Should Investors Use A Larger Than Normal Margin Of Safety On Yahoo?

| About: Yahoo! Inc. (YHOO)

Valuentum sometimes takes some criticism within the Seeking Alpha readership for our conservative nature -- meaning we like to have a large margin of safety around our fair value estimates. Such is the case for Yahoo (NASDAQ:YHOO), too. Though we're not so bold as to know why many may disapprove of using a margin of safety in investing (fair value range), we think part of it may rest on the idea that risk should be viewed as not only potential upside but also potential downside. In setting our margin of safety bands, we like to look at upside, too, and this informs the corresponding bands we place around our fair value estimate. That said, let's dig into Yahoo's margin of safety bands (remember, the high end of the range suggests potential upside).

Our Report on Yahoo

Investment Considerations

Investment Highlights

• Yahoo remains a premier digital media company. The firm generates revenue from the display of graphical advertisements, the display of text-based links to advertisers' websites, and other sources.

• Yahoo's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 2.2% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.

• Although we think there may be a better time to dabble in the firm's shares based on our DCF process (click here to learn more), the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.

• New CEO Marissa Mayer continues to turn things around at Yahoo. Given the incredibly competitive market for talent in the tech industry, Mayer has worked to transform the company into one of Silicon Valley's best places to work. We're expecting great things from her.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Yahoo's 3-year historical return on invested capital (without goodwill) is -62.9%, which is below the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of VERY POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Yahoo's free cash flow margin has averaged about 2.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At Yahoo, cash flow from operations dropped into negative territory from levels two years ago, while capital expenditures fell about 31% during this time period.

Valuation Analysis

Our discounted cash flow model indicates that Yahoo's shares are worth between $12 - $26 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. We admit this is a large range, but most holders of Yahoo may be happy to hear that we see upside to $26 per share. Want to learn more about why we use such a large range, click here. The estimated fair value of $19 per share represents a price-to-earnings (P/E) ratio of about 5.8 times last year's earnings and an implied EV/EBITDA multiple of about 12.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -8.3%. Our model reflects a 5-year projected average operating margin of 40.4%, which is above Yahoo's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For Yahoo, we use a 10.8% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $19 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Yahoo. We think the firm is attractive below $12 per share (the green line), but quite expensive above $26 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Yahoo's fair value at this point in time to be about $19 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Yahoo's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $26 per share in Year 3 represents our existing fair value per share of $19 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.