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

Cisco Systems has the following five main direct competitors:

  1. Aruba Networks (NASDAQ:ARUN)
  2. Black Box Corp. (NASDAQ:BBOX)
  3. Extreme Networks (NASDAQ:EXTR)
  4. Finisar Corp (NASDAQ:FNSR)
  5. Juniper Networks (NYSE:JNPR)

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 ratio is calculated. When used together, these unique ratios generate a quantitative picture of a company's underlying fundamentals, taking into account both strengths and weaknesses.

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The "2014 Mycroft Free Cash Flow Per Share" estimates shown in this table are generated by taking the trailing twelve months (TTM) free cash flow result for each company and then adding the Mycroft/Michaelis Growth Rate into the equation. This generates a forward-looking estimate for 2014. The Mycroft/Michaelis Growth Rate is calculated using the FROIC ratio (Free Cash Flow Return on Invested Capital). FROIC is an indicator of how efficient operations are as it identifies 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 the Mycroft/Michaelis Growth Rate 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. My calculation is outlined as follows:

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.

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 2.82% (rounded off at 3%) and we have a Mycroft/Michaelis Growth Rate of 10% + 3% = 13%.

Cisco Systems' Mycroft Free Cash Flow per share estimate of $2.29 was calculated by taking its TTM free cash flow per share and multiplying it by (100% + 13% or 1.13). We then take its current market price of $22.74 and divide it by $2.29 and get a Price to Mycroft Free Cash Flow per share of 9.93. 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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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). The higher you go above 15, the more overvalued a company becomes. An appropriately priced stock should trade around a Price to Mycroft Free Cash Flow per share result of 15. This benchmark was determined by back-testing.

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).

Cisco Systems, with a Price to Mycroft Free Cash Flow number of 9.93 is very attractive right now. Here are the results for its competition.

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The CapFlow ratio, listed in the first table, is a reflection of 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.

In conclusion, Cisco Systems is six times the size in market capitalization of its five competitors combined. Clearly Extreme Networks and Finisar Corporation should be considered sells right now according to my analysis. Juniper Networks, with a price to free cash flow per share of 61.90, is a short. This just leaves Aruba Networks and Black Box. Aruba has the highest FROIC and highest growth rate, while Black Box is selling for what we consider a deep value play. So if you are a deep value investor then Black Box is for you and if you are growth investor then Aruba Networks is where you want to be. But for the conservative investor who likes a good dividend as well, Cisco Systems is the right choice for you. With this analysis we provide something for everyone: two sells, one short, one deep value play, one growth play, and a conservative dividend play.

Source: Cisco Systems Vs. The Competition: Who Comes Out The Winner?