How did I not purchase Google at a price of $262 on 11/21/2008? What an epic failure!
Summary
1-Year Target Price: $945
Expected EPS Growth Rate: 18%
Scheduled Review Dates:
4/2010 - Next Earnings Release
1/21/2011 - Postmortem on 1-year target
| Expectation |
Low |
High |
Method |
| $915 |
$722 |
$1,493 |
EPS Growth |
| $908 |
n/a |
n/a |
Graham Growth Valuation |
| $1,011 |
$638 |
$1,383 |
Book Value |
| $945 |
$680 |
$1,438 |
Averaged |
| 63% |
17% |
148% |
Margin of Safety from $580 |
| $711 |
$511 |
$1,081 |
Margin of Safety at 33% |
Does Google have a durable competitive advantage? Yes.
It could have been argued ten years ago that Internet search was an emerging technology, competition fierce, and investments subject to a great amount of risk. I don’t think that is any longer the case. Google has established itself as the #1 search engine, making Google the phonebook of the world. Many have tried (Yahoo, Microsoft’s Bing, etc) but have not succeeded. When a person needs information, they Google it. The company’s name has become part of our language. That is a significant competitive advantage.
Is Google’s competitive advantage durable? Is it the same service today as it was ten years ago? Will it be the same in another ten years? Yes. To start, look at the user interface. It hasn’t changed since Google started. They haven’t tried to make it fancy. It’s streamlined, the same way it was at the turn of the millennium. Ten years from today, it will look and act the same. There’s no need to change it.
Anyone who watches television can recall a number of very funny Yahoo commercials. More recently, Microsoft is running a huge marketing campaign for its new Bing search engine. Has anyone ever seen a paid Google ad? Nope. Google doesn’t have to pay to advertise. Why should they? They earned $22 billion in 2008 without any fancy ads. Since day one they’ve advertised through three channels: word of mouth, press, and their own “Ads by Google” caption on websites that use their services. That’s it.
How does Google make money, since their search engine is free to use? A few cents at a time. Above and on the side of your search results are targeted ads. When you click one of those ads, the advertiser pays Google a fee they previously agreed upon. The higher the fee they’ve agreed to pay, the higher their ad appears among the other ads. The minimum amount is $0.10 and amounts up to $1.00 per click can be found for highly competitive keywords. If the average click price is $0.20, it takes 300 million ad clicks every day to add up to $22 billion in one year. Google’s service is used by millions of customers every day. Take that Gillette! I only use your razor once a day but I Google fifty times.
Return on Equity / Return on Capital
Google’s return on equity has averaged 23% since 2003, the first year the company had a positive book value. Google’s capital is nearly identical to its equity so the return on capital has averaged 23% as well. This number is above my minimum requirement of 12% and bolsters the claim that Google has a competitive advantage and is not in a price-competitive business.
Earnings Growth
Google’s earnings have steadily increased year after year, including 2008 which proved to be a trying year. Since becoming profitable, Google has achieved an annualized 87% EPS growth rate. Since achieving revenues of $10 billion in 2006, its annualized rate has been 27%. Although growth was flat in 2008, growth from 2008 to 2009 was 53%, and growth from 2007 to 2009 was 24% annualized. Using a conservative growth estimate of 18% would give Google an EPS of $46.69 in 2014. Google’s price to earnings ratio averages between 30 and 62, giving an expected 5-year price target range of $1,400 to $2,895. From Google’s current price of $580, that would be an annualized 19% to 38%.
Effectiveness of Retained Earnings
Since attaining revenues over $1 billion in 2003, Google retained earnings of $43.53 per share from 2003 through 2008. In 2009, Google’s EPS was $20.41. Compared to 2003 earnings of $0.51, that is an increase of $19.90. Dividing the $19.90 gain into the total of $43.53, Google made a 46% return on the earnings it retained for that period. This shows that Google is excellent at putting it’s earnings back to work to make even greater profits.
Long Term Debt
Google has never had any significant long term debt. I like to see a company carry less debt than 4 times annual earnings. Google’s long term debt plus current liabilities has never been greater than one year’s annual earnings. Google is conservatively financed and can be due to their competitive advantage which is a cash machine.
Organized Labor
Companies with a competitive advantage don’t have to deal with labor unions. Google can pay attractive salaries to its employees because of its competitive advantage. Unions aren’t necessary. I don’t like to invest in companies run by labor unions. Google should never have to deal with union negotiations, a definite plus.
Inflation
A company with a competitive advantage can raise prices as inflation demands. For example, if the price to make a Nike shoe goes up 3%, they will raise their sale price by an equal amount. Nike won’t lose customers. People want their product and will pay a higher price as inflation demands.
The genius of Google’s business plan is that they don’t have to raise their prices. They never set their own prices! Google is always paid whatever the customer decides to pay. Using a bidding system, Google’s price structure is true capitalism.
Inflation is an increase in the money supply. More money being available means the money is less valuable. As Google’s customers receive more money of less value, they will be more willing to spend higher amounts on advertising. Google’s revenues will automatically adjust to inflation as their customer’s sales prices adjust.
Stock Buy Back
Google has not undertaken any aggressive stock repurchasing. This is the only drawback I see to their business strategy but it is hard to argue with putting the cash back in to the business for a 46% return. Buying back its own stock would increase investor share but likely not anything near 46% gains.
Book Value
Google’s book value has steadily increased year after year. This is another mark of a well managed company with a durable competitive advantage. Its first year with a positive book value was 2003 at $7.66 a share. In 2008, the book value per share was $71.09, a growth rate of 56% a year. From 2006, Google’s first year of revenues over $10 billion, to 2008, the book value has increased at 20% per year.
Google’s price has ranged from 6 to 13 times book value. With the 2008 book value of $71.09, Google’s stock price should range from $427 to $924. The current TTM book value of $106.40 yields a price range of $638 to $1,383. At the current price of $580, Google is trading at 5.5 times book value, below its average low. At the average book value multiplier of 9.5, Google’s stock should be priced at $1,011, a 74% gain above today’s price.
Growth Stock Valuation
Benjamin Graham, the father of value investing, gave a formula for calculating the value of a growth stock as EPS * (8.5 + (2 * Expected Annual Growth Rate)). Google’s 2008 EPS was $13.31. Using our conservative growth rate of 18% from above, this formula would give a stock value of $13.31 * (8.5 + (2 * 18)) or $592.30, which approximates the current price. The 2009 EPS was $20.41, which gives a stock value of $908.25. It appears that Google is undervalued by 57%.
Graham’s formula can also be applied in reverse to calculate the growth rate at which the market is currently valuing the company. Using the 2008 EPS of $13.31 and the current price of $580, the formula is (($580 / $13.31) - 8.5) / 2. This yields an expected growth rate of 18%. Using the 2009 EPS of $20.41, the expected growth rate is 10%. This rate is significantly under Google’s historical rates and shows that the stock price is undervalued.
Interesting to note here is that Google’s P/E ratio has historically ranged from 30 to 62 for an average of 46, which is eerily close to the P/E multiplier of 44.5 we receive from Graham’s method when using an expected growth rate of 18%.
Recent Events
Google announced 2009 earnings tonight of $20.41. This earnings report caused a bad quarter in 2008 to drop out of the 12-month trailing EPS picture. Before the announcement, Google was trading at a P/E of 38. With the earnings announcement, the P/E ratio has dropped to 28, below Google’s typical low for P/E ratio. To reach back up to its current P/E of 38, which is still below its average of 46, the stock price would need to reach $776, a gain of 34%.
