When Is a Value Really a Value?

Once a week, I take a look at the benefits of dividend investing or examine an interesting dividend-paying company. But this week I'm going to take a step back and talk about valuation because, at its core, investing for dividends is about buying dividend-paying companies when their valuations are attractive. It's not just about buying yields.

As much as I enjoy the dividend payments streaming into my account, I sometimes wander off the high-yield path toward companies with smaller dividend yields or (gasp!) no dividend at all. Claire'sStores (NYSE: CLE), Timberland (NYSE: TBL), and Starbucks (Nasdaq: SBUX) are three companies I keep an eye on, and all pay little or no dividend. But when I do go down this path, I'm generally looking for two things: a durable business with growing free cash flow (FCF) and the potential to pay out dividends.

What people call value sometimes isn't
I've come across a few articles and message board postings recently that sing the praises of Yahoo! (Nasdaq: YHOO) and its attractive valuation. In fairness, these valuations are being made relative to Google (Nasdaq: GOOG) and are usually based on a price-to-earnings ratio (P/E) or EBITDA. I'm going to skip over the fact that relative valuation by itself can get you in a heap of trouble. Instead, I'm going to focus on straight-up valuation based on Yahoo!'s FCF, and see whether it should be on my watch list.

The cash flow story
A look at Yahoo!'s numbers shows the company isn't generating FCF at nearly the rate that its accrual earnings would lead one to think.

The standard calculation for FCF is cash flow from operating activities minus capital expenditures. From there, I make two adjustments. The first is removing the tax benefits from stock options. I remove these because exercising stock options has nothing to do with the company's operational capabilities and because the amounts vary with stock price increases and stock option exercises, not with operational performance. The other item I adjust for is acquisitions because they are commonly made in place of capital expenditures -- a buy-versus-build decision. And for Yahoo!, acquisitions are annual phenomena.

The table below shows selected cash flow data for Yahoo! for the past five years.

	2001	2002	2003	2004	2005
Net income	-$92.8	$42.8	$237.9	$839.6	$1,896.2
FCF	$20.7	$250.8	$310.8	$844.3	$1,302.5
Tax benefit from options	$2.0	$60.4	$124.9	$409.0	$759.5
FCF without tax benefits	$18.7	$190.4	$185.9	$435.3	$543.0
Acquisitions	$19.2	$189.2	$378.0	$761.6	$1,698.2
FCF after acquisitions and without tax benefits	-$0.5	$1.2	-$192.1	-$326.3	-$1,155.2

Data in millions and from Capital IQ, a division of S&P.

So with these adjustments, Yahoo! has generated only a fraction the cash flow that its earnings imply. Using an adjusted FCF figure as the basis for valuation reveals that there's not nearly as much value here as one might assume by looking at its P/E. That's not to say Google is a great deal, either. Yahoo! just isn't the deal some might think.

Foolish final thoughts
The most important thing I take away from this analysis is that Yahoo! is still a young company with plenty of growth potential, but it's yet to find a way to consistently deliver on its potential cash flow. In the future, it could prove to be a great company, but its current financials just don't justify its valuation. And my second important takeaway: Yahoo! is nowhere near being able to support a dividend, but things could look quite different a few years from now.

In our Motley Fool Income Investor service, Fool dividend guru Mathew Emmert uses FCF as one of many metrics to separate the healthy dividend payers from the dividend pretenders. If you'd like to take a free 30-day trial and learn more, click here.

Nathan Parmelee owns shares in Starbucks but has no financial stake in any of the other companies mentioned in this article. Starbucks is a Motley Fool Stock Advisor recommendation. The Motley Fool has adisclosurepolicy.