Is Yahoo! Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's look at what Yahoo!'s (Nasdaq: YHOO  ) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell Yahoo!'s story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always reported at a steady rate, we'll also look at how much Yahoo!'s free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Yahoo!'s share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is Yahoo! managing its resources well? A company's return on equity should be improving, and its debt to equity ratio declining, if it's to earn our approval.

By the numbers
Now, let's take a look at Yahoo!'s key statistics:

YHOO Total Return Price Chart

YHOO Total Return Price data by YCharts.

Passing Criteria

3-Year* Change 

Grade

Revenue growth > 30%

(24%)

Fail

Improving profit margin

57.5%

Pass

Free cash flow growth > Net income growth

89.7% vs. 2,700%

Fail

Improving EPS

3,190%

Pass

Stock growth (+ 15%) < EPS growth

4.2% vs. 3,190%

Pass

Source: YCharts.
*Period begins at end of Q3 2009.

YHOO Return on Equity Chart

YHOO Return on Equity data by YCharts.

Passing Criteria

3-Year* Change

Grade

Improving return on equity

2,380%

Pass

Declining debt to equity

No

Fail

Source: YCharts.
*Period begins at end of Q3 2009.

How we got here and where we're going
Yahoo! puts forth a solid performance with four of seven possible passing grades, although its bottom-line numbers were skewed by the sale of its Alibaba assets. Without that huge one-time adjustment, Yahoo! might be in even better shape, as odd as that might seem -- its adjusted third-quarter earnings were still a solid improvement over last year's results. A small increase in debt from its formerly debt-free position also costs Yahoo! a point. Can Google (Nasdaq: GOOG  ) transplant Marissa Mayer keep Yahoo! on a growth trajectory without resorting to more asset sales?

To do so, she will have to contend with an array of content threats that could undermine her efforts to refocus Yahoo! on entertainment offerings. Google's dominance of the search market is an established fact by now, but it also has content initiatives through YouTube and Google+. Well, sort of with Google+. One of the greatest "content" initiatives the Internet has ever seen is Facebook (Nasdaq: FB  ) , on which Americans spend eight hours per month, on average, essentially creating the content of their own lives. And then there's AOL (NYSE: AOL  ) , which has a long, troubled history in the content ecosystem, but which appears to be finally making progress in areas Yahoo! would love to claim.

However, "content" need not be defined so narrowly. Rumors have swirled that either restaurant-reservation company OpenTable (Nasdaq: OPEN  ) or mobile-advertiser Millennial Media (NYSE: MM  ) might be targets for Mayer's elephant gun, so to speak. Branching out to help millions of Yahoo! users make reservations could deepen their connection with a brand that simply isn't as embedded in most lives as Google, which follows its users from the desktop to the tablet to the smartphone, with functionality to make many parts of life more efficient. Millennial Media would give Yahoo! that toehold in the mobile space it desperately needs to avoid becoming yesterday's tech company. Yahoo's already made one very small mobile acquisition, but Millennial Media is a much bigger mobile fish.

Yahoo! has done well this year, but to truly succeed over the long run, it must come up with a coherent strategy to succeed in a very different operating environment than the desktop era it was built for.

Putting the pieces together
Today, Yahoo! has some of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.


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