Here's why Brocade Communications Systems (Nasdaq: BRCD) may be cheaper than you think.

In the daily noise machine of CNBC, analyst estimates, and quarterly announcements, investors are inundated with talking heads obsessing over earnings-per-share figures.

Earnings, or net income, is an accounting construction that is the basis for the price-to-earnings ratio, the most popular way of measuring how cheap or expensive a stock is.

But free cash flow -- the amount of cash a company earns on its operations minus what it spends on them -- is another, oftentimes more accurate measure of earnings that can give you an advantage.

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

This graph compares Brocade Communications Systems' 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, Brocade Communications Systems has a tendency to produce more free cash flow than net income. This means that the standard price-to-earnings multiple investors use to judge companies may overstate its price tag.

There can be a variety of reasons to disregard such a discrepancy; for example, free cash flow can overstate earnings in businesses with volatile working capital needs, or understate earnings in high growth companies that are reinvesting capital in the business.

Alternatively, in cases where free cash flow more accurately measures earnings, such a discrepancy can indicate a company that is more -- or less -- expensive than investors realize.

Let's examine Brocade Communications Systems alongside some of its peers for additional context:


Price-to-Earnings Ratio

Adjusted Price-to-Free-Cash-Flow Ratio

Brocade Communications Systems



Cisco Systems (Nasdaq: CSCO)



Tellabs (Nasdaq: TLAB)



Juniper Networks (NYSE: JNPR)



On a P/E basis, Brocade Communications Systems looks substantially pricier than its peers.

Brocade Communications Systems' free cash flow multiple is substantially higher than its earnings multiple, suggesting that Brocade Communications Systems' stock might be a bit cheaper than many investors realize.

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Ilan Moscovitz doesn't own shares of any company mentioned. Juniper Networks is a Motley Fool Big Short short-sale pick. The Fool has created a bull call spread position on Cisco Systems. Motley Fool Alpha has opened a short position on Juniper Networks and owns shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.