(Chart from Yahoo Finance)Google has come under strong selling pressure after (1) confusion around Google’s status in China and (2) their recent miss in Q2 earnings. I thought I would give a short valuation analysis.
First how does Google make money?
Well the answer comes directly from their website:
- “Today, the majority of our revenue comes from advertising… Google AdWords, our auction-based advertising program, enables advertisers to deliver relevant ads targeted to search queries or web content… and advertisers pay us either when a user clicks on one of its ads or based on the number of times their ads appear...”
and
- “We distribute our advertisers' AdWords ads for display on the Google Network through our AdSense program. We share most of the revenue generated from ads shown on a site of a Google Network member with that member.”
What is AdWords?
In short it is the world’s largest ad exchange:
- Advertisers are on one-side while Google and cooperating operators (ie, Google Network members) are on the other
- Advertisers bid $ amounts for their ad’s position. The $’s go to operators which host the ads on their webpage (you know on the side of website)
- Google uses its algorithms to determine a “quality score” of each ad. This quality score reflects relevance and is a key determinant of “cost-per-click” (CPC)
- The trick is how does Google get enough traffic on its site so that advertisers are willing to pay. Well first, they have sites that attract huge volumes of traffic (ie, searching on Google.com or Gmail). But there is more.
The brilliance of the business model is that they pay others for traffic through AdSense.
AdSenseAdSense is the Google service which places ads on willing partners sites and pays for the privilege. As a web site creator you sign up for AdSense and depending on your site’s popularity, Google sends you monthly checks. The amounts are a function of the content as some advertisers are willing to pay more for certain types of keywords (ie, car > snot).
Amounts are also a function of how many people come through your site (ie, traffic). This service is in addition to their traditional means of making money – ads on their own Google.com and Gmail sites.
So to summarize:
Google revenues are a function of,
1. Overall willingness of advertisers to pay for ads
2. Volume of internet traffic (search + content)
3. Google’s share of this traffic
The more Google can do to capture share of a given traffic (ie, start free email services) or create a new type of traffic (ie, YouTube, mobile), the more money it will make all else equal.
Now let's look at it as an investment.
First let's make some simple assumptions:
- Internet growth will continue to grow rapidly
- Traffic will expand at significant rates across variety of content
- Search will remain primary driver of traffic and Google will continue to dominate the category
- Over time new projects such as YouTube will be profitable and add to traffic growth
Company Details
Google TTM Revenues (ie, after traffic acquisition cost) = 26.2bn
Cost of Revenues = 36%
R&D, Sales & Marketing, and G&A = 25%
Operating Margin = 39%
Tax rate = 22%
Net Margin = 30% or ~7.8bn
CFO = ~9.3bn
Capex = ~1.8bn (assumed)
FCF = ~7.5bn
Fully diluted shares = 322mm
FCF/share = $23
For purposes of valuation we will assume FCF grows to $40/share by the end of 2015 (~15% growth)
Then we will assume 5% growth in perpetuity and run valuation levels using 10, 12 and 15% discount rates
Current cash/share is $93. Assuming growth of FCF/share to $40 by year-end 2015 we assume cash/share will grow by (40+23)/2*4.5 years or $142/share. That is we assume year-end 2015 cash/share is $235/share.
If cash is distributed prior it will only change valuation through time value of money assumption
Let's look at the case of a discount rate of 10%.
Let’s assume $40/share in year-end 2015 FCF
We use 10% discount rate and 5% growth rate to get a multiple of 20x FCF or $800. Add cash of $235 and we get a value of $1035 at year-end 2015
We then discount this back to today at 10% and get an NPV of 674.
Equation is:
[FCF per share/(Disc Rate – Growth Rate) + Cash per share]/(1+Disc Rate)^Time
Now we can look at different scenarios for the "fair value"
Using the previous equation,
NPV @ 10% is 674
NPV @ 12% is 484
NPV @ 15% is 339
Also using current market price of 459 we can compute alternate rates of returns for these discount rates
ROR @ 10% is 19.8%
ROR @ 12% is 13.3%
ROR @ 15% is 7.5%
ROR @ 12.4% is 12.4% (In this case the NPV = 459 so the ROR is just the IRR)
Obviously the “right” value depends on discount rate. We won’t get into a debate on what is the appropriate rate, but let’s say that to compensate for the risk of obsolescence or regulatory intervention we probably need a discount rate between 12% and 15%.
At 15% discount rate the stock clearly has further downside which is probably a reasonable worst case (of course, 0 is the worst worst case).
Current undervaluation @ 12% is ~$25/share.
The important thing to remember is whatever you assume as the discount rate is what you are assuming the "asset" compounds at over time. So even though the stock is $100+/share overvalued at 15%, we actually see rapid growth in the share price at that rate. So the year-end 2015 target share price over time is still above today's ($635/share in the 15% example).
So the question is would you like to own a company with as stable revenues as Google with its pipeline of growth at a return trajectory somewhere between 7-20% per annum? Is it worth the obvious risks of obsolescence and regulatory intervention? That's for you to decide...
