Rocket Stock or Dud?

"The bigger they are, the harder they fall." It's the worst nightmare of every investor in today's market -- buying a rocket stock just before it takes a nosedive.

Now I readily admit that sometimes stocks rise for a reason. But sometimes the rise becomes the reason. No matter how often we caution them not to, investors do have a habit of buying "hot" stocks and trusting momentum to keep 'em moving upward.

Problem is if the price goes up too much, even a great company can turn into a lousy investment (and if the company was less than great in the first place). Below, I list a few stocks that may have done just this. Stocks that, according to the smart folks at finviz.com, have doubled (or nearly so) over the past year, and just might be ripe to fall back to earth.

Companies are selected by screening for 100% and higher intraday price appreciation over the past 12 months on finviz.com. Current pricing provided by Yahoo! Finance. CAPS ratings from Motley Fool CAPS.

Question: What do diesel engines have to do with voice over Internet protocol phone calls? What do either of these things have in common with Canadian yttrium-excavation? The answer to both questions is this: The companies behind these products are some of the hottest stocks on the Street.

Over the past year, as pundits voiced fears that China is locking up supplies of the minerals needed to manufacture everything from electric car batteries to smart bombs, shares of Rare Element Resources have nearly tripled in price. Investors in VirnetX have done even better, enjoying a near-fourfold increase in price as their stock soared on reports of patent license payouts from Microsoft, and hopes for further largesse from potential licensees Cisco (Nasdaq: CSCO) and Apple.

Relative to these gains, the mere 129% run-up at Cummins Inc. looks positively puny by comparison. And yet the fact that it has done less well than some companies, has some investors believing it has greater room to run. Investors like ...

The bull case for Cummins
CAPS All-Star NORMALBULL, who expects Cummins to profit as "Older rigs are ... replaced with new fuel efficient ones."

And CAPS member 133T4dip, who thinks "CMI has very good long term prospects. A large part of its current success is because it entered China, India and Brazil decades ago before other companies. They are reaping those rewards only now. These three exploding economies account for a large part of CMI's revenue, and it doesn't show any signs of slowing down. Compared to CAT, it's really cheap, and I think it has better long term prospects than CAT." (For the record, while both stocks are rated four stars on CAPS, Cummins sells for 22.5 times trailing earnings, and Caterpillar (NYSE: CAT) for more than 30 times.)

CAPS investor gweech, who may not be quite as enthusiastic as 133T4dip, admits that Cummins has a "[d]ecent enough balance sheet with enough cash. They are well diversified as a company with multiple manufacturing groups. Most importantly, their CEO has been mentioned multiple times this year as one of the best and is credited with incredibly strong leadership in turning this company around."

Cummins 'round the mountain
I never thought I'd hear a sentence like this one coming out of my mouth, but ... "gweech has a point." With most analysts projecting that Cummins will continue growing its earnings at better than 20% per year over the next five years, Cummins really doesn't look expensive at a 22.5 P/E. The company even pays a dividend (only 1%, which is about half Caterpillar's payout, but still -- money's money.)

Still, when I look a little closer at Cummins' financials, I also have to say that I see reason to worry. Over the past 12 months, you see, Cummins has only generated actual free cash flow ($750 million) sufficient to back up about 80% of its $948 million in reported "earnings," as calculated under GAAP. This isn't uncommon for Cummins, which has averaged about a 10% free cash flow deficit to reported earnings over the past five years.

Foolish takeaway
In other words, while Cummins looks reasonably priced when measured on its GAAP earnings, its free cash flow situation shows it's actually slightly overpriced. Call it 10% historically, or 20% more recently -- either way, there's less margin of safety in this stock's price than first meets the eye. When you combine this overvaluation with the rather ambitious growth rate upon which Cummins' valuation is built ... I'd say there's a significant risk that this particular rocket stock is running on fumes.

Maybe it's just me -- but I wouldn't want to be caught riding it when Cummins finally flames out.

Is it just me? Don't let a Fool make your decisions for you. If you have a different opinion on Cummins' prospects, tell us about it -- on Motley Fool CAPS.