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Both Cisco (NASDAQ:CSCO) and Netflix (NASDAQ:NFLX) have been making headline news this past week for different reasons. Shares of Cisco plummeted this week after they announced earnings and margin compression, while Netflix shares soared enough to call it a decent "year's worth of returns" and famed Hedge Fund manager Whitney Tilson capitulated on his very public short position against the company.

I have to ask, since I am long Cisco and have no position in Netflix, am I wrong? Should I sell Cisco and buy Netflix?

Let's start with Cisco. Although I just wrote a piece showing the deep value that lies within Cisco shares at today's prices, I want to address the fact that many investors seem to be somewhat fed up with the performance of the company and especially its celebrity level CEO, John Chambers. I often read about how he needs to go, and his only interest is in enriching himself and other insiders with stock options. I also read about how the shareholders have little to show for their investment over the past decade as most of the company's free cash flow goes only to pay for stock options that were granted to the employees.

While there is some truth to these statements, I do want to focus on the numbers in order to give the long term holders of the stock some hope.

It is tempting, but too easy to only look at the share price today, near $20, and compare it to the share price in 2001 and conclude that the company has done nothing to create value for the shareholders. Investors jump to the conclusion that Cisco has not created any wealth for the shareholders this past decade.

I caution these shareholders to not be accused of being a cynic, as described by Oscar Wilde when he stated,

"What is a cynic? A man who knows the price of everything, but the value of nothing." - Oscar Wilde, Lady Windermere's Fan, 1892

If we just look at the price of Cisco, then we might become a cynic of the company pretty quickly and begin to accuse them of negligence or fraud, as many have in the comment section of my previous article. But when we look at the numbers, we actually see the true value the company has created for these shareholders over the past decade.

To start, we must realize that when we compare today's price to the price in 2001, it is not a fair comparison. People in 2001 were actually overpaying for Cisco at roughly $20 per share. We can't just automatically assume that $20 was a fair price back then, and then compare it to today and say that nothing has changed for the shareholders. To assume that today's ballpark $20 share price is the equivalent is to miss the value of the company. $20 was too high of a price to pay back in 2001. The fact that it has gone nowhere since is a testament to this argument.

Looking under the hood in 2001, the company had 7.324 billion shares outstanding, thus giving the company a market cap of roughly $150 billion, give or take a few billion. If a person wanted to buy the entire company back then with $150 billion, they would have in return received free cash flow of about .41 cents per share, for a total of about $3 billion in free cash flow. If you do the math, back then, this would equate to only a little over a 2% return on invested dollars from teh business. I would rather put my money in the bank back then, but obviously, investors were anticipating that Cisco would continue to provide high growth rates, and were anticipating the business might double or triple. This, they hoped, would allow them to be able to sell their growth investment for 200-300% more.

Unfortunately, the main problem I see when investing in growth, is I have no idea when that growth might slow or end. If I bought for $20 per share in 2001, and that happened to be the year the company stopped growing, I would have to be happy with a 2% free cash flow yield for a long time. At today's $20 share price, the free cash flow yield is near 9%. If the company stops growing now, I can live with a 9% potential yield, assuming I could buy the entire company. I do not need to be right about when growth might end. The free cash flow yield is good now.

Now look at the current value of the company sitting at the "discouraging to some" price of $20.

As of 2010, Cisco had a float of roughly 5.655 billion shares. Granted, they have not retired as many shares as it seems they have purchased thanks to employee stock options, but the fact remains that shares have been retired. Shares over the previous nine years have been reduced by 1.669 billion, which is a 22.7% reduction from the amount outstanding in 2001. This basically means that even though the stock price has not gone up, the shares in your account have become more rare by 22.7%. When something becomes more rare, it become more valuable.

We can continue to look under the hood and see that over the past nine years, the company has increased revenues by 133% per share, but free cash flow by 320% per share. (Remember that free cash is the cash that the owners of the business can take home if they so choose.) So again, even though the share price has gone nowhere for a decade, the value of each stock has increased greatly. If you are frustrated that you have not made any money in the stock in a decade, realize that some of the blame may need to go to the fact that you overpaid in 2001 at $20 per share. For you to have bought CSCO in 2001 at the equivalent cash flow value one can get today, you would have had purchase CSCO shares for $4.50. Had you done that, you would today be up about 320%, which is the increase rate of the free cash flow. CSCO, although there is large dilution of value from employee stock options, don't forget to carry some of the burden of blame for overpaying in 2001. So buying Cisco at today's cash generating ability is the equivalent of paying $4.50 per share for Cicso in 2001.

Friend, I presume you would not hesitate to go back to 2001 and buy Cisco for $4.50. I hope now that you see you would have been paying too much to buy it for $20 back then.

As a company turns from a growth story into a stodgy cash machine, investors can become highly disappointed when they pay a price that does not produce a nice free cash flow yield on the current business. For an example, just look at Netflix (NFLX). If the business stopped growing today and leveled out, with a current $12.2 billion market cap, the business only generated $243 million in free cash flow over the past 4 quarters. This is a paltry 1.9% return to a business owner who decides to buy the whole company. Obviously, the market is hoping for continued rapid growth.

Eventually, though, even a great story like Netflix will become a stodgy cash machine. Who knows when that will happen in the future, but I don't plan to buy and find out. Assuming Netflix market cap remained unchanged from this point, the company would have to grow free cash flow 350% from here just to match the type of return one could get from buying Cisco whole. Assuming Netflix has it in them to grow their business 350%, what will likely happen is investors will bid the share prices up higher and higher, maybe even to $42.7 billion (350% share price growth to match the business growth). Ultimately though, when the growth slows or stops, what is likely to happen is Netflix will have to compete for investment dollars based on fundamentals with companies like Cisco. If Netflix growth stops at 350% from here, you can expect the price of the stock to likely collapse back down to a $12.2 billion market cap, about where it is today and relative to the type of free cash flow returns that Cisco is putting up. I would say this is partly what happened to these large tech stocks the past 9-10 years.

Cisco has turned from a growth company into a stodgy cash cow. I'll let other gamblers take the risk of buying a business generating current cash flow yields of 1.9%, like Netflix, and trying to time their exit for when the growth stops, by selling to other gamblers hoping for neverending growth. Me, I'll look at Netflix in a decade when it breaks growth investors' hearts and becomes a stodgy cash cow, while sitting in companies like Cisco which earns 9% free cash flow yields in the meantime. I imagine that Netflix buyers today, in ten years will be reliving the experience of a Cisco investor who bought in 2001. They too will call for the removal of the CEO and wonder how a company can go so long and not create wealth for its shareholders, even while the business probably continues to add value, just like Cisco has these past 10 years.

Today's Netflix hopefuls will be tomorrow's cynics.


Disclosure: I am long CSCO.

Additional disclosure: I have no position long or short in NFLX

Source: Cisco vs. Netflix, Value vs. Growth - Which Should You Own?