Friday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines include new buy ratings for Southwest Airlines (NYSE: LUV  ) , Verizon (NYSE: VZ  ) , and Pandora (NYSE: P  ) . Let's dive right in.

Southwest could fly high
First up, the week's ending on a high note for owners of Southwest Airlines, which received an upgrade to "market outperform" today from the analysts at Avondale Partners. This recommendation, however, appears a bit overoptimistic.

Sure, on the one hand, most investors are pretty optimistic about Southwest's prospects going forward. According to S&P Capital IQ, the average projection for Southwest is that the company will grow its profits at the rate of 33% per year over the next five years. Growth that fast could be enough to justify even Southwest's high P/E ratio of 28.

On the other hand, though, the "P" in that equation -- Southwest's profits -- may not be all they're cracked up to be. Last year, Southwest reported earning some $382 million in "net profits." Its actual free cash flow for the period, however, was a mere $67 million -- about $0.18 on the dollar. Valued on free cash flow, therefore, the stock's trading at a heady 155-times-free cash flow valuation. Even at 33% growth, calling this one a "buy" seems quite a stretch.

Making a call on Verizon
Next up is Verizon, the subject of a new initiation at "overweight" (equivalent to a buy or outperform rating) by Barclays. Interestingly, the tale here seems quite the opposite of the one at Avondale-endorsed Southwest.

Priced at $53 and change, Verizon shares change hands for about 133 times reported earnings. For a stock that's projected to grow its earnings at just 9% over the next five years, that looks expensive.

But wait -- according to Capital IQ, Verizon actually generated some $16.8 billion in real free cash flow over the past 12 months, a far sight better than its $1.1 billion in reported net income. Valued on its free cash, therefore, Verizon actually costs a quite reasonable 9.1 times FCF. Factor in a hefty 3.9% dividend yield, and I'd actually argue that this stock is cheap enough to buy -- and Barclays is right to recommend it.

Pandora is trouble
Whether you value your stocks on reported GAAP earnings or on the actual free cash flow they generate, I think there's one thing everyone should be able to agree on: Pandora is a sell.

That's the conclusion that MKM Partners came to this morning, at least, as they initiated coverage of the Internet radio company with a sell rating. It's also a conclusion I agree with. Unprofitable under GAAP, and burning through its cash at the rate of about $8.9 million annually, Pandora does not look to me like a particularly healthy business.

That said, I'm not forecasting that Pandora will go away anytime soon -- or that it will even necessarily fall to MKM's $10 price target immediately. At present, the company's cash burn rate remains modest given its cash reserves. Indeed, with no debt, and nearly $89 million cash in the bank, the company could conceivably stick around and continue providing free Internet-streamed music to its fans for another decade before running out of cash and needing to sell new shares.

Result: Pandora's not doing well now. I wouldn't buy it myself. But with plenty of cash in the bank, and cash-burn still only modest, Pandora does still have some time to figure out a business model that works.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Southwest Airlines.

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