I can make a solid case that AOL Time Warner ( AOL) shares are undervalued by at least 30%.

I'm pretty sure that most investors won't care. They feel there's too much risk in the market and in the stock. That lack of interest even in undervalued stocks is the main problem the market confronts right now.

The idea of putting a convincing valuation on AOL Time Warner is likely to raise howls of laughter in many quarters. Isn't this the company that reports EBITDA -- earnings before interest payments, taxes, depreciation and amortization -- because it doesn't have any real earnings to go with its $27 billion in long-term debt? And isn't this the company that recently announced a Securities and Exchange Commission inquiry into its accounting practices?

How can anyone pretend to value that stock? The answer is to focus on cash flow, the conservative measure that many investors say is the only one that counts.

AOL Time Warner generates a huge amount of good old cash. So far in 2002, AOL Time Warner has generated $2.8 billion in free cash flow -- what's left of cash flow after all nondiscretionary cash expenditures such as taxes and capital spending are subtracted. It's the "extra" cash that the company has available for activities such as reducing debt or buying back shares. AOL Time Warner's cash flow for the full year is expected to reach $3 billion. (Cash flow has been front-end-loaded so far in 2002 because of the timing of working capital needs in the film division.) And 2003 should see another $2.8 billion to $3 billion in free cash flow.

Beautiful Cash Cows

Despite the well-publicized troubles at the AOL division, AOL Time Warner owns some large and profitable cash cows. The Time Inc. magazine division, for example, grew revenue at an annual rate of almost 9% a year from 1997 to 2001. That's far better than its rivals. And Time Inc. made a lot of profit on that revenue, with an EBITDA margin of 23% during those years.

AOL Time Warner generates cash even from businesses that other industry players find to be cash drains. Cable TV systems, for example, are notorious for consuming cash raised from investors on unfulfilled promises. But with about 98% of its system already upgraded for digital services -- including broadband and content on demand for a separate fee -- Time Warner Cable generated pretax free cash flow of about $300 million in the second quarter.

Even the AOL division, with all its problems -- including the continuing prostration of the online advertising market -- is on track to generate free cash flow of $300 million in 2002.

So for the moment, let's forget about all the valid talk about failed synergies, executive-suite turmoil, even murky bookkeeping, and decipher what a company that generates $3 billion in free cash flow a year might be worth.

Free cash flow has a distinct advantage as a valuation measure in today's market: Unlike profit, it's hard to manipulate. The traditional method for valuing a stock on cash flow, called discounted cash flow, is well-established and straightforward. It involves projecting cash flows over some period -- a terminal date of 2008 is reasonable here -- and then discounting that total number by the cost of capital used by the company. In other words, this method arrives at value through an equation that sums all of a company's cash then subtracts the amount the company must invest in its business.

Like all other methods of valuing a stock, this one spits out different answers depending on the assumptions about how fast cash flows grow, how much capital costs and how high the required rate of return should be.

For AOL Time Warner, it's important to look at the range that Wall Street analysts get for the stock price using this method. Near the top, Morgan Stanley gets a value of $22 a share after calculating that free cash flow per share will grow to $1.83 in 2008. That price assumes that the company's cost of capital is 11.75% -- roughly what AOL Time Warner bonds are yielding now. It also assumes that the rate of return demanded by investors is 14% -- roughly twice what many investors now expect from stocks in general over the next decade. Gerard Klauer Mattison gets a roughly similar $20 a share. Both firms rate the stock buy.

Kaufman Brothers, at $13, represents the lower end of the scale. That price is the result of assuming just 4.5% annual growth in free cash flow through 2008, instead of the 7% annual growth assumed by Morgan Stanley. Sanford Bernstein's valuation is also at $13, and Goldman Sachs comes in at $14. Even the lowest of these says that investors buying AOL Time Warner right now can look for gains of 16% in 12 months from the stock's recent price of $11.20 a share.

Kaufman Brothers' $13 valuation seems low. "All in all," Kaufman's analysis says, "we believe this fundamental portrait suggests that there is no inflection point for the business for at least a year (if ever)." "Ever" is a long time, and frankly, I think that the advertising market, even the online advertising market, will turn up sometime before "ever" arrives.

Morgan Stanley's assumptions, on the other hand, seem too optimistic. The headline on the firm's recent report is "The Worst Appears to Be Over." That underestimates the task now facing divisional managers Don Logan and Jeff Bewkes as they take over operations of a disorganized and demoralized company. And Morgan Stanley is certainly more sanguine about subscription growth for the basic AOL online product than I am.

Plugging my own assumptions into the discounted cash flow model, I come up with $18 a share. That's about 60% above recent price levels.

You've Got Problems!

What could go wrong with my numbers and those of the Wall Street firms?

The SEC inquiry could expand, dragging on for months without closure. AOL Time Warner and AT&T ( T) could fail to reach an agreement on restructuring their joint venture Time Warner Entertainment. A disagreement could force AOL Time Warner to buy out AT&T in cash, adding to AOL Time Warner's already hefty debt load and sending shudders through the bond market. The AOL online business could indeed turn out to be trapped between cheaper online competitors and flashier broadband services. This would require AOL management to stumble so badly on rolling out AOL's own brand in the broadband market that the AOL online business enters its own death spiral.

I don't give those last two risks very high probabilities. But I do take the first risk seriously, and not because I expect some massive restatement. The current inquiry involves $270 million in revenue, a relative pittance. The main problem is that shellshocked investors will be reluctant to recognize value if there's any potential bomb waiting to explode. The SEC inquiry isn't likely to erase any value in AOL Time Warner stock, in my opinion, but it will prevent investors from bidding up prices to levels that recognize that value.

A Question of When

Fear will keep the stock trading at prices below its real value -- and it won't reach the forecast levels until that fear goes away. On July 25, Goldman Sachs, for example, downgraded the stock to market perform. "Our change in rating is not based on valuation," Goldman Sachs said. "It is about our perspective that it remains unclear when the company's outlook will improve (or at the very least stop getting worse)."

For AOL Time Warner, I think that "when" will be sometime in the next 12 to 18 months, so I'm keeping the stock in Jubak's Picks with an $18 target price. But I admit my sense of when is based more on projections for when the stock market is likely to put in a bottom than it is on any concrete timetable of corporate events.

And I think that investors who find AOL Time Warner undervalued on its fundamentals should also seriously consider the company's bonds at this point. The better-than-11% yield on the bonds will provide a solid return while you wait for the market in general to come around.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: AOL Time Warner. He does not own short positions in any stock mentioned in this column.

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