Numbers can lie -- but they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:

  • The current price multiples
  • The consistency of past earnings and cash flow
  • How much growth we can expect

Let's see what those numbers can tell us about how cheap LED (light emitting diode) and RF (radio frequency) product maker Cree (Nasdaq: CREE) might be.

The current price multiples
First, we'll look at most investors' favorite metric: the P/E ratio. It divides the company's share price by its earnings per share (EPS) -- the lower, the better.

Then, we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow. This divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). Like the P/E, the lower this number is, the better.

Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.

Cree has a P/E ratio of 35.1 and an EV/FCF ratio of 52.1 over the trailing 12 months. If we stretch and compare current valuations to the five-year averages for earnings and free cash flow, Cree has a P/E ratio of 83.4 and a five-year EV/FCF ratio of 60.3.

A one-year ratio under 10 for both metrics is ideal. For a five-year metric, under 20 is ideal.

Cree is 0 for 4 on hitting the ideal targets, but let's see how it compares against some competitors and industry mates. 

Company

1-Year P/E

1-Year EV/FCF

5-Year P/E

5-Year EV/FCF

Cree

35.1

52.1

83.4

60.3

RF Micro Devices (Nasdaq: RFMD)

15.6

7.3

NM

26.7

General Electric (NYSE: GE)

16.1

20.2

10.1

24.4

Honeywell International (NYSE: HON)

15.0

9.0

16.3

11.3

Source: Capital IQ, a division of Standard & Poor's; NM = not meaningful.

Numerically, we've seen Cree's valuation on both an absolute and relative basis. Next, let's examine ...

The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash flow generation.

In the past five years, Cree's net income margin has ranged from 5.3% to 17.6%. In that same time frame, unlevered free cash flow margin has ranged from 7.2% to 21.6%.

How do those figures compare with those of the company's peers? See for yourself:



Source: Capital IQ, a division of Standard & Poor's; margin ranges are combined.

Additionally, over the last five years, Cree has tallied up five years of positive earnings and five years of positive free cash flow.

Next, let's figure out ...

How much growth we can expect
Five-year analyst growth estimates tend to be comically overstated. If you accept them at face value, you will overpay for stocks. But while you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared to similar numbers from a company's closest rivals.

Let's start by seeing what this company's done over the past five years. In that time period, Cree has put up past EPS growth rates of 1%. Meanwhile, Wall Street's analysts expect future growth rates of 23.7%.

Here's how Cree compares it its peers for trailing five-year growth (negative past earnings make RF Micro's growth rate nonsensical):



Source: Capital IQ, a division of Standard & Poor's; EPS growth shown.

And here's how it measures up with regard to the growth analysts expect over the next five years:



Source: Capital IQ, a division of Standard & Poor's; estimates for EPS growth.

The bottom line
The pile of numbers we've plowed through has shown us how cheap shares of Cree are trading, how consistent its performance has been, and what kind of growth profile it has -- both on an absolute and a relative basis.

The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a 35.1 P/E ratio.

The numbers for Cree aren't mind-blowing on the surface. Its multiples aren't that low, and though analysts expect huge growth, past growth hasn't been impressive. But in the tech space especially, the future can be quite different than the past.

If you find Cree's prospects compelling, don't stop. Continue your due diligence process until you're confident that the initial numbers aren't lying to you.

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Anand Chokkavelu doesn’t own shares in any company mentioned. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.