Archive for September, 2012

Happy Birthday Google!

Thursday, September 27th, 2012

Google Since Going Public

Google turns 14 today, so I thought it would be interesting for you to look at the company through my eyes and see how things are going.

It’s pretty clear from the chart above that Google has been an outstanding investment since it came public in 2004. The graph above shows you a comparison of Google’s price performance to that of the S&P 500 Index since mid-2004. During the period of their public ownership, Google shares are up 595% compared to 25% for the broader market.

Obviously, if you bought Google five years ago, you had a loss in the stock until just recently – that’s the way of the stock market – but you can’t argue with how it has performed coming out of the post-crash bottom in 2009.

We added to shares earlier this year in more aggressive client portfolios, and have about a 33% gain in those shares to-date. Clearly we are pleased with that performance, but what always interests me is what is our potential profit on a going-forward basis.

As I calculate various valuations for Google, I like what I see. So, I thought I’d review some of these for you so you can get a feel for why we plan to hold onto Google and not book this outsized profit.

    Analyst Consensus Target Price

This is the least attractive valuation, but one that I believe to be a timing issue. The Analyst Consensus Target Price is $758.31 compared to today’s price of $756.50.

In my opinion, the analysts that follow this company are simply behind in reviewing the company and updating their target price (in most cases, target prices are 6-month targets, and Google has had a significant run higher in the past six months, meeting most targets). Today, one of the analysts updated their target price to the upper $800’s (I was driving in my card when I heard the news report, so I can’t recall the exact price), so I think this is just the beginning of that process.

    Discounted Cash Flow

I always favor a valuation based upon a Discounted Cash Flow analysis for a mature company like Google. It gives me a fairly clear picture of what the company is worth based upon the cash it can generate from its core business operations.

In my DCF calculation, I start with the most recently reported Free Cash Flow number, add a growth rate to it based upon US GDP Growth and Inflation for the next 51 years, then discount it based upon the Weighted Average Cost of Capital. It’s actually much more complicated than that, but you get the basic concept.

I calculate that the value of Google is $928.09 based upon their discounted cash flows, or a 22.6% increase above current market value.

    Future Earnings Discount

This calculation is similar to the DCF valuation, but instead of cash flow, it takes projected net earnings and discounts those at the Weighted Average Cost of Capital.

Based upon this calculation, you get a value of $900.25, or 18.9% increase above current market value.

    Dividend Discount Model

One of the oldest valuation methodologies derives a value for a company based upon the dividends that it distributes to its shareholders. This methodology came about when shareholders owned companies because they distributed a significant portion of their earnings to their owners – this is not necessarily the case today.

Google pays no dividends (hence the main reason that it is included in our more aggressive portfolio management strategies) so we cannot calculate a value for the company with this methodology.

    Industry P/E X Forward EPS Estimates

A quick and dirty way to come up with a value for a company is to take the average valuation for other companies in the same industry and apply it to the projected earnings for the company in question. The logic behind this methodology is that the company in question may be overvalued or undervalued compared to its closest competitors, and that over time, everything reverts to the mean (meaning that sooner or later, its valuation will move toward the average for its industry).

In the case of Google, you get a value of $855.30, or a 13% increase above current market value.

    Acquisition Value of the Enterprise

For many companies, your ownership is predicated on the assumption that the company will be bought out by a larger competitor. That is not a likely scenario for Google, but we can still apply the methodology to give us a valuation.

This methodology requires a calculation of the enterprise value for the company and the application of a take-out premium. I use the average take-out premium for the past five years, or 36.7%. This yields a valuation of $931.39, or 23.1% increase above current market value.

As you look at these, you can see that there are several ways to come up with a value for a company. No one value is perfect, and in fact I calculate several other values using other popular methodologies as well. I always tend to lean toward the Discounted Cash Flow methodology, but others are valid. In fact, when I compute the average of all of them, I come up with $856.19 for the value, or 13.1% increase over current market value.

    Financial Analysis

There is more to investing in a company than looking at the value of it when making your investment decision of buy/hold/sell. I like to know something about management’s effectiveness, whether the company’s profit generating ability compensates me for accepting the risk of owning their stock compared to a fixed income investment, that those profits are growing greater than a certain level, and that the company is not overvalued.

There are four key pieces of data that I look at relative to these particular things to tell me whether a company deserves further analysis: (1) Return on Invested Capital Vs Weighted Average Cost of Capital; (2) Earnings Yield Vs Average Corporate Bond Yield; (3) Earnings Per Share Growth Rate Vs our 15% Benchmark; and (4) Price/Earnings/Growth Ratio Vs our 2.00 Benchmark.

(1) The Return on Invested Capital tells me how effective the company’s management is at employing shareholder capital. A ratio that is greater than the Weighted Average Cost of Capital tells me that it is managed properly and should over time provide outsized returns. In the case of Google, their ROIC ratio is 15.90% compared to a WACC ratio of 9.01% – so they pass with flying colors.

(2) The Earnings Yield for a company tells me how efficient they are at generating profits. I like to make sure that the yield is greater than the yield available for corporate bonds so I know that I am being compensated for the risk of owning the company. In the case of Google, their Earnings Yield is 4.48% compared to the Corporate Bond Yield of 3.30% – so, again, they pass this hurdle.

