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Google, Inc. - Thoughts on Arithms

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October 17, 2010 – Comments (10) | RELATED TICKERS: GOOGL , MSFT , YHOO

They announced earnings and investors went goofier than they already are, driving the price of the stock up above the $600 mark.

That someone, anyone, would be willing to pay $600 to own a stock amazes us, much less a stock that has gone up in price almost 25% since mid August.

But such is the life of the Queen of Search, Google, Inc. (Nasdaq: GOOG), who announced earnings last week and then watched their stock price move higher by more than $60 a share.

As the single, most dominate search engine of the internet, we think the algorithm that Google as developed and continues to develop, an algorithm we call the Googarithm, is simply the best of the best.

Certainly the Googarithm has its competitors. Microsoft Corporation (Nasdaq: MSFT) has deployed Bing, which we think is simply a stupid name. Bing?

Not only does the Bingarithm not work as well as the Googarithm, but because Google controls so much of the advertising associated with search, the Googarithm can simply direct queries to sites that support Google with advertising dollars.

What is it that Bing does? Sing “White Christmas”?

Then there is Yahoo!, Inc. (Nasdaq: YHOO). The Yahooarithm is, well it’s just odd. What we have often wondered is with all of the advertising revenue that Yahoo! has at its disposal, why its search engine doesn’t seem to capture the Yahoo advertisers.

Okay we admit that Wax Ink is “arithmless”. But still, as strange as this may seem, we are able to think beyond the front or pants!

And in doing so, we came to the conclusion, admittedly without much thought, that we should support companies that support us before we support companies that don’t. That does stand to reason, right? 

Basis 

Financial information presented in this report for Google, Inc. is based on the company’s most recent SEC Form 10-K filing for year ending December 31, 2009, as filed with the Securities and Exchange Commission on February 12, 2010. 

What They Do 

Google, Inc. is a global technology leader, focused on improving the ways people connect with information.

The company’s innovations in web search and advertising have made its web site a top internet property and its brand one of the most recognized in the world.

The company maintains a large index of web sites and other online content, which they make freely available via their search engine, to anyone with an internet connection.

The company’s automated search technology helps people obtain nearly instant access to relevant information from the company’s vast online index.

The company generates revenue primarily by delivering relevant, cost-effective online advertising. Businesses use their AdWords program to promote their products and services with targeted advertising.

In addition, the third-party web sites that comprise the Google Network use its AdSense program to deliver relevant ads that generate revenue and enhance the user experience.

The company was incorporated in California in September 1998 and reincorporated in Delaware in August 2003. 

Short-Term Investment 

The stock closed recently at $601.45 with resistance at $629.51, a 5% increase from a recent close, and support at $518.99, a 14% decline from a recent close.

The stock is clearly in an uptrend, and has been since mid September. With the recent earnings announcement, the stock price has been pushed well into overbought territory.

Since we simply have no idea on a short-term basis what the stock price is likely to do, we have no short-term interest at this time. 

Long-Term (5 Year Hold) Investment 

The company has several financial metrics that must be the envy of every company in America. Their Current Ratio at 10.5, Quick Ratio at 10, and Cash Ratio at 9, are all well in excess of what we consider investment quality.

Couple these ratios with the company’s Return on Invested Capital of 36%, and its Free Cash Flow of $21 per share, and then consider that the company’s earnings yield at 3.23% exceeds the yield on a AAA rated corporate bond by better than 2:1, and it’s no wonder investors are willing to pay such a ridiculous price to own the stock. 

Valuations 

Based on our review of the company’s latest annual financial information, our Reasonable Value Estimate for the stock based on a 5-Year hold is $125, with a Buy Target of $75, a First Sell Target of $146, and a Close Target of $154.

But all is not perfect, primarily because of the high stock price. With the current price 10 times greater than the company’s Net Current Asset Value, a Trailing Twelve month PE of 31 and a Price to Tangible Book of 8, we think the stock price relative to the stock value, is excessive.

In addition, with EBITDA at 41.5% of sales, and Enterprise Value at $576 per share, the Merger and Acquisition return period works out to roughly 23 years, assuming EBITDA stays at current levels. 

Final Thoughts 

The company is on top of its game as a revenue generator. But as a company, we have to wonder.

Recently we had an issue with our AdSense account. Not only did it take us almost 6 months to reach something that was not automated, we were never able to address our specific issue.

Accordingly, we no longer have an AdSense account, nor do we have the little bit of revenue, about $100 a month, that having an AdSense account generated.

We understand that the company is in business to make money. So are we. And we realize that the company provides vast free services not only for small business, but also for anyone with an internet connection. For that we cannot thank the company enough.

