Anonymous Demon

See my original post here: Google Inc (GOOG)

I started writing this review in January, when Google was priced above $600. I then got busy with life and put this review on hold. Here’s how I started:

Once again I failed to follow my own advice and lost out on some nice gains posted by Google. I purchased Google twice in 2010, with an average price of $530. After my first purchase at $580, it dropped $100 and I purchased again. If I would have held until today, I would have been looking at a 15% gain. Instead, I sold at break-even because I was worried about a market down turn.

I need to take Warren Buffet’s advice to heart. The market cannot be predicted. Just because the market *should* go up or down doesn’t mean that it will. Instead of trying to predict, I should just find good companies, wait for them to be priced well, and buy to hold. The reason to sell should be that the stock price is significantly higher than what the fundamentals of the company warrant. This situation signifies a bubble and would be a good time to go to cash.

I’ve since re-purchased Google and intend to hold it for Buffet’s favorite holding period — forever (or once the price is much higher than is warranted by its fundamentals.)

I built a spreadsheet last year and plugged in Google’s numbers. I crunched and crunched until I came up with what I considered a conservative plan. I determined that Google should have a sustainable growth rate of 24% a year (yes, that’s more than the 18% I wrote in my first article.) I plotted estimates for 2010 that looked as follows.

Book: $118.25 per share
Earnings: $25.29 per share
Price: $605 per share

Amazingly, Google performed very close to my estimates.

Book: $121.20 per share
Earnings: $26.31 per share
Price: $620 per share

If Google’s fundamentals matched so closely to expectations, why has their share price not matched the expected prices I posted? The world is fickle. They missed their recent earnings by $0.02, which sent the share price down. They’ve changed CEO’s, which scares people… maybe something bad is happening. Finally, I used overly optimistic calculations. The world is much different today than it was five years ago. Investor’s are more risk-averse.

I’m satisfied with my expected growth rate of 24%. Because a fair P/E ratio is the same as a company’s expected growth rate, Google’s current price should be $631 based on its earnings. It’s currently 19% below that. If Google continues to grow at 24%, the share price could touch $780 sometime in the next year. Here’s what I’m looking for at 2011 year-end.

Book: $150.56 per share
Earnings: $32.68 per share
Price: $621 per share

This price uses today’s P/E ratio of 19. I believe Google warrants a higher P/E but what I think doesn’t really matter. There are reasons its P/E could go up and reasons it could go down. I’m going to be conservative and use today’s P/E instead of relying on the best-case scenario. Here are prices at various P/E ratios using an estimated 2011 earnings per share of $32.68.

P/E 14 (low from 2009): $458
P/E 16 (low from 2010): $523
P/E 19 (current): $621
P/E 21 (growth rate expected by S&P): $686
P/E 24 (fair P/E based on expected return): $784