There's an easier way to create materials. VTFEdit is a tool created by Nem (Ryan Greggs) that puts an easy-to-use GUI over the default SDK texture creation. You can grab it from http://nemesis.thewavelength.net/index.php?c=238#p238. You'll need Microsoft's .NET framework to run the program (also available at the previous web page) as well.

Using VTFEdit is much easier than typing your own commands and creating a folder network. Run VTFEdit and navigate to File | Import to choose an image to import.

A great thing about VTFEdit is its ability to import multiple image types. As long as you conform to the size constraints, you can import bitmaps, PNGs, JPEGs, and many more. After choosing your file, you will see a prompt showing a slew of options. Click on OK to continue, as shown in the following screenshot, since the defaults will most likely suit your needs:

Once you have imported an image, navigate to File | Save to create a VTF based on your imported image, making sure you choose...