The Wall Street Journal is reporting that the Yahoo (YHOO) Board is going to reject Microsoft’s (MSFT) initial offer for the company, claiming that they believe the company is worth at least $40 dollars a share. This would mean (at least) an additional $12 billion dollars to Microsoft’s last offer for the company. I stated before that I think a fair value for Yahoo is $30 dollars a share, but only if Yahoo continues to grow free cash flow at 20% a year. Given this new magic number that the Yahoo board members have come up with, I think it is important to look at what type of grow is needed to justify paying such a hefty price for the number two company in search.

As the DCF Matrix indicates below, the new magic inputs are 28% compound FCF growth for five years, on a 7% discount rate:

I personally have a hard time believing that Yahoo is going to be able to accomplish this type of growth as the US economy is entering - or could possibly already be in - a recession, which would cause firms to cut back on their advertising budgets. Originally, I thought it made some sense for Microsoft to try to acquire Yahoo, but I was skeptical about whether or not they were getting a good price. Now that we know that Yahoo wants at least $40 dollars a share, I think it is fair to say that Microsoft should definitely walk away from this deal. Now the big question: will Microsoft walk away? I do not know what is going through the minds of Redmond, but paying $40 or more per share with the economy at the level that it is would be a big mistake for Microsoft. I think it would make much more sense to keep the cash and look for higher-ROI ways to deploy it, but it might not be that simple, and this deal price could become a function of how much Microsoft is willing to pay to take on Google in the online business.

And now, we await Microsoft’s response.

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