As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Yahoo's (YHOO) case, we think the firm is worth $10 per share, meaningfuly lower than where it is currently trading.
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.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale.
Yahoo earns a ValueCreation™ rating of excellent, the highest possible mark on our scale. The company has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 25.2% during the past three years.
Despite Yahoo's excellent rating, we don't think the firm's valuation indicates an attractive investment opportunity at this time. The market is pricing greater long-term revenue growth and profit expansion than we think is achievable.
Yahoo's second-quarter results left something to be desired. Revenue, excluding traffic acquisition costs, fell 5%, while GAAP revenue dropped 23%, as softness in display revenue and turnover at the sales level impacted results toward the second half of the quarter. The attractiveness of competing sites like Facebook and Google (GOOG) is becoming increasingly more difficult for Yahoo to overcome, in our opinion.
Once Yahoo's technicals turn decidely bearish (if the shares fell below $14), we plan on pursuing a put-option position in the portfolio of our Best Ideas Newsletter. This is change from our neutral assessment on the shares following its second-quarter report.
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 25.2%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of excellent. 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.
We think Yahoo is worth $10 per share, which represents a price-to-earnings (P/E) ratio of about 11.1 times last year's earnings and an implied EV/EBITDA multiple of about 7.2 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of -0.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -3.2%. Our model reflects a 5-year projected average operating margin of 19.5%, which is above Yahoo's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 1.1% for the next 15 years and 3% in perpetuity. We employ a 10.8% weighted average cost of capital to discount future free cash flows.
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 $10 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 $8 per share (the green line), but quite expensive above $13 pershare (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 $10 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 $14 per share in year 3 represents our existing fair value per share of $10 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.