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

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinions of our bloggers and are not formally edited.

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:

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 supposedto tell you how much the company is selling for relative to it's profits. There are two big problems with this.

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:

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.

Continue reading here:
How To Think About Buying Stocks