Previously, I discussed the somewhat promising turnaround efforts at Sierra Wireless (NASDAQ: SWIR) since the company made its full transition into a pure play Internet of Things company. Strong top line growth and opportunities to strengthen profit margins point in the right direction. For this article, I will dive into the valuation to determine whether a successful turnaround is already priced into the stock.

Beware Wall Street's lemmings
The stock is trading at less than half of its 52-week high. It might seem like a screaming buy, but just because Wall Street analysts fall into that trap doesn't mean you should follow the lemmings off the cliff.

Swir Price

SWIR and IJR data by YCharts

Why is the stock off that much? A quick look at the performance of the iShares Core S&P Small-Cap ETF shows it's not the market. Some digging around unearths some explanations.

  • Management has been guiding revenue and adjusted earnings per share below analyst expectations. In May, management guided second quarter revenue to a range between $153 million to $156 million. At the time, the mean analyst forecast was $157 million. Management also guided second quarter 2015 non-GAAP earnings per share to a range of $0.21 to $0.24 versus the mean analyst forecast of $0.25. Most recently, management guided third quarter 2015 adjusted earnings to a range of $0.23 to $0.27 per share against an analyst consensus was $0.30.  
  • Not surprisingly, earnings per share estimates have been falling. In the past 60 days, the mean analyst forecast for 2015 adjusted earnings fell from $1.10 to $1.04, while the 2016 forecast fell from $1.52 to $1.42.  

Investors seem to have a love-hate relationship with surprises. They hate disappointing surprises and have been known to harshly punish stocks that deliver them. As for the love part of the relationship, well, we have all seen the fleeting bull runs from a single outperforming quarter.

In theory, at the right price, any stock might be worth owning, so let's do some heavier lifting with the valuation.

The PEG ratio
In his book Beating the Street, Peter Lynch suggests an approach similar to the price/earnings-growth, or PEG ratio. This metric divides a stock's price-to-earnings ratio by its earnings growth rate. Lynch will also add a stock's dividend yield to the growth rate.

For example, a stock with a dividend yield of 1% and earnings growth of 9% would have a denominator of 10. Trading at 20 times earnings, the resulting PEG ratio would be 2.0. So what's an attractive PEG ratio? Lower numbers are better. According to Lynch, 1.0 is okay, 0.75 is good, and 0.5 is great. Above 1.0 is less desirable, though it's worth noting that many stocks are currently trading in that lofty territory.

Sierra Wireless isn't exactly a buy based on its PEG ratio. Its trailing GAAP earnings are negative, so price-to-earnings and PEG ratios will need to run off of adjusted earnings. The company currently trades at about 21 times adjusted earnings,  and its earnings growth averaged 6% from 2010 through 2014. Sierra Wireless doesn't pay a dividend, so its PEG ratio based on adjusted earnings is 3.5.

Wow, did I mention 1.0 is only okay, and lower numbers are better? Though Lynch advises using the company's historical earnings growth rate, not its projected one as he considers historical performance a much more accurate predictor of future growth than Wall Street forecasts, we are best off considering both approaches here due to the company's unique turnaround position. Sierra Wireless is counting on an emerging technology trend, and its future prospects with the Internet of Things will differ from its previous strategy. Taking the analyst consensus forecast of nearly 90% growth over the next five years, the company's PEG comes down to a much more impressive 0.25.

How to evaluate an unprofitable company
Methods for valuing a stock with negative earnings can also include price-to-sales or price-to-cash flow from operations ratios. Evaluating Sierra Wireless with the alternative valuation methods, the stock trades at 1.2 times sales. While that's down from recent highs, the following chart shows it's still near the top of the range it was trading in before hype about the Internet of Things set in.

Swir

SWIR data by YCharts

At 23 times cash flow, this lies closer to the middle of its range over the past five years. That's a little more encouraging, but let's not forget that operating cash flows have been deteriorating lately, even as revenue growth was impressive. .

Foolish summary
Sierra Wireless shares took a big hit, as its earnings outlook disappointed investors. Sometimes that's a buying opportunity but not always. The adjusted price-to-earnings and PEG ratios are mixed; price-to-sales is middling at best, and the price-to-cash flow ratio is somewhat more encouraging -- if we believe operating cash flows can change course and grow with the top line.

In our next and final article in this series, we will look at the big picture and make a final investment decision for Sierra Wireless.

Cindy Johnson has no position in any stocks mentioned. The Motley Fool owns and recommends Sierra Wireless. 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.