It's hard not admire Cisco Systems (CSCO). The titan of the corporate networking market, Cisco sports a gleaming balance sheet with a $15 billion in cash and no debt. Last year it generated a whopping $6.9 billion in free cash flow and $5.7 billion in net income. Its valuation, on the other hand, is another matter. As likeable as the company may be, its stock price is starting to look stretched.

Cisco shares have surged 26% since January. With the stock lingering below $18.00 for much of last year, the uplift is justified. But, in my mind, the correction is now complete. Even as the company pushes into sexy, new advanced technology markets like home networking, digital TV and IP telephony, Cisco is going to be hard-pressed to post growth numbers that warrant anything much higher than its $21.49 price tag.

My reservations stem from the law of large numbers. Like its high-tech cousins Intel (INTC) and Microsoft (MSFT), the bigger Cisco gets, the tougher it gets to grow. Even a few billion dollars in extra sales won't do much for a $125 billion company.

Cisco dominates the market for networking router and switch hardware. Nearly two thirds of Cisco's sales come from these solid, cash-generating product lines. Unfortunately, their sales grew at a meagre 7% last year. Fierce competition from Juniper Networks (JNPR), Redback Networks (RBAK), Nortel Networks (NT), Alcatel (ALA) and from China's low-cost provider Huawei Technologies could push it lower.

So, to boost its market value any higher, Cisco will need really big gains from outside of its traditional hardware business. By my reckoning, top line growth targets of 12-15% will demand 25-30% growth from Cisco's expanding advanced technology portfolio.

That's asking an awful lot. Consider two of Cisco's top growth drivers, home networking and digital TV. Sales growth from the Linksys home networking unit is expected to peak at about 20% per year. Digital TV sales meanwhile will come largely from acquired digital set-top box maker Scientific Atlanta. That company's sales have been growing at about 12%. It isn't obvious where the necessary growth will come from.

Then there is Cisco's profitability to worry about. Grabbing growth from consumer markets – selling home networking and TV set-top boxes – could taint Cisco's enviable 67%-plus gross margins. Consumer products typically carry lower margins, which could erode Cisco's bottom line earnings gains.

Of course, reducing its number of shares outstanding through share buybacks could boost earnings per share. The trouble is Cisco is already buying back shares to offset the effect of the generous stock options issued to employees.

Cisco looks pricey compared to the S&P 500. Cisco is now trading at 20 times earnings. Analysts expect the company to book annual earnings growth of 12% next year. By contrast, investors are paying 14.7 times next year's earnings for S&P 500 stocks, whose earnings are expected to grow by 13.1% next year.

Don't get me wrong, I think very highly of Cisco. Were I to buy a richly valued, mature tech stock, it would be among the first I would snap up. While Cisco is a great company, that doesn't mean you should pay any price for it.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  2. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  3. Professionals

    What to do During a Market Correction

    The market has what? Here's what you should consider rather than panicking.
  4. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  5. Mutual Funds & ETFs

    ETF Analysis: Schwab US Broad Market

    Take an in-depth look at the Schwab U.S. Broad Market ETF, an incredibly low-cost fund based on a wide selection of the U.S. equity market.
  6. Professionals

    Tips for Helping Clients Though Market Corrections

    When the stock market sees a steep drop, clients are bound to get anxious. Here are some tips for talking them off the ledge.
  7. Stock Analysis

    The Safest Stocks You Can Invest in Right Now

    These stocks are likely to hold up better than others in a bear market, but there's a twist.
  8. Investing Basics

    5 Reasons to Expect Lower Stock Returns

    Lower stock returns are likely here to stay for some time. Here are five reasons why.
  9. Investing Basics

    What to Cut From Your Portfolio Right Now

    Owning stocks may shortly become too scary for your portfolio. Here's why, and here are some alternatives.
  10. Personal Finance

    Careers: Equity Research Vs. Investment Banking

    Equity research is sometimes viewed as the unglamorous, lower-paid cousin to investment banking. In this article, we compare the two careers.
  1. Security

    A financial instrument that represents an ownership position ...
  2. Series 6

    A securities license entitling the holder to register as a limited ...
  3. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  4. Board Of Directors - B Of D

    A group of individuals that are elected as, or elected to act ...
  5. Strike Width

    The difference between the strike price of an option and the ...
  6. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  4. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!