Estimating Cisoc’s future cashflows Case Study Solution
Financial Ratio Analysis:
Ratio analysis is a competitive method of predicting the profitability of the company by comparing information contained in the financial statements. It is a tool used to evaluate the progress over the company by comparing its performance with prior years. (kenton, 2020)
Pros and Cons of using financial ratios:
Pros:
- Ratios will help the investors in evaluating and comparing the financial position and performance of the company.
- In addition, it assist the investors in validating and disapproving the management decision in relation to financing, operating and investing.
- It will help the investors in understanding the financial standing of the company by allowing the investor to conduct comparison with industry trends and competing firms.
- Ratio analysis will help the investor in understanding the business risk of the firm by evaluating the leverage and interest cover ratio of the company.
Cons:
- The tool is based on historical data which is not a predictor for future performance and stability of the company.
Horizontal Analysis:
Horizontal analysis is used to identify the trend and changes in the items of financial statements over a period of time. It enables the investors to make investment decisions and predict organization’s profitability based on the analysis of trends. (Accounting For Management , 2020)
The pros and cons of using horizontal analysis to predict the future profitability of the company are mentioned as follows:
Pros:
- It enable the investors to assess and evaluate the significance of an item in determining the profitability of the business
- It enables the investors and management of the company to control the abnormal variation in the item by analyzing the situation of the trend
Cons:
- It provides misleading results in times of inflation or changes in price level
- It does not follow accounting concepts and accounting convention
DCF Analysis:
Discounted Cash Flow Analysis enable the company to predict how much profit it is going to earn in the future by estimating the value of the company in present terms. (Chen, 2020)
The pros and cons of using DCF valuation method to predict the future returns and profitability are mentioned as follows:
Pros:
- It relies on the cash flows of the company and includes future expectations.
- It evaluates whether the share price of the company is undervalued or overvalued and justify the company’s share price.
- It is used in attracting investors as it determines the position of the company.
Cons:
- It requires large number of assumptions which might be unrealistic and result in unreliable estimation of the company’s value and future profitability.
- It requires the use of various assumptions and any change in these assumption will change the value of the company.
Alternatives:
In order to assist the investor in making investment decision, discounted cash flow valuation method and ratio analysis was used to assess the future share price and cash flows of the company. The free cash flows for a period of five years have been projected using current weighted average cost of capital of Cisco system i.e. 8.5%, and assuming free cash flows will grow by 4% in the next four years i.e. 2017-2020. (See Appendix 1)
Invest In Cisco:
Based on the results of the DCF analysis, the shares of the company are estimated at $53.96 per share which indicates that the existing share price of the company is undervalued. On the other hand, the investor will pay a maximum amount of $53.96 in order to purchase a share of Cisco. The undervalued share price of Cisco’s shares makes the investment opportunity attractive for the investor as less investment will be required to purchase Cisco’s shares. Investing in Cisco will improve reputation and image of the investor as he will be associated with a renowned and profitable firm. The constraints involved in purchasing Cisco’s shares includes lack of funding required to purchase equity in Cisco.
Do not invest in Cisco:
Alternatively, the investor can decide not to invest in the business as a result of higher debt to equity ratio, low interest cover and low return on equity as compared to 2015. Similarly, the business might decide to not invest in the business due to risk of default as the business is exposed to volatility in exchange rates, cultural, political and economic risks as it operates in various regions and countries in the world. The constraint involved in adopting the alternative is the firm has high growth potential which is evident by the results of DCF and ratio analysis.
Invest in Cisco at alter date:
The investor can also decide to invest in Cisco’s shares at a later date, this will give adequate time to the investor to evaluate the profitability of the firm to support his investment decision. The constraint involved in employing this alternative is that the share price of the company might rise significantly in future which will make the investment expensive for the investor.
Recommendation:
Based on the ratio and horizontal analysis performed above in the report, it is advised to the investor to invest in the business. The net income of the business increased by 20% in the year 2015-2016, similarly, the business ‘s gross profit margins, operating profit margins and increase in dividend per share indicates that Cisco system is a profitable business and has high potential for future growth. The alternative of investing in Cisco at a later date is not recommended as the business’s performance is likely to increase in future which will result in increased share price of the company and increased investment requirement.
Considering, the increasing trend in the dividend per share and profitability of the company, investing in Cisco system Inc., will benefit the investor in terms of increased wealth, guaranteed high returns as the business is profitable and likely to grow further in future. In addition, investment in Cisco system might increase Adam Stark’s image and reputation as his firm will be associated with a profitable business...........................
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