(3) The Earnings Per Share Growth Rate is THE key metric in my investment system. My system is keyed around our owning companies that have a greater than 15% growth rate in their net earnings year-over-year. In the case of Google, their EPS Growth Rate is 21.64% y-o-y – so, again they exceed this key metric.

(4) The Price/Earnings/Growth Ratio (or PEG Ratio as the acronym goes) is a valuation methodology that takes the traditional P/E Ratio and adjusts it for the Growth Rate of the company. This allows you to make apples-to-apples comparisons of companies that are really apples-to-oranges. You may have a company like Google with a P/E ratio of 22.34 compared to the broader S&P 500 Index P/E ratio of 14.08 and believe it to be overvalued, but when you adjust the valuation for the growth rate, you get a PEG Ratio of 1.17, or well below our benchmark of 2.00.

In actuality, companies with PEG Ratios less than 1.25 get very high marks in my system because you are getting a company with earnings that are growing significantly faster than the broader market but paying well below average for those earnings. A relationship like this gives you an indication that you have come across a company that is undervalued by other investors and that it is worth further analysis.

There are many things that go into that further analysis, but in my system, it all leads to a relative ranking against the other 6,000+ publicly traded companies. We give every company two scores, or ranks, against the other companies: (1) our Earnings Growth Model Rank and (2) our Financial Strength Model Rank.

(1) Our Earnings Growth Model Rank is a relative ranking based upon a financial statement analysis that emphasizes earnings growth, shareholder returns, and valuation, along with price strength, on a scale of 100 (Highest) to 1 (Lowest) along a normal distribution. Google attains an Earnings Growth Model Rank of 99.89.

(2) Our Financial Strength Model Rank is also a relative ranking based upon the soundness of a company’s balance sheet and quality of their earnings also on a scale of 100 (Highest) to 1 (Lowest) along a normal distribution. Google attains a Financial Strength Model Rank of 99.23.

Anyway you slice it, whatever valuation methodology you choose, and based upon a further analysis of their operations, Google is a top company that we are very happy to own in client portfolios at the current time.

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Equity Volatility for You

Wednesday, September 5th, 2012

Most of you have probably already read Mark’s August 2nd Commentary entitled “Equity Valuations”. If you have not read it, I highly recommend going to Mark’s blog and reading it.  In keeping with that longer-term investing theme, I wanted to build on that particular Commentary. Specifically, I would like to focus on determining what type of equities are right for you.  Whenever the market goes through one of its inevitable rough periods, many investors start to question whether their stocks will ever “come back”.  One of the key points Mark mentioned in his Commentary was if you are someone who wanted to sell (or did sell) after the market was down substantially, then stocks may not be the proper investment vehicle for you.  Each individual needs to perform an honest self-assessment to determine if stocks are the right type of investment for your specific needs and temperment.   Assuming equities are going to be at least a part of your overall portfolio, we need to drill down into just what type of stocks you should own.  For simplification purposes, we will assume there are two basic types of equities, high beta (higher volatility) and low beta (lower volatility). 

In general, you will find that higher beta stocks are found in industries that have above average long-term growth prospects (technology and biotech companies, for example).  The companies that operate in these high growth industries can grow extremely fast (Apple), but they also face the almost constant threat of new companies making their business models obsolete (Palm).  So, the stock prices of these types of businesses tend to fluctuate substantially, both up and down.  These businesses also tend to retain most (or all) of their earnings for future growth opportunities so current dividends tend to be very low.  Most of the stock return in the long-run will come from capital appreciation, not dividends.

At the other end of the spectrum, there are the slower-growing, lower-beta stocks.  Generally known as “Blue Chips”, these are the stocks that most of us have heard of (Pepsi, Johnson & Johnson, Kraft, for example).  These businesses are generally very established in their industry, and their threat of obsolescence is quite low.  Most of these companies have fairly stable, but low, growth rates.  The stocks tend to pay a pretty good dividend since the companies don’t need all of the cash flow to reinvest in their business.  Generally, in the long-run, somewhere around half of an investor’s return will come from dividends, the rest from retained earnings.  The dividend yield generally helps to provide a cushion during market pull-backs.

So the question becomes, are you someone who is comfortable with the substantial ups and downs of higher beta stocks (our Best Ideas portfolio is similar to this) in order to target a higher than average long-term return, or are you more comfortable with the lower volatility of the blue chip equities (our Blue Chip portfolio) with the realization that your long-term returns will likely be lower?  The answer to this question is very important.  Both types of equities will have their day, but they tend to work somewhat inversely of one another. 

It is much better to figure out ahead of time what you are comfortable with, not after a large pull-back in the market.  If you have a long-term investment timeframe (years, not months), and can stick out the inevitable rough periods, then the more aggressive approach will most likely pay off in the end, but you need to stick with it.  If you believe you will feel the need to switch into a more conservative investment, like blue chips, after the aggressive portfolio has underperformed in the short-term, then you will be better off sticking with blue chips from the start.  You may give up some return in the long-run, but you will sleep better at night and stick with it.  Sticking with a long-term investment plan, through good times and bad, is probably the most important part of successful investing, but it is certainly not easy to do.