Mayer's Yahoo: Outcome of acquisitions will be the key
Yahoo! Inc. (NASDAQ:YHOO) has been using the Google playbook; free meals and iPhones for employees. The Sunnyvale, CA based search giant has also started buying small tech startups to gain a wider audience. It all started with the purchase of the social media site Snip.It and now it is the headlinegrabbing acquisition of blogging site Tumblr for $1.1B. This is a big step in boosting Yahoo's mobile ad business as a lot of Tumblr users are teens and young adults that log into the site via its wellliked mobile app.
Yahoo has also been in talks to buy Hulu. This would be a good purchase as it is a popular videostreaming service that would give Yahoo additional advertising revenue. Hulu has a strong user base and the subscription revenue will also factor into any potential offer.
It is true that Yahoo has a bad record with its past acquisitions with GeoCities being a famous example. But that is going to change under Mayer who has been instrumental in leaving the underlying structure of a purchased company mostly unaltered. At the end of the day, Yahoo will be judged on the success of Tumblr over the next couple of years and this is justifiable given the $1.1B price tag.
With all that Yahoo has got going on, the stock makes sense for a value play. I want to see how much I should pay for Yahoo shares and I will use the present value of free cash flows (FCFF) to find out.
Present Value of FCFF
Valuing Yahoo using the present value of FCFF makes a good case to buy the stock right now. The Present value of FCFF is an easy to use tool for investors to quickly assess a stock as it is great at finding intrinsic stock value estimates.
The Present Value of FCFF is based on a discounted cash flow (DCF) valuation technique. The idea is that if the value obtained from this method is higher than what the shares are currently trading at, then the stock is undervalued.
Free cash flows are basically cash flows minus direct costs and payments made to capital suppliers.
Intrinsic Stock Value
This is using the free cash flows.
Year 
Value 
FCFF_{t} or Future Value [FV_{t}] 
The Math 
Present Value at 6.64% 
0 
FCFF0^{1} 
921 

1 
FCFF_{1} 
893 
=921*(1+ 2.98%) 
837 
2 
FCFF_{2} 
878 
=891*(1+ 1.50%) 
823 
3 
FCFF_{3} 
876 
=876*(1+ 0.025%) 
822 
4 
FCFF_{4} 
888 
=875*(1+ 1.45%) 
833 
5 
FCFF_{5} 
913 
=887*(1+2.93%) 
856 
5 
FutureValue (FV_{5}) 
25,330 
=913*(1+2.93%)/(6.64% 2.93%) 
23,753 
Intrinsic Value of capital 
27,924 

Less: Debt (Fair Value) 
 

Intrinsic Value of common stock 
27,924 

Intrinsic Value of common stock (per share) 
$25.02 

Current share price 
$25.81 
1 FCFF_{0} = 2012 Values
It is easy to see that Yahoo is trading close to its intrinsic value (a little overvalued) from the table above and so it makes for a fairly good investment idea. But there must be a number of questions on your mind. Specifically, what is the "calculation" column and how are the growth rates obtained. The good thing is that I am going to show you everything so that you will be able to do a Present Value of FCFF valuation on any stock you wish to analyze.
First, here is how the FCFF for 2012 is arrived at.
12 months ended 
Dec 31, 2012 
EBIT* ( 1  T ) 
2,655 
Add: Depreciation & Amortization 
655 
Investment in Long Term Assets 
(272) 
Investment in Working Capital 
(2117) 
Free Cash Flow to the Firm [FCFF] 
921 
USD $ in millions
Weighted Average Cost of Capital  WACC
To calculate the WACC simply take the weight of the source of financing and multiply it by the corresponding cost. There is one exception: you should multiply the debt portion by one minus the tax rate. Then sum the totals. The equation looks something like this:
WACC = W_{d} [k_{d}(1t)] + Wce(kce) 
Where:
 WACC = weighted average cost of capital (firm wide required rate of return)
 W_{d} = weight of debt
 k_{d} = cost of debt financing
 t = tax rate
 W_{ce} = weight of common equity
 k_{ce} = cost of common equity
Yahoo has no debt and so we can forget about the debt part of the equation and focus only on the common equity component.
Then for kce, we look up Yahoo's beta value which is 0.91. We then subtract the riskfree alternative rate which is the current yield to maturity of a 10year Tbill which is about 2% from the overall market return which is taken here as the return of the S&P 500 over the last 10 years. So we subtract 2% from 7.1% to get 5.1%.
We then multiply this figure by the stock's beta value and we end up with 4.64%. The riskfree rate is added to this to calculate the required rate of return on equity. In this case, it is 6.64 percent.
Then WCE will be 1 because Yahoo has no debt. We proceed to put these values in the WACC equation above:
WACC = 0 +1(6.64%)
WACC = 6.64%
FCFF growth rate [g] implied by DuPont Analysis
Dec 31, 2012 
Dec 31, 2011 
Dec 31, 2010 
Dec 31, 2009 
Dec 31, 2008 

