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In this article, I will present a real time quantitative analysis of Cisco Systems (NASDAQ:CSCO) that will demonstrate the power of free cash flow in the investment process and give an opinion on how an investor should act based on my research.

Cisco Systems reported its earnings results last week that missed analyst estimates. Management then proceeded to guide lower, expecting an 8-10 percent drop in revenue in the current quarter after lower sales to telecom and cable service providers, and weakness in emerging markets hurt its results in the quarter ended October 26. For those interested, Seeking Alpha has provided a transcript of the Cisco Systems conference call that you can read by going here.

The earnings report was a bit of a shock to Wall Street and as a result it prompted at least 17 brokerage firms to cut price targets on its stock and two to downgrade their ratings. Having said that, it is now time to analyze the company from a free cash flow point of view and try to determine what an investor should do now.

This analysis will use the following six free cash flow ratios:

  • CapFlow
  • FROIC
  • Price to Mycroft Free Cash Flow
  • Mycroft/Michaelis Growth Rate
  • Free Cash Flow Payout Ratio
  • Free Cash Flow Reinvestment Rate

Those new to this analysis can find an introduction by going here that will explain in detail how each of these ratios is calculated. When used together, these unique ratios will generate a quantitative picture of a company's underlying fundamentals, including strengths and weaknesses.

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The "2014 Mycroft Free Cash Flow Per Share" estimate in the table above is generated by taking the trailing twelve months (TTM) free cash flow result for Cisco Systems and then adding my Mycroft Michaelis Growth Rate into the equation in order to generate forward-looking estimates for 2014. That growth rate is generated by using my FROIC ratio (Free Cash Flow Return on Invested Capital). Basically FROIC tells us how efficient operations are as it zeros in on how much free cash flow is generated for every $1 of total capital employed. Cisco Systems has a FROIC of 15%, which means that for every $100 of invested capital, they generate $15 in free cash flow. Now my Mycroft/Michaelis Ratio takes that 15% and multiplies it by the firm's free cash flow reinvestment rate. The reinvestment rate that I use is a free cash flow reinvestment rate instead of the standard one used by analysts that simply uses net income:

Free Cash Flow Reinvestment Rate = 100% - (Free Cash Flow Payout Ratio).

Or;

Free Cash Flow Reinvestment Rate = 100% - (Total Dividend/Total Free Cash Flow).

By replacing net income in the payout and reinvestment ratios with free cash flow, I am thus able to make my analysis more precise by incorporating capital spending (Cap Ex) into the equation.

Therefore, from this we can determine that Cisco Systems has a reinvestment rate of 66% and went on to use 34% of its free cash flow to pay out its dividend. Thus by taking 15% (FROIC) x 66% = 9.9% (rounded off at 10%). From there we add the dividend yield of 2.9% (rounded off at 3%) and we have a Mycroft/Michaelis growth rate of 10% + 3% = 13%.

Cisco Systems Mycroft Free Cash Flow per share of $2.29 was generated by taking its TTM free cash flow per share and multiplying it by (100% + 13% or 1.13). Once we have our result, we then take its current market price of $21.53 and divide it by $2.29 and get a Price to Mycroft Free Cash Flow result of 9.4. I consider a Price to Mycroft Free Cash Flow per share result of less than 15 to be good for purchase, and anything under 7.5 to be excellent.

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The higher you go above 15, the more overvalued a company becomes. I use a Price to Mycroft Free Cash Flow per share result of 22.5 as my sell price, and 45 as my short price.

An appropriately priced stock should trade around a Price to Mycroft Free Cash Flow per share result of 15. This benchmark result was determined by backtesting.

Buy (opinion) = A Price to Mycroft Free Cash Flow per share result of less than 7.5 is considered excellent (50% below the initial Hold level), and anything under 15 is attractive.

The result I give as my Buy opinion in the table above uses a Price to Mycroft Free Cash Flow per share result of 7.5.

Hold (opinion) = 15 to 22.5 (I use 15 in the table).

Sell (opinion) = 22.5 or higher (50% above the initial Hold level). (I use 22.5 in the table).

Short (opinion) = 45 or greater. The Price to Mycroft Free Cash Flow per share result of 45 was determined by going back to the peak of the market (in the year 2000) and averaging the Price to Free Cash Flow per share results for the key players at that time. (I use 45 in the table).

Therefore, in the table above you will see that Cisco Systems with a Price to Mycroft Free Cash Flow number of 9.4 is very attractive right now. Cisco Systems despite its slowing growth in revenue, in the end is still a tremendous free cash flow generator.

The CapFlow ratio result that you see in our first table above is an original ratio I created in order to tell me how much Capital Spending is used as a percentage of Cash Flow. A result of less than 33% is considered ideal and with Cisco Systems coming in at just 9%, means that 91% of the company's cash flow is actually free cash flow and can be used to buy back stock, which I am a big fan of.

In conclusion, Cisco Systems is clearly a value investor's type of investment as Management is not succeeding in its current turnaround plans. Management, as was demonstrated in its latest earnings report is obviously struggling to grow its revenues. The stock should be of little interest to the growth investor as there is little consistency in their operations and CEO John Chambers is also very confusing as one quarter he is very bullish and then the next he is very bearish. This pattern of inconsistency on the message continues to show up each quarter and has done so for years.

By looking at the chart below, the investor in Cisco Systems, over the last decade, has seen little appreciation in their holding, if they were practicing buy and hold. On the other hand the smart value investor has had many opportunities over the past decade to buy the dips, after negative guidance was issued and then sell out when the bullish guidance soon followed. With Cisco Systems stock currently down about 17% from its high of the year, I believe we may just see it hit my 2014 opinion of $17.18 at some point. Clearly at that price the stock would be worth the risk in my opinion, especially with Cisco Systems' board of directors constantly increasing the amount allocated to its stock buyback program. With growth slowing, Management sending out confusing guidance from quarter to quarter and demonstrating zero consistency in their message, I for one am going to wait on the sidelines and see if the stock will hit my buy price opinion of $17.18.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Cisco Systems: Should You Buy, Hold, Sell Or Short The Stock?