Cisco’s (NASDAQ:CSCO) Price Weakness Offers an Opportunity to Buy a Solid Defensive Stock at a Discount

Cisco Systems' ( NASDAQ:CSCO ) has joined the growing  list of companies lowering guidance for the current quarter due to supply chain constraints.  The stock sold off on Thursday after announcing first quarter results. However, Cisco’s underlying fundamentals make it a solid defensive stock which is now quite reasonably priced.

First quarter financial highlights:

• Revenue of $12.9 billion was up 8% YoY, $90 million lower than expected.
• GAAP EPS of $0.70 were up 37% YoY, slightly higher than expected
• non-GAAP EPS of $0.82 were up 8% YoY, slightly higher than expected

Second quarter guidance:

• Revenue to grow 4.5 to 6.5%
• GAAP EPS $0.64 to $0.68
• non-GAAP EPS $0.80 to $0.82

These results were broadly in line with what was expected - but the guidance was a lot softer than expected and resulted in the share price falling as much as 10%. There’s no denying that Cisco isn’t the growth stock it once was, but, if we consider it as a defensive play, it still has a lot going for it.

In particular, we like the fact that Cisco has maintained an impressive ROE, despite it’s pedestrian growth rates. Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Cisco Systems

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Cisco Systems is:

26% = US$11b ÷ US$41b (Based on the trailing twelve months to July 2021).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.26 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Cisco Systems' Earnings Growth And 26% ROE

First thing first, we like that Cisco Systems has an impressive ROE. Second, a comparison with the average ROE reported by the industry of 16% also doesn't go unnoticed by us. This probably laid the groundwork for Cisco Systems' moderate 8.0% net income growth seen over the past five years.

As a next step, we compared Cisco Systems' net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 9.8% in the same period.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for CSCO? You can find out in our latest intrinsic value infographic research report.

Is Cisco Systems Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 55% (or a retention ratio of 45%) for Cisco Systems suggests that the company's growth wasn't really hampered despite it returning more than 50% of income to its shareholders.

Our latest analyst data shows that the future payout ratio of the company is expected to drop to 42% over the next three years. Regardless, the ROE is not expected to change much for the company despite the lower expected payout ratio.

Conclusion

Besides the impressive ROE, Cisco has several other factors going for it:

• With a well covered 2.6% dividend yield, Cisco is on track to become a dividend aristocrat.
• The company has paid down a lot of debt in the last few years, resulting in a very manageable 27.9% debt to equity ratio.
• By our estimates, the stock price is comfortably below its intrinsic value .

Cisco is unlikely to turn out to be a multibagger for investors, but it is a defensive, dividend paying counter which is quite rare in the tech sector. Have a look at this free report on analyst forecasts for the company to find out more.

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Simply Wall St analyst Richard Bowman and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.