Here's Why Cisco Looks Expensive

Recently, Doug Kass penned a column detailing why he thinks Cisco Systems (CSCO - commentary - Cramer's Take) is worth buying.

In a nutshell, Doug says that at $9.50 a share (the stock's price on Oct. 7) you get a well-capitalized, cash-rich business that will prosper handsomely as competitors fall by the wayside and a resumption in IT spending sparks stronger earnings growth.

I can buy Doug's thesis, but Cisco is still too expensive. For a spreadsheet to illustrate my points, click here.

1. Piotroski's Nine-Point Value Model

For starters, the Internet networking company only earns four points in the Joseph Piotroski nine-point value-ranking model. According to results published in the Journal of Accounting Research, the University of Chicago professor finds that one-year returns at companies with his top ratings (eights and nines) beat the broader market by an average of 13 percentage points annually.

As we see in Exhibit No. 1 of the spreadsheet, Piotroski's model combines elements of profitability, capital structure and operating efficiency. Incidentally, going back to fiscal 1991, Cisco has never earned above a six.

2. Enterprise Value/Enterprise Defensive Profits Ratio

If you bought all 7.5 billion of Cisco's shares today at $10.50 a pop, put the $21.4 billion of excess cash, marketable securities and investments (assuming the balance sheet is a close proxy of intrinsic value) in your pocket, and assumed the $828 million of debt equivalents (operating leases, in this instance), the company's real value, or "enterprise value," is $58 billion.

Meanwhile, in the denominator, after making certain adjustments, most notably reversing the working capital "gain" from fiscal 2002 and assuming that capital spending and depreciation eventually offset each other, you get $2.3 billion in enterprise defensive profits. Thus, by dividing $58 billion by $2.3 billion you get an enterprise value-to-enterprise defensive profits ratio of 25 times.

All the studies I've seen say that if you habitually pay this high a price to own a pro rata share of a business, you'll lose money. I wouldn't pay more than 15 times, which implies a stock price of $7.50. Assuming no adverse changes to the business, this gives you a 6.2% cash-on-cash yield, which equals the current five-year Treasury yield of 3.18% plus a 300-basis-point "margin of safety" factor.

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].