- We were once bearish on Yahoo, but the potential monetization of its Asian assets has proved us wrong.
- We're still surprised the market is valuing Alibaba at such a lofty price, but we admit there is a ton of value in this asset.
- We think Yahoo may have reached its peak share price range at this juncture.
What do Bill Miller, Warren Buffett, and Valuentum have in common? They perform cross-methodological work. Miller put up a great streak by buying undervalued, growth companies, while Buffett understands that growth is just a part of the value equation. Buffett's strong performance (momentum) from buying undervalued (value) stocks makes him one of the first investors to have used the Valuentum style without even knowing it. Let's apply the Valuentum process to Yahoo's (NASDAQ:YHOO) shares in this article.
But first, a little background to help with the terminology. We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Think of Bill Miller scooping up high-growth Amazon (NASDAQ:AMZN) as a value investor, or Warren Buffett holding a strong-performing (high-momentum) stock that he still thinks is undervalued for years. He may only see it as undervalued, but it's at Valuentum stock. This is what the Valuentum process entails in combining processes from value through momentum as the directional arrows reveal.
(click to enlarge)
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Yahoo posts a Valuentum Buying Index score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. The Valuentum Buying Index is an actionable methodology at any point in time. So, for example, if Yahoo had registered a 9 or a 10 on the index (a "we'd consider buying rating) several months ago, we'd still be holding it until it registers a 1 or 2 on the index (a "we'd consider selling" rating). Said another way, we like stocks that are underpriced and moving higher and dislike stocks that are overpriced and moving lower. To many investors, this is just common sense. To others, they don't know of another way to invest. For relative valuation purposes, we compare Yahoo to peers Facebook (NASDAQ:FB), Google (NASDAQ:GOOG), and Baidu (NASDAQ:BIDU).
Yahoo's Investment Considerations
• 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. Its ownership stakes in Alibaba and Yahoo Japan are quite valuable ($30 per Yahoo share, by our estimates).
• Yahoo's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in core business fundamentals and an inability to earn economic profits through the course of the economic cycle (note the emphasis on core). We think there are better quality firms out there.
• 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.
• The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming. We only consider firms to be overvalued or undervalued if their share prices fall outside the estimated fair value range.
• New CEO Marissa Mayer is working 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 credit the management team.
An Exercise in Valuation
Recently, we raised our intrinsic value estimate of Alibaba to approximately $100 billion from $75 billion previously. Our updated valuation details of Alibaba are shown below.
The previous table had a typo regarding the long-term growth rate of the perpetuity calculation, which has been corrected in the table above.
Though we think our forecasts are very optimistic (~$100 billion fair value estimate), even more-optimistic analysts suggest that Alibaba could fetch an initial valuation of over $130 billion. We fully admit that $130 billion is within the range of probable outcomes for Alibaba's valuation as even small tweaks in the long-term growth potential can have large implications, and we're not ruling out the strong likelihood that its market capitalization (aggregate market price) may reach those levels shortly after going public. We value Yahoo! Japan at $7 per share, and the core business at $8 per share, which after backing out its non-core earnings, reflects an appropriate price-to-earnings multiple. We defend our $38 per share fair value estimate via a discounted cash-flow process shown below.
Yahoo's Core Business Quality
Economic Profit Analysis on Yahoo's Core Business
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. 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. Yahoo's core business is faltering.
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 Valuentum.com. 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.
Our discounted cash flow model indicates that Yahoo's shares are worth between $29.00 and $48.00 each. We think the high end of this range would reflect Yahoo retaining its complete stake in Alibaba and Yahoo! Japan, as is, and those two components growing rapidly in the future to demand even higher embedded valuations. We think the high end of the range is very unlikely. The lower end of the fair value range reflects continued evaporation of economic profit in Yahoo's core business and ongoing cash investments in value-destroying endeavors. Over the long haul, we think the low end of the range is more likely. The estimated fair value of $38 per share, however, is the most likely scenario, representing a price-to-earnings (P/E) ratio of about 11.6 times last year's earnings and an implied EV/EBITDA multiple of about 6.4 times last year's EBITDA. Shares of Yahoo are trading at roughly $35 at the time of this writing. 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 $38 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 $29 per share (the green line), but quite expensive above $48 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 $38 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 $52 per share in Year 3 represents our existing fair value per share of $38 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
The time to consider owning Yahoo was a few years ago. Now, that the word is out on its Alibaba stake, we see very little upside potential from its current fair value range. We missed the boat on this one. But we did even better with Google (NASDAQ:GOOGL) - see our history here.
Additional disclosure: BIDU and GOOG are included in the Best Ideas portfolio.