But to us, there is a certain amount of humility associated with being the biggest, or the best, or the most anything. Every effort should be made to resolve any issue that users have, whether that user is part of the Google Network, or a child wanting to play a game.

We find the company's hubris very disconcerting, and have to wonder if, as time goes by, this inattention to the simple needs and wants of its users will spell the end of the Googarithm, replaced instead with an arithm resembling a single digit from an outstretch hand. 

Wax

10 Comments – Post Your Own

#1) On October 17, 2010 at 11:05 PM, walt373 (99.83) wrote:

That someone, anyone, would be willing to pay $600 to own a stock amazes us, much less a stock that has gone up in price almost 25% since mid August.

Why does it matter how much a share costs? The share count is arbitrary... GOOG could do a 10 for 1 stock split any time they wanted to and it would not change the business. Berkshire Hathaway would've been an amazing buy at $600, since each share now fetches $124,000...

Also, why does it matter if a stock has gone up 25%? It can still be undervalued. Maybe by a lot. Not saying GOOG is, but I don't think any stock should be ruled out just because it went up a lot.

Based on our review of the company’s latest annual financial information, our Reasonable Value Estimate for the stock based on a 5-Year hold is $125

You don't think Google deserves a P/E higher than 6? There must have been a miscalculation...

Also, I don't think book value matters to a company like Google. They don't make money from their book value. Most of their assets are in technology that is expensed in R&D, as well as their competitive position and brand name, none of which are carried on the books.

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#2) On October 18, 2010 at 4:25 AM, wax (96.58) wrote:

walt;

We never quabble over what investors are willing to pay for a share of stock.

We are often amazed by it, but we in the end, it's their money they are putting at risk and if they are happy that the reward is greater than the risk, then by all means, pay forward.

As to the share price, it is not arbitrary to us since we believe that price determines return.

And yes to us, it does matter that a stock has gone up 25% in price in a very short period of time. If we buy after the fact haven't we overpaid by 25%?

And if we have overpaid by 25%, hasn't our risk level increased? Albeit maybe not over the longer term, but for the very short term we think it has.

Certainly the stock may still be undervalued, but the as we have said earlier, to us,  price determines return.

We noted in the article that with another 5% increase in price, the stock will face resistance to moving higher, while at the same time the price will find support after it has fallen 14%.

While we realize these are short-term events, we also realize that what the stock price is doing relative to the markets, can be used to our advantage when starting or adding to a position.

So do we think Google deserves a PE of 6? Good question. Let's put it this way. Their earnings may not rate a PE of 6, but then we are not valuing JUST their earnings.

We are valuing the entire company and it's the company, not just the company's earnings, that we think deserve a PE of 6.

As to book value, we look at it as just one measurement of risk. If the stock is currently trading at a large multiplier to it's book value or better yet it's tangible book value, then it may not be a good time for us to considering buying it.

Wax

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#3) On October 18, 2010 at 1:26 PM, Goofyhoofy (< 20) wrote:

And yes to us, it does matter that a stock has gone up 25% in price in a very short period of time. If we buy after the fact haven't we overpaid by 25%?

 No, not if it's going to go up another 25% in a short time, as happens all the time. You haven't "overpaid." Indeed, there's an argument to be made that you have underpaid, you just paid more than someone who bought a while ago. Since when is that a criteria? If you go by that measure, you'll never buy any stock.

 We are valuing the entire company and it's the company, not just the company's earnings, that we think deserve a PE of 6.

What other companies do you find available with a PE of 6? 

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#4) On October 18, 2010 at 2:17 PM, NajdorfSicilian (99.87) wrote:

This is one of the most ridiculous 'PotD' I have ever seen. You gave GOOG a $39bn valuation with your price target. They have $33.3bn in cash. They have generated over $8 bn in profits the past 12 months alone = $41.3bn.

 Your target is 5% less than their cash on hand and past year's earnings. Try again.

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#5) On October 19, 2010 at 5:09 AM, wax (96.58) wrote:

Goofy;

If the stock has run up 25% in a very short period of time, then in all likelihood the reason is momentum related.

Certainly the stock price may retain its gain, but the better scenerio is that it will give up at least some of those gains. It is at that point, assuming the stock is within our buy target, that we would want to buy.

As to other companies with a PE of 6, we have no idea since we don't track companies on our watch list by their PE.

I would ask you to remember, that earnings are simply one small part of  valuing a business, and the PE of 6 was not one we came up with, since it is not the PE at all.

The PE of 6 is the Price to our Reasonable Value Estimate for the entire company and would be better represented as P/FV, where FV equals fair value.

Wax

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#6) On October 19, 2010 at 5:27 AM, wax (96.58) wrote:

Crying;

We gave them a $61B market cap with our target price if memory serves.

