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August 4, 2012

Stock Valuation vs. Risks

By Charles Rotblut

Cisco Systems’ (CSCO) low valuation, balance sheet strength, revenue and earnings growth, and positive free cash flow caused it to appear on my personal stock screen. Based on these measures, the stock looks attractive, but there are risks.  

This week I’m going to walk you through my analysis, explaining both what is positive about the stock and what worries me. The purpose is to show you why a low valuation does not automatically make a stock a bargain. Rather, thorough analysis is needed to identify any potential risks that would create concerns about the stock.

Cisco Systems, as many of you know, makes networking equipment. It is a leading manufacturer of routers, switches and other equipment that enable the digital transmission of voice, video and data. The company is on track for its sixth year of revenue growth in the past seven years. Earnings per share are forecast to have risen for the fifth time in seven years. (Cisco Systems’ fiscal year runs from August to July.) 

The stock trades at a cheap price-to-book ratio of 1.6 and a price-earnings ratio of 11.7. Not only are these ratios far below the company’s historical averages, but they are also low on an absolute basis. 

Cisco Systems is fiscally sound. It reported more than $48 billion dollars in cash and cash equivalents at the end of April. Meanwhile, total liabilities were less than $40 billion. The company consistently generates free cash flow and its return on equity of 15.1 is double the median for the technology sector. 

There are risks, however, which become apparent when further analysis is conducted. The historical five-year growth rate for net income is 5.6 percentage points below the five-year sales growth rate (3.1% versus 8.7%), a sign of narrowing margins. The I/B/E/S consensus earnings estimate suggests profit growth will remain slow, with earnings rising 4% in fiscal 2013 and 6.5% in 2014. The stock’s price chart shows a downward trend characterized by steep one-day drops, including a 5.9% plunge that occurred last week. Plus, a low valuation can always go lower; beleaguered technology giant Hewlett-Packard (HPQ) trades at just 6.7 times earnings and 0.8 times book value. 

These characteristics are a sign that all is not right. With Cisco Systems, concerns about competitive pressures and questions about management’s business strategy exist. 

The issues with Cisco Systems are well known to technology investors. But what about when you have questions about companies that aren’t as large or well-known? Quarterly earnings reports, corporate press releases and conference calls often reveal a lot about what is occurring with a company. You can also read through the 10-K, an annual form required by the Securities and Exchange Commission (SEC), to see who the major customers and competitors are and then find out what factors are affecting them. And if you still can’t figure out what’s going on? Find another stock or park your money in an index fund until you do find an attractive stock. 

The Week Ahead

Approximately 35 S&P 500 companies are scheduled to report earnings next week. Included in this group is Dow component Walt Disney (DIS), which will report on Tuesday.
The first economic report of note will be the initial estimate of second-quarter productivity, published on Wednesday. Thursday will feature June international trade data. Friday will feature July import and export prices.
The Treasury Department will auction $32 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday.
Federal Reserve Chairman Ben Bernanke will speak publicly on Tuesday.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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