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 Level 3 Communications (Nasdaq: LVLT) 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.

Level 3 Communications has a negative P/E ratio and an EV/FCF ratio of 19.8 over the trailing 12 months. If we stretch and compare current valuations to the five-year averages for earnings and free cash flow, Level 3 Communications still has a negative P/E ratio and a five-year EV/FCF ratio of 38.0.

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

Level 3 Communications 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

Level 3 Communications NM 19.8 NM 38.0
AT&T (NYSE: T) 13.2 12.9 15.5 15.7
Verizon Communications (NYSE: VZ) 127.2 9.8 18.3 15.6
Internap Network Services (Nasdaq: INAP) NM 13.5 NM 53.9

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

Numerically, we've seen how Level 3 Communications' valuation rates 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, Level 3's net income margin has ranged from -32% to -8.7%. In that same time frame, unlevered free cash flow margin has ranged from -3.3% to 10.5%.

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, Level 3 Communications has tallied up zero years of positive earnings and four years of positive free cash flow.

Next, let's figure out ...

How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. 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, Level 3 Communications has put up past EPS growth rates of that aren't meaningful (due to moving from a negative number). Meanwhile, Wall Street's analysts expect future growth rates of -1.8%.

Here's how Level 3 compares it its peers for trailing five-year growth (due to negative earnings, its growth rate isn't meaningful):


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 Level 3 Communications are trading, how consistent its performance has been, and what kind of growth profile it has -- both on an absolute and a relative basis.

None of the numbers we've looked at makes Level 3 look appetizing. It's been churning out negative earnings for years. Its cash flow is positive, but it's not that plentiful. Even the usually optimistic analysts are projecting negative long-term growth.

I probably won't be going much further with Level 3, but maybe you found a nugget here. If you find Level 3 or one of its competitors 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.