This portfolio has a successful and storied history with the AOL wing of AOL Time Warner (NYSE: AOL). In fact, on a sultry August day in 1994, AOL was the first stock purchased by this real-money port. At the time, AOL was as controversial as it is... well, right now.

From 1994 to 2000, what a profitable ride controversy provided. In the mid-'90s, many doubted that AOL would ever turn a profit; many doubted that its technology would ever work well (remember all the busy signals and useless Web browsers?); many doubted AOL's accounting. And many more doubted that AOL's stock could keep rising -- but it did.

AOL has been our most successful investment, even following its sharp decline. Consider this: The port only invested $4,954 in AOL in 1994, buying a mere 85 shares. After numerous stock splits, by late 1999 we owned 4,400 shares. And that was after partial sales in 1997 and 1998, banking nearly $50,000 in profits. Those 4,400 shares, bought for less than $4,000, were worth more than $412,000. We were up 20,351% on the original investment.

That was the top. The stock peaked at $94 per share on Dec. 13, 1999, on record trading volume. We sold another chunk of our shares just four days later. One month after that, the Time Warner merger was announced. It's been all downhill since.

At $11.50, AOL is 87% below its all-time high, while Nasdaq was recently 75% below its peak. Our 20,350% gain in our remaining AOL is now a 2,500% gain. Unconscionable.

As has often been the case in the last eight years, many questions surround the stock. Accounting is an issue again, with an SEC investigation underway; there's pressure on profitability and sales; management is in upheaval; there's a large debt burden and lower credit ratings. We recently wrote about the challenges facing AOL Time Warner, so we won't revisit them now. Instead, take a look at its valuation.

Given that the company has net $26 billion in long-term debt, its enterprise value (which is market cap minus cash and equivalents plus long-term debt) is more important to consider than just market cap. The most meaningful measure we can look at is the company's enterprise value to free cash flow ratio (EV/FCF), measured on the last 12 months.

For the year ended June 30, as reported on a "historical" basis, we have (in millions except EPS):

FCF (as reported)      $4,632
FCF (OCF - Cap Ex)     $3,705

Diluted shares out      4,600
Share price            $11.58
Market cap            $53,268
Cash + Equiv.          $1,709
Long-term Debt        $27,935
Enterprise Value (EV) $79,494

EV/FCF (as reported)    17.16
EV/FCF (OCF-Cap Ex)     21.46

2002 EPS est.           $0.88
P/E on 2002 EPS est.    13.16

With an enterprise value of $79 billion, AOL Time Warner is valued at 17 times trailing 12-month normalized free cash flow (with one-time events removed by the company), and 21 times straight free cash flow. (Neither cash flow calculation deducts tax benefits from options because the company doesn't show them.) The problem is, free cash flow is expected to taper because much of it occurs early in the year. Free cash flow this year and next is expected to be about $3 billion. 

The company's enterprise value is 26 times that annual free cash flow projection. The S&P 500 trades at about 26 times free cash flow. So, beleaguered AOL Time Warner is not at a discount to the S&P 500 on a free cash flow measure. It is at a significant discount on an earnings per share (EPS) measure. The stock sits at 13 times EPS estimates, about half the S&P 500 average.

Which valuation do you prefer to use? I suggest weighing both.

Doing so, while I wouldn't buy the stock, I'd need another reason to sell it at this price. The company should have the wherewithal to service debt assuming no surprises. The SEC investigation is the biggest wildcard, but the investigation is public knowledge. Meanwhile, a recovery in the intermediate term is likely if we can assume new management starts to find its bearings and advertising eventually ticks upward. The stock's price is likely to move sideways -- up a little, down a little -- until either happens.

We were right
Moving away from AOL for now, the Fool is often said by detractors to have encouraged stocks all the way up and been obtuse to the downside risk. This is so far from true. In countless articles from 1997 to 2000, Fool writers warned about excessive stock valuations and countless "crappy" (as one Fool writer liked to put it) companies with soaring share prices.

Additionally, the Fool has always warned about the downside risk of stocks, with two of its founding principles being: Don't use margin, and only put money in the stock market that you won't need for several years. In fact, David Gardner's first column of 2000, on Jan. 4, asked if you were ready for the stock market to bomb because, "It could happen this entire year. Are you prepared for that?" He went on to warn about margin, among other follies.

Plus, the Fool was founded on principles that included warning the public about immense conflicts of interest among brokers and stock analysts. Nine years later, the government agrees.

Meanwhile, throughout 1999, I took to writing about the dangers of investing in almost any Internet stocks that were incredibly popular at the time. And in late 2000, as biotechs soared, I warned that most biotech stocks were due for a big decline in "Biotech's Fatal Attraction." Granted, we've been wrong as often as we've been right (just remember ATC Communications, @Home, Innovex, 3dfx, 3Com, Celera, and others). But thankfully, when you're right, you typically win big, and when you're wrong, your loss is by design limited.

Our past columns are archived. Today, in what may become a regular feature called "We Were Right" or "We Were Wrong," we look back at something we wrote. As the name implies, sometimes we'll look at something we got right, oftentimes we'll consider when we were outright wrong. Today, from the middle of the boom, we revisit words that we published on July 26, 1999:

...I believe that history is going to show these days as creating more unmerited (and therefore temporary) value than almost any other. Incredible market value is being created and insiders are made wealthy, but much of this market value will be lost because business value will never... support it.

Perhaps years from now the rash of IPOs that rose three- and four-fold this year -- from trade one -- will come to serve as a reminder of what a highly speculative, excited market of irrational investors involves. It involves investors who are ignoring or forgetting the fact that lasting value is very hard to create.

If you don't point out when you're right, it's rare anybody else will. When you're wrong, quite a few will go through the trouble to point it out. The Fool has a disclosure policy. You can see a writer's stock holdings by viewing his profile.

Rule Breaker Portfolio Returns as of 7/29/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      +5.85%**   +9.65%   --      +4.10%
Month     -6.96%**  -17.16%   --     -12.34%
Year     -29.80%**  -28.59%   --     -34.24%
 8/4/94   20.48%      7.55%  7.86%     7.49%

*Dividends added.

**Please keep in mind that these figures will be distorted for the RB Port once a quarter when we deposit $12,500 in new cash. See next note! 

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure accounts for the periodic deposits. Total return wouldn't be meaningful, because we started adding cash to the portfolio in July 2001. In a total return calculation, or (Current Value - All Cash Deposited)/All Cash Deposited, cash added shows up as returns.