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HEROES

Commercial banking, trust company, and asset manager Northern Trust <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NTRS)") else Response.Write("(Nasdaq: NTRS)") end if %> gained $2 7/8 to $64 3/8 after Standard & Poor's announced that it will add the company's shares to the S&P 500 Index as of the close of trading on Friday, January 30. Northern Trust moves up from the S&P MidCap 400 and will take the place of Pepsi bottler Whitman Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WH)") else Response.Write("(NYSE: WH)") end if %>, which will be placed into the MidCap index because of the spinning off its Midas Mufflers and Hussman Corp. refrigeration units. PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> and Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %> are the only soft drink companies left in the S&P 500 after this change, while Northern Trust is the 34th bank or S&L joining the index.

Northwest Airlines <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NWAC)") else Response.Write("(Nasdaq: NWAC)") end if %> gained $4 9/16 to $55 5/16 after hooking up with Continental Airlines <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CAI.A and CAI.B)") else Response.Write("(NYSE: CAI.A and CAI.B)") end if %> in a strategic alliance under which Northwest expects to generate an additional $275 million in pre-tax income by the third year of the agreement. Northwest will also acquire the majority voting control of Continental in an exchange for $300 million in cash and $219 million in Northwest shares. Northwest says the shares will be kept in a trust and that the two companies will not be merged. Continental Class A shares gained $2 5/8 to $56 5/8 today. USAirways <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: U)") else Response.Write("(NYSE: U)") end if %> rose $3 to $60 on hopes of improving industry efficiencies and anticipation of more combinations or mergers. Delta Air Lines <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DAL)") else Response.Write("(NYSE: DAL)") end if %>, which conducted talks to merge with Continental in late 1996, finished down $1 11/16 at $112 5/16.

Digital Equipment Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DEC)") else Response.Write("(NYSE: DEC)") end if %> jumped $10 to $55 7/16 after agreeing to be acquired by Compaq Computer <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CPQ)") else Response.Write("(NYSE: CPQ)") end if %> for $30 per share in cash plus 0.945 shares of Compaq. The combined company will control over one-third of the NT workstation market, will take third place in the combined UNIX/NT workstation market behind Sun and Hewlett-Packard, will take the lead in multi-user storage systems with 19.3%, and will also continue to lead the server market with over 31% market share to number-two IBM's 13.1% market share. Compaq says the deal will be accretive in the year in which it is completed, which looks possible if it can accomplish the same remarkable improvement in DEC's return on invested capital that it achieved with its Tandem acquisition. Since DEC has been something of a fitful turnaround, investors are having a tough time believing that, but there's enough of a product overlap to cut costs and enough of a complimentary relationship between the DEC service business and the entire product lineup that earnings accretion looks entirely possible.

QUICK TAKES: Restaurant operator Apple South <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: APSO)") else Response.Write("(Nasdaq: APSO)") end if %> gained $1 1/16 to $12 3/16 on announcing that it is making progress with its divestiture of Applebee's restaurants and accelerating the growth of its proprietary restaurant brands... Auto parts and fire protection gear manufacturer Gentex Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: GNTX)") else Response.Write("(Nasdaq: GNTX)") end if %> rose $2 3/4 to $32 after reporting record Q4 revenues of $52.6 million and EPS of $0.31, up 41% and 55%, respectively, over last year... Ambassador Bank of the Commonwealth <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ABPA)") else Response.Write("(Nasdaq: ABPA)") end if %> gained $3 5/8 to $31 5/8 after the eastern Pennsylvania bank agreed to be acquired by bank holding company Fulton Financial Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: FULT)") else Response.Write("(Nasdaq: FULT)") end if %>. Ambassador shareholders will receive 1.12 shares of Fulton for each share they hold, valuing their shares at $34.72 as of Friday's closing prices.

