Financially and operationally, Web search and online tools giant Yahoo! is rolling. Its business has sweet dynamics and is performing well as the online advertising business has recovered. Investors have bought into Yahoo!'s resurgence, bidding up shares approximately 180% in the last 12 months.
But that puts both current and potential investors in a difficult position today. Does the company justify, and can it continue to justify, its current share price? From my perspective, it seems doubtful.
There's concern on the business side. Despite recording solid gains in sales and earnings in recent quarters, a theme discussed in the company's second-quarter 10-Q filing raises questions about the quality of the growth at Yahoo! While revenue is growing in the company's key marketing services segment, the average price collected for page impressions and "clickthroughs" is under pressure.
There are similar rumblings at Overture Services, which Yahoo! bought earlier this year in a mostly stock deal. Overture, a pay-per-click online search company, has expressed concern that it's collecting less per click from customers. This, in turn, has caused it to broaden its customer search. More, smaller customers help revenue, but in the end can hurt the bottom line.
Both of these tidbits are just another way of saying Yahoo!'s strong business position and improving market comes with a tradeoff: tough competition. As the online advertising business continues to recover -- a phenomenon validated by the increased quality, legitimacy, and financial health of competitors Google, Ask Jeeves
Admittedly, Yahoo! is doing well in the face of competition. It continues to grow net profit, thanks to strong gross and operating margins, and to deliver free cash flow well in excess of earnings. Despite this, however, investors are being asked to pay an awful lot for this company. Using a market capitalization of about $26 billion and a price per share of $40, the company is valued at more than 100 times projected 2003 earnings and 70 times projected 2004 net income. A forward PEG ratio of 2.5 is anything but cheap, even given the sort of growth the market expects.
While paying a premium for a growing, market-leading company is certainly understandable, the current multiple seems excessive. Calculating Yahoo!'s sustainable long-term earnings growth rate using a simple formula for a range of years starting in 1999 and including the past 12 months, we get numbers that run from the negative (because of the net loss in 2001) to about 9%.
Yahoo!'s growth is still erratic -- in a good way, lately -- so that number is perhaps most useful as a reminder that forecasting rapid long-term growth for a company, as the market seems to be doing for Yahoo! at the moment, is a risky business. Taken together, the data surrounding Yahoo!'s stock provides plenty of reasons for pause today.
While the company looks as strong as it has in some time, I'm confident that there are plenty of stocks where I can find a greater margin of safety without sacrificing what's good about Yahoo!: growth, financial strength, and market positioning.
Dave Marino-Nachison doesn't own shares of any companies in this story. He can be reached at firstname.lastname@example.org.
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