Still Crazy After All Three Years

Let's compare the sector with the broad market. TheStreet.com's Internet Index measures the Internet sector. This group contains giants such as Microsoft, IBM(IBM - Cramer's Take - Stockpickr), Cisco(CSCO - Cramer's Take - Stockpickr) and Oracle(ORCL - Cramer's Take - Stockpickr), as well as troopers such as eBay(EBAY - Cramer's Take - Stockpickr) and Amazon(AMZN - Cramer's Take - Stockpickr), along with high-profile flotsam such as AOL Time Warner(AOL - Cramer's Take - Stockpickr). The Russell 3000 represents the broad market. The relative performance should surprise no one.

It Can't Go Lower, Right?

Source: Bloomberg

All call options are characterized by a limited loss feature. As the joke runs, that's all you can lose, and I'll guarantee that you'll lose it. The relative performance of the DOT to the Russell over the past year suggests we have realized the maximum loss. What will it take in earnings growth to justify Yahoo!'s price, and should anyone be willing to, once again, buy the entire sector in hopes of extracting a glistening pearl from a humble oyster?

Trees Grow to the Sky, Don't They?

At the close of business on Dec. 18, 2002, Yahoo! was selling at 110.53 times expected 2003 earnings, which translates to an earnings-to-price ratio of 0.905%. This number can be compared with the 4.034% yield on the 10-year note, which also is an E/P.

The analyst consensus for Yahoo!'s long-term growth rate was 23.34% a year. At year-end in 1999, the comparable numbers were an expected P/E of 983.38 and earnings growth of 56.06%, so some measure of reality has descended upon the land. A one-year call warrant's volatility was at 70.1%, comparable with the 1999 number.

The estimated P/E of 110.53 implies average annual growth of 41.567% for 10 years.

Earnings Growth Required to Justify Yahoo!'s Multiple

Source: Bloomberg

Can Yahoo! grow so rapidly? Probably not, and I haven't seen anything over the past three years that would indicate the Internet industry can grow at such a pace, either. So, should we load the cannon and point it at Yahoo!'s head?

The Bet

If Yahoo!'s earnings did in fact grow at 41.567%, the company's earnings would be 31.33 times as great at the end of 2012 as they are today. If we plug these numbers into the rangebound formula below to see how many standard deviations, Z, we would have to move from the current price to get 33.1 times current earnings; we can solve for Z = 0.66.

The 0.66 number for Z corresponds to a probability of 74.7% that Yahoo!'s earnings won't grow that much. Convert this number to odds, 0.747/(1 - 0.747), and we find that we only have odds of 2.96:1 of winning our bet against Yahoo!.