Savings bank Pulaski Bank <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PULB)") else Response.Write("(Nasdaq: PULB)") end if %> rose $2 3/4 to $34 3/4 on announcing that it will convert from a mutual holding company to a stock holding company... U.K.-based utility company, coal producer, and energy marketer The Energy Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TEG)") else Response.Write("(NYSE: TEG)") end if %> gained $2 9/16 to $47 15/16 after it said it has received additional buyout offers from companies other than known suitor, utility holding company PacifiCorp <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PPW)") else Response.Write("(NYSE: PPW)") end if %>... Drug distributor Bergen Brunswig <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BBC)") else Response.Write("(NYSE: BBC)") end if %> added $3 13/16 to $45 after the drug distributor -- or supply channel management company, if you will -- announced a five-year, $500 million agreement to supply 900 retail pharmacy outlets of United Drugs... Battery maker Exide Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EX)") else Response.Write("(NYSE: EX)") end if %> picked up $2 1/16 to $23 1/16 after reporting Q3 EPS of $1.12 (before charges), beating the mean analyst estimate of $1.06.

EARNINGS MOVERS

Vicon Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: VII)") else Response.Write("(AMEX: VII)") end if %> up $2 3/4 to $9 5/8; Q1 EPS: $0.31; Estimate: $0.19

GOATS

Nabisco Holdings Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NA)") else Response.Write("(NYSE: NA)") end if %> crumbled for a $5 3/4 loss to $39 after the maker of Oreos, Chips Ahoy!, SnackWell's, Ritz, and a bunch of other consumer brands said it was disappointed with year-end sales trends for its Biscuit division and issued a cautious outlook for the year ahead. Year-end EPS of $1.61 met expectations, but conditions in Latin America, the company's largest international market, are below company expectations. Adding back amortization expenses, Nabisco is the largest cookie maker in the U.S., selling at 16 times earnings. That sort of value is unusual, especially if the company's board could be persuaded to buy back shares or reduce debt. Parent company RJR Nabisco Holdings <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RN)") else Response.Write("(NYSE: RN)") end if %> slipped $2 5/16 to $31 9/16 on the news.

ADC Telecommunications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ADCT)") else Response.Write("(Nasdaq: ADCT)") end if %> fell $11 1/16 to $17 1/16 after the telecom equipment supplier once again revised its outlook for the first quarter. On January 16, the company announced that it would miss analysts' estimates; on Friday it said it will report 10% to 15% revenue growth and flat earnings of about $0.19 per share. Merrill Lynch doesn't like the implications for other telecom equipment suppliers and cut to "hold" its near-term ratings on both Tellabs <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TLAB)") else Response.Write("(Nasdaq: TLAB)") end if %>, which fell $3 3/8 to $48, and Northern Telecom <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NT)") else Response.Write("(NYSE: NT)") end if %>, which declined $2 5/16 to $40. For those having a tough time with the investment thesis here, check the archives of WorldCom <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WCOM)") else Response.Write("(Nasdaq: WCOM)") end if %> for a discussion of where spending cuts will come from after it merges with MCI <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MCIC)") else Response.Write("(Nasdaq: MCIC)") end if %>. Telecom infrastructure company DSC Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DIGI)") else Response.Write("(Nasdaq: DIGI)") end if %> slipped $2 7/16 to $18 in advance of reporting Q4 EPS of $0.30 (before an asset write-down) after the bell, slightly below analysts' expectations.

QUICK CUTS: AT&T <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: T)") else Response.Write("(NYSE: T)") end if %> fell $3 13/16 to $61 11/16 despite turning in a virtually flawless earnings report. Q4 EPS of $0.81 was better than expected by 14% and the company says it expects to hold down discretionary overhead next year and achieve FY 1998 EPS of $3.25 to $3.35, better than analysts had been expecting... PC multimedia card company Creative Technology <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CREAF)") else Response.Write("(Nasdaq: CREAF)") end if %> was blasted for $2 3/8 to $17 3/4 after reporting Q2 EPS of $0.79 (before one-time charges), slightly ahead of the analyst mean estimate of $0.78... Hollywood Entertainment Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: HLYW)") else Response.Write("(Nasdaq: HLYW)") end if %> stumbled $2 1/8 to $8 13/16 after the retail video rental company said it will not buy back the 8 million to 16.8 million shares it had planned on buying in an $11 per share cash self-tender offer. The minimum amount of shares required to complete the transaction was not tendered.

