Cash-Flow Valuations Prove Viable Stock Measurement.

A year ago I was wiping egg off my face regarding some stocks I had recommended based on their low price-to-cash-flow ratio.

My August 1999 crop of cash-flow picks had declined 2.6 percent on average in 12 months, compared with a 15 percent gain for the Standard & Poor's 500 Index.

I'm happy to say that the tool has redeemed itself. Or maybe the tool was always OK and the user has redeemed himself. The four stocks in my Aug. 31, 2000, column that were chosen based on cash flow rose an average 76 percent through Friday, Aug. 24.

Over that same period, the Standard & Poor's 500 Index fell 21 percent.

Calculating cash flow is an attempt to adjust reported earnings to better reflect the actual cash moving in and out of a business. One simple formula is reported earnings plus depreciation and amortization.

Let's say Leonard's Lemonade has recently bought a $100,000 lemonade stand and a $60,000 super-fast juice squeezer. We'll assume Leonard's has annual sales of $50,000 a year and expenses (for sugar and lemons) of $20,000 a year.

If the stand and the squeezer were depreciated or amortized over 10 years, reported earnings would be reduced by $16,000 a year, so reported earnings would be about $14,000. (That is: $50,000 in sales minus $20,000 in expenses minus $16,000 in depreciation or amortization).

Cash flow would be $30,000. If you believe that Leonard will never need another stand or juicer -- or that the stand and juicer will actually appreciate -- then the depreciation-influenced earnings figures are misleading. In that case, cash flow is a truer number than reported earnings.

You can also calculate "free cash flow." In its simplest form, this is cash flow minus a reasonable level of capital expenditures. Free cash flow can be used to expand or modernize the business, to pay dividends or to buy back stock.

Here are the performance numbers on last year's picks. Blockbuster Inc. is up 135 percent, USEC Inc. 82 percent, Yellow Corp. 70 percent and Agco Corp. 16 percent.

Other survivers

As for the six surviving stocks from two years ago, LaFarge Corp. is up 40 percent in the past 51 weeks. Liberty Financial Cos. is up 32 percent, Alaska Air Group Inc. 27 percent, Reinsurance Group of America Inc. 20 percent and First American Corp. 19 percent. Delta Air Lines Inc. is down 17 percent.

Here are my third annual recommendations on stocks that sell for a low multiple of cash flow: Forest Oil Corp., Valero Energy Corp., First Citizens BancShares Inc. Protective Life Corp. and Visteon Corp.

Forest Oil, based in Denver, is an exploration and production company with an emphasis on natural gas. Sixty-two percent of revenue is from the United States and 38 percent from Canada.

Forest is small for an energy company, with a market value of $1.2 billion and annual sales of about $1.1 billion. The stock sells for 3.9 times cash flow, 1.3 times book value (corporate net worth per share) and 1.1 times revenue.

Valero is a refiner based in San Antonio. Since I expect energy prices to be firm, it might seem strange that I would recommend a refiner. To a refiner, crude oil is a cost, and a major one at that.

But I believe we are in a period when all phases of the oil business -- exploration, production, refining and marketing -- will be profitable. And Valero looks extremely cheap to me at 3.7 times cash flow, 3.9 times recent earnings, 1.2 times book value and 0.14 times sales.

First Citizens serves the Southeast, which still looks like a growth area. It has a low ratio of non-performing loans to total loans (0.25 percent as of December 2000) and a good spread between lending rates and borrowing rates (4.1 percentage points last year).

The stock sells for seven times last year's cash flow, 11 times recent earnings, and 1.3 times book value.

Protective Life offers life insurance, annuities and other financial products. In July, it agreed to sell its dental insurance operation to Fortis, Belgium's largest financial services company, for $300 million. It will use the proceeds to invest in its main businesses.

Protective's stock fetches only 2.3 times cash flow and 1.2 times revenue, according to the Bloomberg database. Those are the sorts of numbers that sometimes attract a takeover offer.

Finally, there's Visteon, formerly the internal auto-parts operation of Ford Motor Co., now independent.

Besides being in a tough and unglamorous industry, Visteon faces several problems -- a slowing economy, declining earnings at Ford (which accounts for more than 80 percent of Visteon's revenue) and prickly labor relations. But the stock goes for a mere 0.65 times book value and 0.12 times revenue. Those are levels that I find hard to resist.

John Dorfman is a columnist with Bloomberg News

Trimming the Fat Before Earnings Fall

A lot of companies may report disappointing earnings for the next several quarters. Some of those stocks are selling at a high multiple of earnings and book value (corporate net worth). Highly valued stocks tumble more than others when disappointment hits.

Here are several I consider at risk. I'd refrain from buying them, consider selling them if you own them, and consider selling them short if that risky investment technique is part of your arsenal.

* Genzyme Corp., based in Cambridge, Mass., is a rarity - a biotechnology company that actually makes money. It turned a profit the past four years and is expected to earn $1.19 a share this year, up from $1.13 in 2000.

Its five-year earnings growth rate, though, is 14.5 percent, only one percentage point better than average. If analysts are right, the growth rate this year will be less than 6 percent. And yet investors are paying 52 times the past four quarters' earnings for Genzyme and 47 times estimated 2001 earnings.

* King Pharmaceuticals Inc. is a stock I have sold short in a few client accounts. The Bristol, Tenn., company makes brand-name prescription drugs and does contract manufacturing for drug and biotechnology companies.

At $45.30, King stock sells for 77 times the past four quarters' earnings and 45 times estimated 2001 earnings. That's a high multiple even if analysts are right in saying King will show earnings growth of 22 percent a year in the next five years.

But analysts may be too optimistic. With-annual sales of close to $800 million a year, it will be harder to sustain rapid growth.

* Krispy Kreme Doughnuts Inc., out of Winston-Salem, N.C., makes delicious donuts. But the stock is too fat, in my opinion. At $29.62 a share, it sells for 86 times the past four quarters' earnings, 10 times book value and 4.7 times revenue. That's a heck of a lot to pay for a doughnut shop chain.

John Dorfman is a columnist with Bloomberg News