, WACC (Weighted Average Cost of Capital)… to determine the intrinsic value of a stock. The ‘discounted cash flows’ model for example uses ‘expected future cash flows’, discounted to today’s value. Numbers with a precision of 2 digits after the decimal point give the illusion of a very precise calculated value. If you play around with the estimated growth rate and the WACC (discounting factor), you would see how much your intrinsic value varies. Even for very stable companies, the value can be very different in optimistic versus pessimistic cases. Cisco’s example shows how difficult this is: a growth of 40 % changes to -10 %, earnings of 1.5 $ change to negative values, and the resulting share price changes 85%.
On historic performance of Cisco and its infamous track record: