How To Think About Buying Stocks

By Timothy Green - September 6, 2012 | Tickers: CSCO | 0 Comments

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What does it mean to buy stock? Are you simply buying a number, hoping that number will rise so that you can then sell that number to someone else? Some people view the stock market in this way, as a randomly fluctuating collection of numbers, where profit is acheived only by finding patterns or by guessing correctly. This view is admittedly more exciting than what the stock market really is: a place where you can buy pieces of companies. So before I buy a stock, this is the question that I ask:

If I were to buy the entire company at the current market capitalization and pay off all of the debt and debt-like obligations, how much profit could I pull out of the company each year?

This is ultimately what matters. I treat buying shares of a company exactly the same as buying the whole company. I don't care about the past performance of the stock because it doesn't matter. The most common mistake that people make is to buy stocks that have performed well in the past. Imagine that you own a car wash and, after all expenses, you pull in $100,000 in profit each year. A man comes in every day and offers to buy your car wash, sometimes for $200,000, sometimes for $2,000,000, and sometimes for amounts in between. The value of the car wash is unrelated to these offers. The value of the car wash depends on how much profit can be extracted from it. Stocks are exactly the same.

The Price to Earnings (P/E) ratio, which is widely used to judge the cheapness of a stock, is supposed to tell you how much the company is selling for relative to it's profits. There are two big problems with this.

• The company's debt is not taken into account. If you were to buy the entire company, the debt would have to be dealt with.
• Earnings is inherently an accounting number, used for tax purposes. Much of the time earnings is a poor representation of the true profitability of a company.

To solve these issues, I like to look at a different ratio. I call it the Owner's Ratio. The numerator, instead of simply the stock price, is the total cost of buying the company. This is the sum of the market capitalization and all debt and debt-like obligations that must be paid off. The denominator is trickier. Free cash flow (FCF) is widely used as an alternative to earnings, but even this is not perfect. Instead, I like to look at Owner Earnings, described by Warren Buffett as follows:

These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

Owner earnings tells us, on average, how much cash can be pulled from the business each year. The Owner's Ratio is simply the total cost of the company divided by the owner earnings.

Using this metric, I will look Cisco (NASDAQ: CSCO) and determine it's true profitability.

Cisco

Cisco is the leader in networking equipment, maintaining a dominant market share in its core businesses. Cisco's stock collapsed after the dot-com crash of 2000, and has since been largely flat.

CSCO data by YCharts

Cisco is a classic case of confusing stock performance and company performance. While the stock remained stagnant the company nearly tripled profits. Let's calculate the Owner's ratio for Cisco. First, the total cost of ownership. As of this writing Cisco trades at $19 per share, putting the market capitalization at $103.2 billion. Cisco's balance sheet has a significant amount of cash: $48.4 billion. The total debt is $16.4 billion, leaving $32 billion in cash. This effectively lowers the ownership cost, since buying the company buys the cash as well. So the total ownership cost is $103.2 billion minus $32 billion, a total of $71.2 billion.

At first glance owner earnings looks nearly identical to free cash flow. One difference is that free cash flow includes changes in working capital. A company requires a certain amount of working capital to function, and this number fluctuates from year to year. These fluctuations don't matter: they don't add or subtract to the average profitability. So owner earnings should only include permanent changes in working capital.

Here are the relevant numbers for Cisco from fiscal 2011:

We include interest because we are working under the assumption that we are buying the company and paying off the debt, meaning that interest payments are no longer necessary. Since interest is tax-deductible, we must add only (1 - tax rate)*interest. The tax rate for Cisco was about 17% in 2011, so we add (1 - 0.17)*628 = $521 million for interest. This leaves a total owner earnings of $9.699 billion. So the Owner's Ratio is simply $71.2/$9.699 = 7.34. This means that if you bought Cisco, assuming no growth going forward, it would take only 7.34 years to recoup your entire investment.

Conclusion

When buying a stock, you should treat it as though you are buying the entire company. What matters is not the stock performance or imperfect P/E ratios, but how much real profit can be extracted from the business. Cisco offers a great example of a company which is trading at an incredibly low Owner's Ratio, due in part to the large store of cash on the balance sheet. People look at the stock performance of the past decade and see stagnation. But what I see is opportunity.

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