Jerry Yang is asking for a lot. The Yahoo! founder and chief executive is turning down a bid from Microsoft that values the search engine at 66 times last year’s net earnings. That sort of valuation would have most company bosses holding up their hands in surrender.

The decision is based, officially at least, on a remarkable optimism about Yahoo!’s ability to trade its way out of its difficulties, but the harsh reality is that the undersiege search engine probably needs a deal if it is to escape Microsoft’s clutches. Even that appears to be a stretch.

In a lengthy e-mail to staff, Mr Yang emphasised the value in the Yahoo! brand, with 500 million users worldwide, and the heavy spending the company has made in the past two years. The way Mr Yang sees it, this is the “pivotal moment” to capitalise.

Yet the promise is always on the verge of materialising when a company marshals its defences. Mr Yang highlighted a “double-digit” improvement in operating cashflow in 2009, a jam-tomorrow promise that concedes that 2008 will be less good. Operating cashflow is projected to decline slightly in 2008 from $1.92 billion (£974 million) to about $1.85 billion.

Yahoo! relies on the belief that online advertising is rocketing, from $45 billion in 2007 to $75 billion in 2010 – implying annual growth rates of 15 to 20 per cent, but the search engine is underperforming that. It managed 8 per cent last year, far below Google, and is aiming at 9 per cent this year, which means one of the world’s most popular websites is losing market share.

Yahoo! can make two credible points. First, it is easy to undervalue its substantial minority stakes in Alibaba, the Chinese online market place, and Yahoo! Japan, where its branded partner is the market leader. Jeff Lindsay, at Sanford Bernstein, valued these together at $17.6 billion, accounting for just over $13 of Yahoo!’s $29.68 share price – although the affiliates contributed a more modest 15 per cent of operating profit last year.

The second point is that Microsoft’s timing is opportunistic. Although the bid does place a significant premium on Yahoo!, internet valuations have always been inflated because of the growth potential. Mr Yang can argue that when Microsoft made its bid, Yahoo! shares were trading at their lowest levels since 2003. Sentiment could turn upwards again.

The key phrase in Mr Yang’s e-mail was the observation that Yahoo! is “continuously evaluating all of its strategic options”. Noises about some sort of tie-up with Time Warner’s AOL – hardly an advert for a successful web business – were being played down by Time Warner management yesterday. Yahoo!, though, privately is enthusiastic.

It always remains possible that another white knight could arrive, but it would have to bid aggressively to match Microsoft’s fire power, without any obvious synergies. EBay is not the force it once was. Amazon, at $31 billion but better run, does not obviously fold together with Yahoo!’s targeting of advertising revenues.

Yahoo! will have to take some time to explore its options, while Microsoft can afford to wait. Jerry Yang needs a clear, compelling alternative.

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