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 expensive or cheap Nuance Communications (Nasdaq: NUAN) 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 -- 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.

Nuance has a negative P/E ratio and an EV/FCF ratio of 22.5 over the trailing 12 months. If we stretch and compare current valuations to the five-year averages for earnings and free cash flow, Nuance has a negative P/E ratio and a five-year EV/FCF ratio of 31.6.

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

Nuance is zero for four on hitting the ideal targets, but let's see how it compares against some competitors and industry mates. Nuance itself produces voice and language solutions, a rather unique niche mainly facing off against larger peers like Google and Microsoft. However, taking a look across other application software-focused companies can give us a feel for how its relative valuation stacks up.

Company

1-Year P/E

1-Year EV/FCF

5-Year P/E

5-Year EV/FCF

Nuance

NM

22.5

NM

31.6

salesforce.com (NYSE: CRM)

283.7

172.7

440.8

122.3

Citrix Systems (Nasdaq: CTXS)

52.3

25.2

69.5

36.9

Lawson Software (Nasdaq: LWSN)

39.7

12.6

155.7

24.2

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

Numerically, we've seen how Nuance's 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, Nuance's net income margin has ranged from -4.6% to 0.3%. In that same time frame, unlevered free cash flow margin has ranged from 20.4% to 27.8%.

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

Nuanmarginrangesv

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

Additionally, over the last five years, Nuance has tallied up one year of positive earnings and five 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. Due to losses, Nuance has put up past EPS growth rates that aren't meaningful; however, Wall Street's analysts expect future growth rates of 13.9%.

Here's how Nuance compares to its peers for trailing five-year growth:

Nuantrailing

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:

Nuan

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 the price multiples shares of Nuance are trading at, the volatility of its operational performance, 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 negative P/E ratio, and we see that its enterprise value to free cash flow multiples are stronger. Looking into the future, analysts are projecting a forward P/E multiple of 14. Given all this, Nuance may be worth a second look. If you find Nuance's numbers or story compelling, don't stop. Continue your due diligence process until you're confident one way or the other. As a start, add it to My Watchlist to find all of our Foolish analysis.

If you want some more stock ideas, check out my recent article: "The Greatest Companies of 2020."

Anand Chokkavelu doesn't own shares in any company mentioned. Salesforce.com is a Motley Fool Big Short short-sale recommendation. Google and Microsoft are Motley Fool Inside Value selections. Salesforce.com and Google are Motley Fool Rule Breakers recommendations. Nuance Communications is a Motley Fool Stock Advisor choice. Nuance Communications is a Motley Fool Hidden Gems pick. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Google and Microsoft. Alpha Newsletter Account, LLC owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.