The Dow Jones Industrial Average (DJINDICES:^DJI) was down 18 points in early afternoon trading on Tuesday as financial media coverage continued to ask how high this bull market could go.
Whether the Dow continues its run or takes a summer hiatus is really insignificant to all the value investors out there. What matters in the value world is finding stocks that are trading for less than their real value. Companies like Cisco (NASDAQ:CSCO).
The value play
I've written recently about how I identified Cisco as a potential value investment target (for the step-by-step guide on exactly how to do this, click here).
The tl;dr (too long; didn't read) version is pretty straightforward. First, Cisco's profit-to-enterprise value ratio is way above average, meaning that its market price-to-earnings ratio is attractive relative to the rest of the market. Second, its return on shareholder capital is also way above average, meaning there is a strong return on investment potential over the next several years.
The next question, then, is why is Cisco undervalued? What does the market know that we don't?
A simplistic peer comparison
Let's start by comparing Cisco's price-to-earnings ratio with some of its main competitors -- noting that Cisco is in the poll position in the networking industry.
Hewlett-Packard is not a pure comparison, with consumer-facing computing being the company's primary business. Network hardware remains a niche division.
Alcatel-Lucent (UNKNOWN:ALU.DL) posted negative earnings of $0.56 per share on a trailing 12-month basis. The $10 billion market cap company has a gross margin below its peers, negative revenue growth year over year, and a paper-thin 2% operating margin.
Juniper Networks is a pure network company comparison, and it is the only company with quarterly revenue growth year over year. It is this growth, which was 11% for the most recent quarter, that is driving its P/E ratio to such a high level.
The picture, as of now, is of industry giant Cisco losing market share to an upstart competitor while fighting for its lunch against HP and other household names. It's a picture of an entrenched incumbent, suddenly out of favor in the markets as other, shinier, high-growth competitors steal the spotlight.
When others are fearful, be greedy
Over the last year, Juniper Networks' stock has risen 32%. Cisco's has risen just 1.7%.
Why? My guess is that Juniper is new and shiny, while Cisco is old and dull. So old and dull that the market has forgotten what a great company Cisco is.
I could be wrong on the reason, of course, but the numbers speak for themselves. Cisco's quarterly revenue has grown 35.7% over the past five years, nearly matching Juniper's 42% growth.
How does that revenue translate into profit? Cisco has an operating margin of 20% on a trailing 12-month basis. That compares to just 9.9% at Juniper. Over the past five years, Juniper's margin has actually shrunk by 34% while Cisco's has remained essentially constant.
The long-term case for Cisco
The bottom line is that Cisco remains a very strong company. It has the size to outcompete or absorb any real upstart competition. It can invest in next-generation technologies at scale.
Cisco has a strong, consistent operating margin. For the next two to five years, it's fair to say that investors know what they are going to get. Using my previous calculations available above, investors can expect an earnings yield of approximately 8% annually and an annualized return on capital employed of nearly 14%. Both of these valuation metrics are far superior to Cisco's competitors and the rest of the Dow.
Of all the companies on the Dow Jones Industrial Average, Cisco today is the best value investment target. Do your homework, and let me know what you think on Facebook here.