Women's and young women's retailer Claire's Stores <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CLE)") else Response.Write("(NYSE: CLE)") end if %> slid $3 9/16 to $16 on concern that the company's president is ill or contemplating resignation, according to Bloomberg News. President Leslie Dunavan has been on vacation since Christmas and has not returned calls. Individual Investor's Special Situations Report also rated the company a "sell" in its most recent issue... Local loop telecom equipment company Advanced Fibre Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AFCI)") else Response.Write("(Nasdaq: AFCI)") end if %> lost $3 13/16 to $26 15/16 thanks to industry peer ADC Telecom's double-pump earnings warning... Florida homebuilder Engle Homes <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ENGL)") else Response.Write("(Nasdaq: ENGL)") end if %> fell $1 13/16 to $14 1/4 after announcing that it sees new home closings for the first quarter of 1998 falling from last year's level and per-share earnings falling below expectations.

Culligan Water Technologies <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CUL)") else Response.Write("(NYSE: CUL)") end if %> dropped $3 5/16 to $35 3/16 after the water treatment systems and services company announced that it expects fourth quarter revenues to be below plan, pulling Q4 EPS below the mean analyst estimate of $0.46... Canadian broadband datacom products company Newbridge Networks <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NN)") else Response.Write("(NYSE: NN)") end if %> lost another $1 7/8 to $27 7/8 after signing an expected strategic alliance.

EARNINGS MOVERS

Hall, Kinion & Associates <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: HAKI)") else Response.Write("(Nasdaq: HAKI)") end if %> down $4 1/4 to $15; Q4 EPS: $0.10; Estimate: $0.10

Activision <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ATVI)") else Response.Write("(Nasdaq: ATVI)") end if %> down $2 5/16 to $14 7/16; Q3 EPS before charges: approximately $0.52; Net EPS: $0.47; Estimate: $0.46

Orckit Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ORCTF)") else Response.Write("(Nasdaq: ORCTF)") end if %> down $2 1/2 to $17 7/8; Q4 EPS: $0.04; Estimate: $0.03

Tidewater <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TDW)") else Response.Write("(Nasdaq: TDW)") end if %> down $3 3/4 to $41 1/4; Q3 EPS from continuing operations: $1.15; Estimate: $1.08

Correction: In Friday's "Earnings Movers" we wrote that Visio Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: VSIO)") else Response.Write("(Nasdaq: VSIO)") end if %> reported Q1 EPS of $0.15. Wrong! Visio actually reported Q1 EPS of $0.26, $0.02 better than expectations.

FOOL ON THE HILL
An Investment Opinion
by Randy Befumo

Security Analysis, Part 2 -- Valuation:
The Price Paid In Relation to the Cash Created

RULE 2: When you buy a business, the price you pay should relate directly to the cash you expect the business to generate.

RULE 3: Context, context, context. It is critical to understand a company's economic model on its own terms, in relation to industry peers, and in relation to the business environment as a whole.

RULE 4: Valuation determines future returns.

As much as purely quantitative criteria outside of any business context alarm me, valuation is probably the most important parameter to consider when committing capital to a business. The reason for this is the underlying and indisputable logic for purchasing publicly traded businesses. Aside from any superificial psychological benefit to owning shares in various corporations, when you purchase a stock you are buying that business because you believe the future value of the cash the business will generate will end up being worth more than the current value of the dollars you are paying.

Literalists might wince at this description given that with publicly traded companies you rarely receive all of the cash that they generate, but I must again stress the axiomatic assumption made in the last installment -- "Investing in businesses makes the most sense when it is business-like." Whether or not you actually receive the stream of cash, were you to buy the whole company you would have absolute discretion over what to do with all of the money that the company made. As we are assuming the same rigor in buying portions of a company as when we buy the whole thing, the fact that if you only own shares you don't actually get the earnings or the cash flow the company generates is an entirely moot point.

