This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best ...
Yahoo! (NASDAQ:YHOO) shareholders are all smiles this morning, watching their stock race ahead of the market. For their good fortune they can thank the friendly bankers at Kaufman Bros. for a timely and ... dare I say "logical" upgrade?

Arguing that Yahoo! is enjoying stronger search performance than some analysts have suggested, that the display advertising market is "firming," and that approval of the Microsoft (NASDAQ:MSFT) deal to outsource search functions could provide around $500 million in savings to operating income a year, Kaufman upped its rating to "buy." Investors have responded by bidding the shares up to nearly $16, but if Kaufman's right, there's still $4 more profit ahead of us as these shares climb toward its $20 price target.

30% profits, ho!
Nearly 30% upside from the pre-upgrade price? Sounds pretty attractive to me, but if Kaufmann is right about this, the reaction from investors actually looks a little underwhelming, with the shares up less than 2% since news of the upgrade broke. The more so when you consider Kaufmann's strong record in the Internet Search and Services space:

Now, that's not to say that Kaufman is perfect. Like all of us, it's subject to errors of judgment from time to time:

But overall, the analyst's record of better than 60% success in this sector -- and a combined 550 percentage points worth of market outperformance across its multiple picks -- argues strongly in favor of today's Yahoo! pick. Kaufman's status as an analyst ranked near the top 10% of investors we track on CAPS owes largely to its success in picking i-winners like Yahoo!

But isn't it too expensive?
At first glance, and right now, yes -- Yahoo! does look a mite pricey. Any time a stock reaches a triple-digit P/E, you're right to question whether it's perhaps costs just a bit too much. But before dismissing Kaufman's advice out of hand, consider what Yahoo! might look like tomorrow.

Right now, Yahoo! is generating some $800 million in free cash flow from its business -- several times more than it reports as net income under GAAP, in fact, which explains the triple-digit-ness of its surface valuation. But if offloading the search business and its related costs onto Microsoft can indeed boost $500 million in annual operating income for Yahoo!, and if Yahoo! can succeed in converting most these gains into cashflow, we could soon see the company generating something closer to $1.1 to $1.2 billion in annual cash profit.

For a $22 billion stock like Yahoo, that translates into a price-to-free cash flow ratio of roughly 19 -- not bad when you consider that most analysts expect Yahoo to grow at near-18% annually going forward. Now, throw in the fact that Yahoo's cash stash ($3.9 billion cash and equivalents, versus less than $100 million in debt) lowers the price on the actual business you are buying, and the enterprise value-to-free cash flow ratio on this puppy drops down to something more like 16 times.

Foolish takeaway
If -- and yes, in investing it's always a big "if" -- Yahoo can come close to the growth rates that Wall Street posits for it, this suggests a reasonable margin of safety exists for the stock at today's prices. Whether it's big enough to generate the full 30% profits that Kaufman envisions remains to be seen. But if you ask me, yes, initial indications look good.