With an average analyst rating of hold, Cisco Systems is clearly not a favorite. But some of the best stock picks are contrarian in nature. With most analysts more focused on growth than on value, a mediocre analyst rating does not necessarily mean a stock is a bad investment. So what do we know about CSCO's valuation?
Let's start our value analysis with the price to book (P/B) ratio. This is perhaps the most basic measure of a company's valuation, which is its market value divided by its book value. Book value refers to the sum of all of the company's tangible assets minus its liabilities -- you can also think of it as the company's equity value.
Traditionally, value investors would look for companies with a ratio of less than 1 (meaning that the market value was smaller than the company's book value), but such opportunities are very rare these days. So we tend to look for company's whose valuations are less than their sector and market average. The P/B ratio for Cisco Systems is 4.12, compared to its sector average of 1.97 and the S&P500's average P/B of 4.59.
The most common metric for valuing a company is its Price to Earnings (P/E) ratio. It's simply today's stock price of 46.77 divided by either its trailing or forward earnings, which for Cisco Systems are $2.96 and $3.55 respectively. Based on these values, the company's trailing P/E ratio is 15.8 and its forward P/E ratio is 13.2. By way of comparison, the average P/E ratio of the Telecommunications sector is 22.69 and the average P/E ratio of the S&P 500 is 27.65.
The problem with P/E ratios is that they don't take into account the growth of earnings. This means that a company with a higher than average P/E ratio may still be undervalued if it has extremely high projected earnings growth. Conversely, a company with a low P/E ratio may not present a good value if its projected earnings are stagnant.
When we divide Cisco Systems's P/E ratio by its projected 5 year earnings growth rate, we obtain its Price to Earnings Growth (PEG) ratio of 7.44. A PEG ratio of 1 or less may indicate the company is undervalued in terms of its growth potential. On the other hand, a PEG ratio higher than 1 could indicate that investors are paying too high a premium for these growth levels. Bear in mind, however, that the 5 year earnings growth estimate could very well be an over or underestimate!
Indebted or mismanaged companies can't sustain shareholder value for long, even if they have strong earnings. For this reason, considering Cisco Systems's ability to meet its debt obligations is an important aspect of its valuation. By adding up its current assets, then subtracting its inventory and prepaid expenses, and then dividing the whole by its current liabilities, we obtain the company's Quick Ratio of 0.7. Since CSCO's is lower than 1, it does not have the liquidity necessary to meet its current liabilities.
One last metric to check out is Cisco Systems's free cash flow of $19.04 Billion. This represents the total sum of all the company's inflows and outflows of capital, including the costs of servicing its debt. It's the final bottom line of the company, which it can use to re-invest or to pay its investors a dividend. With such healthy cash flows, investors can expect Cisco Systems to keep paying its 3.4% dividend.
In conclusion, Cisco Systems may hold more intrinsic value than analysts give it credit for. If analysts are unenthused about the stock despite its attractive valuation, it is likely due to their perception of limited growth potential, as evidenced by its elevated PEG ratio. We will keep following CSCO to see whether the value or growth thesis prevails.
