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Can Google Do What Apple Couldn’t?

GOOGLE

We’ve started to see the Wall Street Analysts come out with $1,000 target prices on Google, much like we say with Apple last Summer as it was heading higher. Obviously, with Apple’s 40% correction in price, those analysts are feeling a bit embarrassed – much like the guys predicting $250 oil a few years ago. However, I wanted to go through the numbers on Google and let you make up your mind on whether you think Google can make the $1,000 per share price or whether this is another head fake to avoid.

I thought we would kick it off with our price analysis that we do for each company that we own:

google-price-data

This summary represents hundreds of calculations based upon a company’s balance sheet, income statement and cash flow statement. The summary first looks at some external sources for target prices set by the analysts. You can see that the consensus price is around $850 per share versus the current price of $836, or a roughly 2% upside.

However, when I calculate valuations based upon several different methodologies, you can see that the potential appreciation is quite higher – but we have to keep in mind that the calculations are really longer term in nature than the 6-month or 1-year price targets analysts use. When I calculate a value, I want to determine the intrinsic value of the company so I know whether I want to be an owner and not just a trader of the stock.

One method I like is to calculate the Net Present Value of the Free Cash Flow and add that to the current Book Value. This method tells me what the current assets and operations of the company are worth; the result is $978 so its not too far off from the $1000 the news making analysts have stated.

I also calculate two different versions of Discounted Cash Flow – each is an accepted methodology but attacks it from a different angle. Discounted Cash Flow calculations discount a company’s free cash flow and add to it a terminal value for that cash flow. It is similar to the calculation above except instead of using the current book value for the company it places a value on the cash flow into perpetuity.

DCF #1 uses trailing twelve month actual free cash flow along with analyst projections for growth. DCF #2 uses trailing ten year cash flow and calculates growth rates based upon historic data. Both discount at a Weighted Average Cost of Capital that we calculate at 8.66%. I like using the two methodologies, but in a case where the results are so different, such as this, I tend to average them: $1,297.90 + $849.52 = $2,147.42 / 2 = $1,073.71, also not too far off from the analysts.

There are also several other calculations I perform which I rely on less than the top three, but they still provide useful information. Calculations, like the Dividend Discount Model can be good for companies for whom you rely on the dividend stream for a significant portion of your expected total return – but in the case of Google, that just does not apply.

But, when I average all of the calculations out, I get an average valuation for the company of $1,034.20.

Let’s take a look at the company from an operating standpoint. In the graphic above, the final two line items represent my proprietary ranking system. I use a series of calculations that when aggregated and applied to the universe of 6,000+ companies in our data download, gives me a ranking based upon a normal distribution, with 0 as the worst and 100 as the best. One system provides a rank based upon earnings growth and one is based upon the quality of its financials.

Google, as you can see, ranks very highly on both measures. We use these rankings as a jumping off point and as a way to track a company over time. So, lets take a look at some of the factors we use as inputs to the rankings:

google-key-statistics

This chart shows you the down and dirty of investing according to me: the Key Statistics are a dashboard that show you at a glance how the company is operating and where it stands from a valuation perspective:

> In any company I own, I want to make sure that the Return on Invested Capital is well ahead of its Weighted Average Cost of Capital. This tells me how the company management is using the money its shareholders have entrusted to it.

> The Earnings Yield needs to be greater than the corporate bond yield so that I know this equity security is, from an asset allocation standpoint, a better allocation of capital than a fixed income security.

> I also like the Free Cash Flow Yield (whether on Market Cap or Enterprise Value) to also be above the Corporate Bond Yield to tell me how effective it is in its operations in generating cash for its shareholders.

> From a valuation point of view, I prefer to buy companies when their Enterprise Value is less than 5 times its EBITDA. When I already own a company, if I see it getting too high it tells me that it is awfully close to its intrinsic value and that appreciation could potentially be limited until EBITDA increases or until after the price corrects. If I am a buyer, 5 is a key level where other companies, particularly private equity, looks for take over candidates.

> Like any good investor who grew up marveling at the work of Peter Lynch, we want the PEG Ratio to be less than two. Or, in other words, we don’t want the P/E Ratio to be more than twice the Earnings Growth rate for the company.

> I have a target for earnings growth of 15% for companies. Historic earnings growth is important, but what I really want is to see the next 5-years earnings growth exceed 15% particularly if the past year has not done so (this is the case with Google).

> And it is always important for me to own companies whose earnings are growing faster than the broader market.

It is always important to me to know where the companies I own are compared to their competitors:

google-comparison

You can see that Google excels at growth rates, profitability and financial strength – and is represented fairly well by valuation compared to competitors.

For me, I want to own this company. I don’t know whether Google will hit the $1,000 mark in the next 6 months as the analysts who’ve stuck their neck out believe, but I am fairly comfortable that the value for Google is certainly higher than it is today.

The stock market will go up and down in price, but we try to focus on owning a wide variety of companies that have strong fundamentals (cash flow is king, valuation is critical, earnings growth is vital, and strong financial position is key). Sometimes Value investments are in favor but other times Growth investments are in favor – by having a 7 to 10 year horizon for an investment we try to make sure we own those that have the fundamentals we believe represent the best investments for our clients.

Our holding period is rarely the full 7 to 10 years – if we experience big gains in a shorter time frame we may sell and try to buy it back if the price goes down (and we can get it closer to a 5 EV/EBITDA) but we may hold it even if we have big gains depending upon our view of the macro events in the world and the position of the company relative to various catalysts driving stock prices.

Google is a great holding and we plan to hold on to it as we definitely believe it will reach an intrinsic value over $1,000 at some point based upon its operations. Not many companies can say that, but we will discuss others here in coming posts.

Mark