Selected Financial Data (USD $ in millions)  
Provision for Income tax 
1,940 
242 
222 
219 
263 
Net income 
3,945 
1,049 
1,232 
598 
424 
Tax rate^{1} 
32.97% 
18.75% 
15.27% 
26.81% 
38.28% 
Interest expense after tax and dividends^{2} 
3,945 
1,049 
1,232 
598 
424 
EBIT(1  Tax Rate)^{3} 
2,655 
852 
1,044 
438 
262 
Total stockholders' equity 
14,560 
12,541 
12,558 
12,493 
11,251 
Total capital^{4} 
14,560 
12,541 
12,558 
12,493 
11,251 
1 2012 Tax Rate = [Provision for Income Tax/(Net Income + Provision for Income Tax)] * 100
=[ 1,940/(3,945 + 1,940)] * 100 = 32.97%
2 2012 Yahoo has no interest Expense and dividends paid over the last five years
3 EBIT*(1tax rate) is the cash flow from the firm's operations assuming no debt financing. This is the net income added to the interest expense after tax. For 2012, EBIT*(1tax rate) = 3,945*(132.7%) = 2,655
4 Total Capital = Shortterm debt + Longterm debt + Total Stockholders' equity (Yahoo has no debt)
From the values in the table above where we derived the "Total Capital" figure we need in this analysis, we compute the Retention Ratio (RR) and the Return on Invested Capital [ROIC] for the last 5 years. The calculations for 2012 are shown here.
RR = [EBIT(1  Tax Rate)  Interest expense after tax and dividends]/ EBIT(1  Tax Rate)
= [2,655  3,945] ÷ 2,655 = 0.49
ROIC = [EBIT(1Tax Rate)/total capital] * 100
= [2,655/14,560] * 100 = 18.23%
The values for the last 5 years are listed below.
RR 
0.49 
0.23 
0.18 
0.37 
0.62 

ROIC 
18.23% 
6.79% 
8.31% 
3.51% 
2.33% 
We will then find the averages of these RR and ROIC values and their product gives us the growth rate of FCFF or g. The averages are 0.38 and 7.83% respectively.
g = RR * ROIC = .41 * 7.93% = 2.98%
The growth rate can be difficult to predict and can have a drastic impact on the resulting value of the firm. This is why we use two growth rates and then use linear interpolation for the rest of the growth rates.
Singlestage model FCFF growth rate [g]
g = {Enterprise Value * WACC  FCFF0/(Firm Value + FCFF0)} * 100
= {25,540 × 6.64%  921)/(25540 + 921)} = 2.93%
Year 
Value 
g_{t} 
1 
g_{1} 
2.98% 
2 
g_{2} 
1.50% 
3 
g_{3} 
0.025% 
4 
g_{4} 
1.45% 
5 and thereafter 
g_{5} 
2.93% 
where:
g_{1} is implied by the DuPont formula
g_{5} is implied by singlestage model
g_{2}, g_{3} and g_{4} are calculated using linear interpolation between g_{1} and g_{5}
Calculations
g_{2} = g_{1} + (g_{5}  g_{1}) × (2  1) ÷ (5  1)
= 2.98% + (2.93%  2.98%) × (2  1) ÷ (5  1) = 1.50%
g_{3} = g_{1} + (g_{5}  g_{1}) × (3  1) ÷ (5  1)
= 2.98% + (2.93%  2.98%) × (3  1) ÷ (5  1) = 0.025%
g_{4} = g_{1} + (g_{5}  g_{1}) × (4  1) ÷ (5  1)
= 2.98% + (2.93%  2.98%) × (4  1) ÷ (5  1) = 1.45%
Conclusion: Is Google's dominance unsurpassable?
Yahoo knows that it will have to step up its game to compete with Google Inc. (NASDAQ:GOOG). GOOG has made some great acquisitions in the past, most notably the YouTube video streaming service. Yahoo is trying to narrow the gap by spending a lot of its cash. The Tumblr and PlayerScale acquisitions is a move away from its traditional business. Yahoo's shareholders must be hoping that the internet giant can buy Hulu as well as it looks like the most promising of the three. But a deal might be hard to get as the price target could be too high for Yahoo and then there is the competition that will come from Netflix, Inc. (NASDAQ:NFLX) if Yahoo snaps up Hulu.
I have no qualms with what Yahoo is doing at the moment as the Ali Baba sale late last year netted the company $2.8B. So Yahoo has a lot of cash and it can either sit on it or use it to fund purchases that can bring in additional revenue and content. Yahoo needs to outpace its Silicon Valley rivals and these large cap tech companies have been quite active. Facebook (NASDAQ:FB) recently bought Instagram for close to $1B. The recent acquisitions by Yahoo are a gamble and they had to be taken.
Still, there are a lot of reasons for investors to be bullish about Yahoo. Mayer's Yahoo has a highly competent management team and now there is Tumblr's David Karp that joins the ranks. The 26year old selftaught Karp has a very unique story and he actually makes me believe in Tumblr and that the match with Yahoo is a good one.
Moreover, the Present Value of Free Cash Flows reveals an intrinsic value of $25.02 a share and Yahoo shares are currently hovering slightly above this value. This is a good time to buy Yahoo stock and it could continue to dive slightly postacquisition in the coming weeks enabling investors to dollar cost average.
All material sourced from Morningstar and MSN Money.
Disclosure: I am long YHOO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.