As to cash, based on the financial data we used, they have $10.1B in cash and yes, net income after taxes for FY09 was indeed almost $8B.

As to our price target being less than cash on hand, when we look, we see cash on hand of about $26 a share versus our price target of $154 per share.

Wax

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#7) On October 19, 2010 at 10:49 AM, walt373 (99.83) wrote:

As to the share price, it is not arbitrary to us since we believe that price determines return.

The share price is arbitrary because the share count is arbitrary. The company picks any number they would like for the share count and they can easily change it any time they would like by simpling doing a stock split or a reverse split. The number you need to look at is total market cap - that is what the company is valued at by the market. Of course price determines return. But not the share price!

There is no way GOOG is worth only a P/E of 6 unless you believe their business will decline significantly, or risk bankruptcy or something big like that. How did you reach a FV of $125? Using DCF, if you assume that their earnings fall by 40%, then zero growth to perptuity at a discount rate of 10%, and they flush all their cash down the toilet, I get about $125. Seems unlikely to me.

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#8) On October 20, 2010 at 5:03 AM, wax (96.58) wrote:

walt;

You are right share price is arbitrary, that's the reason the price fluctuates.

Market cap is okay, but it too is based on price. When we do our valuation work, price and earnings growth are thrown out, we don't use them at all.

What we are trying to determine is a fair value for the company at this point in time.

We stay away from price and growth because price is what we are trying to determine and we simply refuse to pay for growth.

Working out our fair value formulas, back testing them, and then applying them to the real world has been an almost 3 year effort, an effort that we wanted to do for us.

Instead of valuing the many businesses that a company has and going through all of that, we value the different financial items of a company and then determine a value based on our assesment of those diffferent numbers.

When we purchase a stock, we generally are buying in 1000 share lots. We are not interested if the name of the company is Google or Butter Beverage Company. We simply don't care.

We have identified a stock that we believe is worth X and is currently trading at Y, with Y representing a substantial discount to X.

We overlay that stock information with what our perception of the particular industry the company is in, then overlay all of that with our perception of the economy in general.

The valuations we come up with are then, to us, reasonable for the entire company as going concern.

That's why saying we have given the stock a PE of 6 is very misleading, we simply have not done that.

We have given the business of the company as an ongoing concern a value and that value relative to its current price is 6.

Most of the comments regarding our post have basically told us we missed the boat with Google, and perhaps we have.

But look at what is included in their comments about how we blew our analysis of Google.

The numbers they are looking at are quarterly numbers and they all include earnings growth.

We went to three sites just now and found analysts' earnings growth rate projections of -7.6%, 5.6%, and 16.5%.

Which one is correct?

Of the $600+ for a single share of Google, how much are investors paying to own growth, growth that may never arrive?

Certainly we may have missed the boat with our valuation, we never claimed otherwise.

So the fact that we valued Google at $125 means what? At the end of the day, it means nothing.

Folks are going to pay the price for Google or they aren't. We just happen to be in the "aren't" camp.

Wax

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#9) On October 20, 2010 at 1:21 PM, walt373 (99.83) wrote:

As you know, the value of a company is simply the sum of all discounted cash flows, nothing more and nothing less. You can calculate the precise value of a stream of cash flows if you know what the future cash flows will look like. Like I said, I assumed -40% growth then 0% growth to perpetuity, and ignored Google's cash balance. These are very draconian assumptions to be sure, and with these assumptions, I got $120 for a fair value.

(8 billion * 0.6) / (0.1 - 0) = 48 billion

48 billion / 400 million shares outstanding = $120

How did you reach $125? If you are able to come up with a precise number, then you must have an equation.

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#10) On October 21, 2010 at 4:39 AM, wax (96.58) wrote:

Walt;

The sum of all of the cash a company will generate over its lifetime, discounted to its present value is one measure. But to us, it the measure of the valuation of a stock, not a company.

Certainly we consider that information. But we are attempting to value a business, not a stock, which is what we did with Google.

There are things that the vast majority of analysts include in their valuations, that we simply throw out.

For instance, how much is the brand Google, worth? To almost everyone it has great value. To us it has none.

The same thing with earnings growth. How much is that worth? To almost every analyst and investor it is a major factor.

But to us, it has no value at all, and we simply refuse to pay for it. So we back it out, all of it.

We simply try and take a company's annual financial information, which includes its earnings, and rearrange it keeping what we want to keep, what is important to US as investors, and then determine the value of what we kept.

Is there a formula for that? Sure. We spent about 3 years developing it. Does it work every time? No, but then how many do.

But it does highlight the things that are important to us, which as we have learned, are very different from 99.9% of what is important to the rest of the investing community.

And since it is our money we are investing, we are extremely comfortable knowing that.

Wax

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