A business exists to generate profits using whatever assets it has. After generating these profits, the business can decide to reinvest, make acquisitions, pay dividends, or repurchase portions of itself from other owners. The earnings you can reasonably assume to make over the lifetime of the business put in today's dollars is the value of a company at any given space in time. Current events and wild speculation may change the perceived amount of these cash flows, but in the end, the business is worth the cash it can generate with its assets, whether they be tangible like a factory or intangible like a tradename.

Ever wonder why the price/earnings ratio has become the Holy Grail for investors? Sure, you may use it all of the time, but why is this even relevant? Why not the price/inventories ratio? Or the price/depreciation ratio? Both of those are concrete financial factors that almost every business can report. The reason is that the price/earnings ratio tells you how many years it will take at the current rate of earnings for you to make all of your money back. Nothing more, nothing less. If a company has a price/earnings ratio of 10, that means if the earnings stay constant you will make back in earnings the money paid to buy the stock in ten years. The price/earnings ratio is ubiquitous because it uses the same inescapable logic that any actual acquirer would apply to a business being acquired -- How long will it take to make my money back? What is the current value being placed on the future earnings power of this company?

Certainly earnings are not the only variable we can use to approximate the actual cash a business can generate. In fact, sometimes earnings can become distorted due to temporary factors, making other numbers that correlate directly with the cash a company can produce -- like sales, cash flow, liquid assets, or even subscribers -- make more sense. The point is not to use a special, sacred tool to figure out what a company is worth -- the point is just to understand a company's economic model and with that understanding select the tool that best represents the value that the company can create in the form of cash generated. In this regard, the actual value of the company at any given moment in relation to a host of factors can be deemed important or not important depending on the type of company. While after-tax earnings are critical to a manufacturer, they are useless for a real-estate investment trust.

While the valuation method used depends on the company you are valuing, the ultimate impact of that valuation is indisputable. The wider the gap between the current value and the intrinsic value, the higher the return. Current valuation defines future returns, with higher valuations decreasing future returns by a proportional amount. If you overpay for the future earnings, you will either lose money or suffer through mediocre returns until the point where the valuation becomes attractive relative to the intrinsic value. The shares of stock can only increase in value if there is a significant difference between their value today and the cash they are going to generate in the future. If there is no difference or if the shares have actually overestimated the cash that will be generated, they cannot mount a sustainable increase in value unless you assume that all parties involved will remain irrational.

While some like Jack Welch have argued that for large acquirers like General Electric <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GE)") else Response.Write("(NYSE: GE)") end if %>, increased equity value can translate into higher future cash-flows through acquisitions -- meaning the property can never be overvalued -- there are several assumptions in this premise that are just not true. The first is that an organization can attain infinite size without sacrificing efficiency. The second is that there is an ample supply of skilled, motivated management to actually run these acquisitions. The third is that the supply of potential acquisitions that would actually affect the bottom line is infinite, which is simply not the case. Finally, acquisitions are a two-way street. The party being acquired has to believe that the shares of the acquirer reflect rational expectations about future cash flows or they will not accept them as tender. In fact, one could argue that valuation means a heck of a lot more to the acquired than to the acquirer, as the acquirer is always happy to do a deal when its shares are overvalued.

Without going into the innards of valuation, which can be found in the Fool's How to Value Stocks collection, the philosophy is simple. Valuation matters because valuation is an expression of the future cash that a company will generate. As buying at current prices gives you a right to that future cash, the price you pay today determines the returns that you can expect tomorrow. At some point, although it is arguable exactly when, a company can and will reflect an accurate valuation or an over-estimation of the cash it can reasonably generate over the foreseeable future. In the end, the higher the price you pay, the more likely your returns will either converge with the market returns for a significant period, or fall below them if you not only overpay but also buy a low-quality business. Tomorrow we will examine some aspects of business quality.

CONFERENCE CALLS

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Randy Befumo (TMF Templr), a Fool One

Dale Wettlaufer (TMF Ralegh), Fool Two

Alex Schay (TMF Nexus6), Fool Three
Contributing Writers

Brian Bauer (TMF Hoops), Fool Four
Editor