Remember about five years ago when 30x earnings was considered a fairly "rich" valuation? Nowadays, 30x revenues is often considered reasonable. And then there's our own Rule Making Internet portal, Yahoo! (Nasdaq: YHOO), which sells for more than 200x 1999 revenues! Is there any sanity whatsoever in these valuations? Strangely enough, I believe so. I think investors have figured out that companies that double their sales every year can grow from a start-up to a Fortune 500 biggie within the span of only a few years.
Last week, I said that the market perpetually overvalues predictability and undervalues expanding possibilities. Yahoo! may well be the king of expanding possibilities. In a recent interview with Knowledge@Wharton, Yahoo! CEO Timothy Koogle said, "The only way to scale a business without limits is to run a variety of experiments at the same time." Almost weekly, the company adds a new service to its network in order to further addict its 120+ million userbase. The latest additions to the _____.yahoo.com family are FinanceVision, a streaming webcast for financial news and information, and the B2B Marketplace, a one-stop industrial shop that amalgamates products for all industries from many B2B sites.
Additionally, Yahoo! is using acquisitions to build its business possibilities. Last Thursday, the company acquired Arthas.com, whose technology will enable Yahoo! to allow person-to-person online payments. The press release explains it thusly: "Arthas.com's technology platform enables individuals to electronically send money to and receive money from anyone with an email address. Individuals also can send personalized electronic bills to anyone with an email address, which can be quickly paid online using the payment service. Additional possible applications for person-to-person payments services include online auctions, classifieds and event planning." This acquisition should go a long way towards allowing Yahoo! to achieve its goal of being the Internet's largest gross enabler of transactions.
Attacking new business opportunities at every turn, Yahoo! is growing sales at a triple-digit pace. During this hypergrowth phase, making sense of a company's value can be an especially difficult task. Conceptually, the most important thing to realize as an investor is that high valuations are to be expected when buying a piece of a business that has the likelihood of being much, much bigger in only a few years.
I wouldn't describe Yahoo! as cheap, but it's price doesn't seem unreasonable considering the broad array of profitable expanding possibilities. The company hasn't yet released its full-year cash flow statement, but I'm guessing Yahoo! earned along the lines of $160 million in free cash flow. There are two ways to look at this: backwards and forwards.
The backwards method is the way most often presented by skeptical journalists on CNBC and in the pages of Barron's. From this point of view, Yahoo!'s valuation is an "outlandish" 750 times trailing cash flow. (Actually, these earnings-focused Wise guys would be more likely to tell you about the company's P/E ratio of 1968.) Looking at historical results can be incredibly useful, but it must be done in the right context. At Yahoo!'s 180 mph pace, it's ridiculous to expect a price-to-anything ratio to be at the same level as that of more mature companies.
That leads to the second method. The forward-looking investor will assess Yahoo!'s fast-growing business by doing some simple math and making some educated guesses at what Yahoo! might look like in only a few years. One way to go about this is to extrapolate free cash flow growth over the next five years.
If Yahoo! were to double its free cash flow for each of the next five years, it would have $5.1 billion in 2004 free cash flow. For context, that's more than three times the amount of free cash generated by Pfizer (NYSE: PFE) during 1999. And Pfizer's current market cap is $134 billion. From that perspective, Yahoo!'s $120 billion market cap doesn't look so ridiculous, eh? As you can see, little companies can QUICKLY become big during hypergrowth.
Consequently, a high-growth start-up with the promise of rapidly becoming a big profitable company is priced according to the company's soon-to-be-realized potential. It's kinda like the way parents buy clothes for a young child. Since you know your toddler's feet are going to grow like crazy, you don't buy shoes that fit just right, but instead buy shoes one or two sizes larger so the kid will grow into them. Similarly, in the stock market, high-growth companies are given valuations they will grow into.
With simple math and a close eye on Yahoo!'s business, I think we can foresee a continued profitable investment. And so here we are with the April $500 decision upon us, and Yahoo! continues to strike me as our quintessential Rule Maker. None of our other companies so perfectly meets our RM criteria while also having such a close connection with consumers the world over. Yahoo! now reaches 120 million monthly users in 22 countries. Those users find an ever-increasing bounty of services on Yahoo!'s network of sites, and therefore spend an ever-increasing amount of time on Yahoo! Correspondingly, demand for Yahoo!'s advertising services is hot, hot, hot. And meanwhile, Yahoo! continues to roll out creative new ways to monetize its userbase.
I've gotten used to the fact that the best companies are almost always the most expensive ones -- and justifiably so. Ever since Yahoo!'s huge run in November and December, I've been hoping for a pull back, at which time I hoped our portfolio might be able to scoop up some shares on sale. (By the way, that's not market timing, just market wishing.) Perhaps its a corollary to Murphy's Law, but I've noticed that the stocks you always wait to buy on a pull-back are the ones that just keep climbing steadily. Sure, they may pause and catch their breath from time to time, but it's never much of a meaningful pull-back. So even without the pull-back I'd hoped for, I now vote to give Yahoo! our next $500.
By the way, Zeke does an awesome job of covering Yahoo! as part of our new stock research. Check it out.
Have a great night!
