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No. of Recommendations: 120
When you get to these gigantic market caps that exceed the GDPs of most nations on Earth, the tendency is to get concerned. But worrying about market cap alone is a canard. You don't even look directly at market cap regularly, although you do look at share price. Yet worrying about share price alone is also canard. It's the valuation metrics that people focus on. There are different ways of valuing companies. But any good valuation scheme should take into account earnings growth rate and not just be a multiple of price to earnings as the P/E ratio is. TMF seems to like the PEG, which is P/E divided by earnings growth rate.

The problem comes in predicting earnings growth rates in the future, which is what will determine what the company should be worth. Ideally, a fairly valued company should be worth its present assets plus the sum of all its future earnings, discounted for inflation. You don't know these future values, so you estimate and guess. Now people are worrying that CSCO's earnings growth rate will inevitably come down as demand for routers and other CSCO products may decline as the networking industry matures or moves to new paradigms. So the debate is on the unknowable future. But let's at least look at CSCO compared to GE, the company with the biggest market cap of any right now.

GE is a highly diversified conglomorate. It's almost an anachronism being so extremely diversified in an age where companies spin off units that are not directly related to their core business. GE is in a number of industries. The people in one of its units couldn't have a conversation about what they do with people in another, because they are totally different businesses. GE is the archetypal "Acme corporation" from the old RoadRunner cartoons, the mega-company that makes everything.

GE has a market cap right now of $580 billion. Its P/E is about 50. GE's earnings are growing at a rate of about 10%/year (optimally), which is quite impressive for a company that is so huge and diversified and which sells mainly products that are "old economy." GE's PEG is approximately 5. A PEG above 2 is generally considered to indicate an overvalued company. Historically, in fact, stocks have tended to be seen as fair value when P/E approximately equals earnings growth rate, which corresponds to a PEG of 1. Nowadays, though, the average PEG for the S&P500 index is closer to 2. But even given this "valuation inflation" of recent times, GE is extremely overvalued by measures taking into account earnings growth.

However, since GE is such a blue chip company, so diversified, well-run, stable and established, it does perhaps deserve a premium for being a less risky business than many in the "new economy." In other words, since the business is solid and relatively safe, the stock can be viewed as safer, all other things being equal. But not so much that we see a company valued at 5 times its earnings growth rate. GE is overvalued any way you look at it.

Now, CSCO has a market cap at this time of $434 billion and a P/E of 116. CSCO's earnings growth rate has recently still been about 50%, which is phenomenal for such a big company. However, let's concede that this will drop somewhat over time, since it is hard to see how such growth can be indefinitely sustained. Remember, though, that the Internet and networks are not built to their final states, and that even if they were, there is going to be improvements and needed regular upgrades. As long as CSCO maintains dominance in networking, it's reasonable to expect higher earnings growth rates than for "old economy" industries, where the state-of-the-art changes much more slowly and upgrades are not just a part of the game. In order to CSCO to rise to a PEG similar to that of GE, with its present market cap, CSCO's earnings growth rate would have to fall back to about 20%. That would be an extreme fall in earnings growth rate from recent quarters and that is not going to happen soon.

As it stands now, CSCO's PEG is on the order of 2-3. GE's is closer to 5. GE is then, by this measure, twice as "overvalued" as CSCO.

Now why is that there's not as much discussion in the media about GE's valuation? Because the CSCO-bashing is part of the media phenomenon of "new economy" apocalypse thinking. Since so many "dot-coms" have had trouble recently, the media snatches upon the idea that the "new economy" is unraveling, which makes a good story and serves as a sort of morality play on greed and how those who get too close to the sun get their wings burned. Since CSCO is now the default standard bearer for all of tech, it makes for a good story to talk again and again about CSCO, when many "old economy" companies, like GE, are much more overvalued. In fact, the media still recites the tired and untrue "fact" that "new economy" is generally overvalued, while "old economy" is undervalued. It's not that simple. There's a lot of old economy that is absurdly overvalued. On the other hand, there's lots of new economy that is undervalued. You have to consider the earnings growth rates.

Before you criticize the speck in CSCO's eye, you should criticize the log in GE's. Don't be a sheep. Think for yourself.
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