I'd like to follow up on Zeke's Friday article by offering a few valuation tools investors can use when looking at Rule Maker companies.

We've raised the valuation issue many times over the last several months because our own thinking on the subject has matured, because readers regularly ask about it on discussion boards, and because, frankly, I don't know of a single portfolio that ignored price and beat the market over the long term. If you know of one, I'd love to hear about it. Please understand, however, that one example, or two, or even five isn't inconsistent with luck.

It's no wonder investors get confused about valuation. It's complex. If you're listening to snippets of information, even from well-informed investors, you might get the wrong idea. Check out these two quotes from Charlie Munger, Berkshire Hathaway's (NYSE: BRK.A) vice chairman. Both quotes came from the Outstanding Investor Digest.

"If you can buy the best companies, over time the pricing takes care of itself."

That sounds great, nice and easy, but you have to tie it together with other Munger comments on the subject:

"It's easy to see some companies have better businesses than others. But, the price of the stock goes up so high that all of a sudden it's difficult to determine which stock is the right one to buy."

That's the rub. We've said before in the Rule Maker that we're willing to accept valuation risk in exchange for minimum performance risk. In other words, we'll risk paying too high a price for a company with a solid track record of operating performance, even though there's a chance the company won't continue to generate the kind of returns we require.

That's what we're doing with Intel (Nasdaq: INTC) this month, buying shares of a company at 33x trailing free cash flow. This isn't cheap, considering we paid 26x free cash flow two years ago, and Intel is a company facing serious challenges. Can it be successful in markets outside its traditional area of competence, such as communications chips and Web hosting?

In addition, Intel already has a $217 billion market capitalization. We understand there's a good deal of performance risk in our bet that it can outperform, yet we accept that risk based on Intel's track record, its moves to reorganize its focus, and the opportunity that $13.6 billion in cash and short-term investments provides. It's not a dead lock, but it's a reasonable bet for us in this portfolio.

In truth, valuation and performance risk are two sides of the same coin. We don't want to lose out on an investment we really believe could appreciate 10-fold in 10 years just because it's trading at a high value relative to the market or its industry. After all, Rule Makers are commonly priced to beat the band. But we want to avoid nightmare valuation situations as well, and it's just not Foolish to fly without the tools needed to spot them.

This was the idea behind introducing the 2x5y concept in an article last November. We wanted to avoid investing in situations where the valuation was so high that the performance required for a reasonable return was simply unrealistic. We're looking to find companies that can double (2x) in value in five years (5y), growth that requires a 14.9% annualized return.

Is it likely that Cisco Systems (Nasdaq: CSCO), which has a $301 billion market capitalization and trades at well over 100x trailing free cash flow (if you exclude tax benefits from options), will double in five years? We're not going to take that bet anymore.

We're not going to spend our time trying to find the right price a company should be trading at, either. Rather, we'll screen out companies with unrealistic values and think very carefully about purchasing any that are stretching the limits of reason and risk. It's not easy to do, but hey, that's what investing is all about: balancing value with price, risk with reward. 2x5y is one way of getting us to think about the valuation process.

Another tool I like using is historical price-to-free-cash-flow ratios. It sounds horrible, but really all we're trying to do is get a look at how the market has priced the stock in the past. Since the market prices different industries and companies very differently, this gives us some idea what range of prices the market has awarded the company previously, to which we can compare the current price. Here's a look at Intel's price-to-free-cash-flow ratio for the last four years (calculated at time of 10-K issuance each year).

Intel  Current   '00    '99     '98    '97
P/FCF    33     49.5   42.9    30.1   22.6

Now, Intel is a volatile stock, so investors can expect the ratio to fluctuate, but you can see the trend is clearly up. What is the right price? I don't know. This exercise just helps you get a sense for the size of the sandbox. It's not flawless. After all, the market often has good reasons for increasing or decreasing the cash-flow multiple it's willing to award a company. Maybe the company has improved its working capital management and boosted its return on invested capital; maybe the company has failed to deliver on an important project and let a competitor grab market share.

The more you can find out about the company's history and the way the market views it, the better. But, over time, the market has had a chance to get used to a company and understand its story and its ability to create or destroy value. So, looking at a spread of multiples over time is instructive, especially if you take data more than once a year and average it out. It's also very useful for comparing companies to competitors.

It's very hard to set ground rules for valuation. For Rule Makers, established growth companies whose value is already understood by the market, it might be worth considering capping the price-to-free-cash-flow ratio at 40, a very generous multiple for a blue-chip company, but one that would clearly put a firm like Cisco Systems, one sitting on the mountain top, out of reach at current prices.

This is just an early stab at helping Rule Maker investors think about valuation. Please share your thoughts on the Rule Maker Strategy Discussion Board.

Finally, a special treat to share with you -- in the latest edition of Newsweek, Tom Gardner answers questions on everything from interest rates to New Year's resolutions. Check out this online excerpt

Have a great day!