It's hard to pass up a company that's performing well. But at today's prices, I think that's exactly what you should do with action-sports retailer Zumiez (NASDAQ:ZUMZ). Zumiez reported its third-quarter earnings report last week. Intrigued by the performance covered in our latest Fool by Numbers on the company, I decided to take a closer look. Zumiez is certainly well-run, but unfortunately, its share price leaves much to be desired.

Let's start with CAPS
If you haven't already, check out our new stock rating service, Motley Fool CAPS. In CAPS, 327 of 345 investors think Zumiez will outperform the S&P 500 index, giving the stock a four-star rating. Many of our Foolish CAPS players' pitches talk about the company's growth prospects and its recent price decline, based on missed expectations earlier in the year.

I love a bargain, so I'm all about looking for companies with recent stock price drops. But before we make any decisions about Zumiez, let's look at some performance numbers.

Operating performance is good.
Margins are one of the best places to start investigating a retailer:

1/31/2004

1/29/2005

1/28/2006

Gross Margin

31%

32.8%

35.4%

Operating Margin

6.3%

8.9%

10.5%

Net Margin

3.8%

4.7%

6.3%
Data provided by Capital IQ.

Over the last three fiscal years, margins have been rising across the board, even as the company continues to open new stores and make acquisitions. That's a very good sign. It's not easy to open stores, simultaneously increase performance, and capture some of the economies of scale.

Sure, margin expansion has slowed a bit over the trailing-12-month period. But Zumiez' margins are still moving in the right direction.

It generates high ROIC.
Margins aside, I always look at how well management generates return on invested capital (ROIC). After all, that's why we give companies access to our capital in the first place.

1/31/2004

1/29/2005

1/28/2006

ROIC

36.1%

29.7%

24.6%
Author's calculations.

From the table above, we see that ROIC is high, but declining. Small, growing companies require more and more capital to grow, and generating returns from a growing capital base gets harder and harder.

The data is a bit confounding, but not uncommon. I've seen increasing margins and falling ROIC before at other growing retailers, like Dick's Sporting Goods (NYSE:DKS) and Cabela's (NYSE:CAB). But unlike Zumiez, these two have traded at discounts to their thumbnail valuations.

But then you see the price
Unfortunately for Zumiez, my thumbnail valuation leads me to believe that it's not trading at a discount. In fact, to justify its current share price, Zumiez' adjusted free cash flow (accounting for the growth capital that is being spent to open new stores) must grow 25% per year for the next five years, and 15% for the five years after that.

Unfortunately, the company's adjusted free cash flow hasn't grown that quickly over the last few years. It's absolutely possible that the company's growth can accelerate over the next five years, but I wouldn't bet on it, especially at the stock's current premium prices.

The Foolish bottom line
Zumiez is a fine company with strong operations. It's serving a growing niche in the sporting-goods industry, and it generates high returns on invested capital. Given its trends over the past few years, it's tough not to like the company.

But I don't care what the trends are, or what the CAPS data says. I'm taking the George Foreman approach: I'm not going to pay a lot for this or any retailer. In the end, price determines investment returns. A refusal to pay high multiples led many great investors to pass up amazing companies such as Wal-Mart (NYSE:WMT) and Home Depot (NYSE:HD) for years on end. Instead, these managers waited until the market offered shares at what they believed were discount prices. Fools, if we pay too high a price, even for great companies, we're just asking for our portfolio to underperform.

Here at The Motley Fool, we don't always have to agree with each other. To see why Tom Gardner picked Zumiez for his Motley Fool Hidden Gems , try the premium small-cap newsletter service free for 30 days.

Retail editor and Inside Value team member David Meier owns shares of Cabela's, but does not own shares in any of the other companies mentioned. He is currently ranked 72 out of 13,432 investors in The Motley Fool's CAPS rating service. You can view his TMF profile here. Wal-Mart and Home Depot are both Inside Value recommendations. The Fool takes its disclosure policy very seriously.