Cisco Systems: With Earnings Coming Up, What Does Its Owner Earnings Yield Tell Us?

| About: Cisco Systems, (CSCO)

Cisco Systems (NASDAQ:CSCO) is currently trading -14.42% from its 52 week high that it achieved on August 14, 2013. The company is scheduled to report its quarterly earnings on February 12, 2014 and I thought it would be timely to present some research on Cisco Systems "Owner Earnings." Owner earnings is one approach to an analysis of companies using Mr. Buffett's owner earnings ratio. The following is an introduction to that ratio:

On February 27, 1987, Warren Buffett released his 1986 Letter to Shareholders as part of the Berkshire Hathaway Annual Report for that year. That letter was probably one of his better-known pieces written as CEO of Berkshire Hathaway (NYSE:BRK.B) (NYSE:BRK.A) because it included a special section at the very end entitled, "Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy."

Mr. Buffett provided, in essence, a tutorial on how both he and Charlie Munger select the important information in a company's financial statements. In doing so, he set forth their formula on how to successfully analyze companies. Here is that paragraph:

If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (NYSE:A) reported earnings plus (NYSE:B) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) less (NYSE:C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in. However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.) Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes's observation: "I would rather be vaguely right than precisely wrong."

From Mr. Buffett's 1986 Letter to Shareholders, we have an additional way of calculating free cash flow or "owner earnings" as Mr. Buffett calls it. This formula, when broken down to its core ingredients, is very different from the calculations that are commonly used by analysts on Wall Street in calculating free cash flow.

The difficult part in Mr. Buffett's owner earnings calculation is that he has to factor in changes in working capital. This is not a one-step process, and requires increases or decreases in the following items to be factored in:

  1. Receivables
  2. Inventories
  3. Pre-Paid Expenses
  4. Other Current Assets
  5. Payables
  6. Other Current Liabilities
  7. Other Working Capital

And then factor in other non-cash items like stock based compensation for instance.

Using Mr. Buffett's owner earnings formula, the results for Cisco Systems are shown in the following table:

From the foregoing owner earnings data for Cisco Systems, I will now present an "Owner Earnings Yield" analysis, which is similar to the "Free Cash Flow Yield" except that instead of using free cash flow per share in the numerator, I have replaced it with owner earnings per share.

Owner earnings yield is calculated by taking Cisco Systems' owner earnings per share and dividing it by the current market price. For example, on November 6th, 2007, Cisco Systems had an owner earnings per share number of $1.04 (we use results from 2006 in the calculation as that is the only one that was available at the time) and a stock market price per share of $31.85. If we divide ($1.04/$31.85 X 100), we get an owner earnings yield of 3.26%. An owner earnings yield of 3.26% is very low and usually signals that the stock is ready for a correction. That is exactly what happened and the stock price of Cisco Systems went from $31.85 down to $12.75 on March 9, 2009 for a drop of -59.96% before it recovered. At the opposite end of the spectrum, which occurred on August 8, 2012, you would have seen Cisco Systems stock trading at $13.12, and having an owner earnings yield of 14%, which is super.

Cisco Systems is currently trading at $22.67 and has an owner earnings yield of 9%, which is still very attractive. If the company were to have a mis-step on February 12th when it reports its earnings, then we could be setting ourselves up for an attractive long term purchase as the owner earnings yield could spike up nicely, especially if CEO Chambers reduces forward guidance. Whenever he has done so, the company's stock price usually gets hit hard. Since Cisco Systems is a blue chip bell-weather, this could also have a negative effect on the markets as Cisco Systems is a major force in the S&P 500 (NYSEARCA:SPY), DJIA (NYSEARCA:DIA) and NASDAQ (NASDAQ:QQQ) markets.

Besides analyzing Cisco Systems owner earnings yield here, I have also done a long-term technical analysis of the company that shows that its stock price is very attractive right now. You can read that analysis by going here. In addition, I have previously done a more detailed free cash flow analysis of the company for Seeking Alpha (in November of 2013) that you can read by going here , in which I had a deep value buy price of $17.18 as my target for purchase. If we see a large enough miss on February 12th and have John Chambers guide lower in addition, it may set up the ultimate buying opportunity, especially when you factor in the very bearish tone in the markets these days. If Cisco Systems were to beat and guide higher, then one could also do very well buying it after it reports, as that may result in a breakout in the stock price. For those holding the stock now, my research recommends that you add more to your positions after the report by doubling down if they miss or adding more if they beat, as my 2014 hold price is $34.35. Thus in the end there is a lot of upside in the stock going forward for the long term.

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.