Ever since I suggested a long Google (GOOG), short Yahoo! (YHOO) paired trade here back in July of 2006, it's been very interesting to compare the earnings reports of both companies to see exactly how the search market is playing out on the web. Yahoo! leads off by reporting its fourth quarter tonight (Google is slated to release results next Wednesday) and I doubt their results will be overly impressive.

The argument for the paired trade, in my mind, is twofold. I believe Yahoo! is becoming less and less relevant on the web, as Google takes market share in search and other competitors eat into their other businesses. In addition, there is a valuation gap that has Yahoo! trading at a premium to Google, despite its slower growth rate. Currently, Google trades at 35 times 2007 earnings estimates, versus Yahoo! at 46 times.

The two most common arguments for why Yahoo! trades at a premium are its more diverse product line (Google gets nearly all of its profit from search, whereas Yahoo! is less concentrated there), and its equity investment in publicly traded Yahoo! Japan (Yahoo! owns 34%, worth approximately $8 billion). I feel these two arguments are lacking in two respects.

First, Yahoo!'s more diverse product line, while evident, will not necessarily translate into better operating performance. Since the bottom line is the most important driver of shareholder value over the long term, I don't think it warrants a huge valuation gap with the likes of Google.

Second, investors who merely subtract $8 billion from Yahoo!'s market cap to account for their stake in the Japanese company and recalculate the stock's P/E ratio are being too simplistic. This action does reduce the company's valuation (YHOO's 2007 forward P/E would drop from 46x to about 36x if you subtract $6 from YHOO's share price) but such an adjustment is not enough. The reason is because Yahoo! includes its share of Yahoo! Japan's operations in its own income statement.

If their 34% share of the Japanese company wasn't accounted for at all by Yahoo when it reports earnings, then investors would be right in simply adding $8 billion to their valuation models. However, investors in Yahoo! are indeed already paying for Japan's business. If people want to add the equity value of the Yahoo! Japan stake to Yahoo's overall valuation, they must also subtract its contribution to Yahoo!'s reported earnings so nothing is double counted.

We'll see what tonight's report from Yahoo! brings. Since I put on the paired trade about six months ago, Google shares have risen by 19%, while Yahoo! has dropped 15%. So far, so good.

Full Disclosure: Long GOOG and short YHOO at time of writing