Is Cisco (Nasdaq: CSCO) a cheaper stock than you imagined? It could be, and here's why.

In the daily noise machine of CNBC, analyst estimates, and quarterly announcements, investors are inundated with talking heads obsessing over earnings-per-share figures. That's the primary metric we use to mark corporate progress. Earnings -- or net income -- are also the basis for the price-to-earnings ratio, the most popular way of measuring how cheap or expensive a stock is.

Free cash flow -- the amount of cash a company earns on its operations minus what it spends on them -- is another, and often more accurate, metric that can help you identify cheap stocks. That means investors like us who peek at free cash flow can gain a significant advantage in the market.

How Cisco stacks up
If Cisco tends to generate more free cash flow than net income, there's a good chance that earnings-per-share figures understate its profitability and overstate its price tag. Conversely, if Cisco consistently generates less free cash flow than net income, it may be less profitable and more expensive than it appears.

This graph compares Cisco's historical net income to free cash flow. (I omitted various gains and charges such as tax deferrals, restructurings, and benefits related to stock options.)


Source: Capital IQ, a division of Standard & Poor's, and author's calculations.

As you can see, Cisco has a tendency to produce more free cash flow than net income. That means the standard price-to-earnings multiple that investors use to judge companies may overstate its price tag.

Let's examine Cisco alongside some of its peers for additional context.

Company

Price-to-Earnings Ratio

Adjusted Price-to-Free-Cash-Flow Ratio

Adjusted Enterprise-Value-to-Free-Cash-Flow Ratio

Cisco

15.5

14.4

11.4

Juniper Networks (Nasdaq: JNPR)

38.0

29.9

25.5

Brocade Communications (Nasdaq: BRCD)

21.8

18.9

23.4

It's not unusual for Cisco's peers to generate more free cash flow than net income, nor is it unusual for Cisco itself.

What's interesting is the extent to which that multiple falls even further -- from 14.4 to 11.4 -- when we take into account Cisco's cash hoard. On this measurement, Cisco is substantially cheaper than its peers and than its price-to-earnings multiple indicates. Cisco might indeed be much cheaper than many investors realize.

Ilan Moscovitz doesn't own shares of any company mentioned. The Fool has written a bull call spread on Cisco Systems. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.