Shares of Google (NASDAQ:GOOG) have returned 29.7% over the past 12 months. At $753.67, the stock is trading fairly close to its 52-week high of $774.38 attained in October 2012. Is now still a good time to acquire the shares after the solid price appreciation? In this article, I will elaborate on my stock valuation analysis which may assist you in formulating the investment decision.
Sell-side analysts predict Google's revenue, EBITDA, and EPS to grow at solid CAGRs of 16.2%, 16.9%, and 17.4%, respectively, over the current and next years (see comparable analysis chart below). Those consensus estimates are notably better than the averages of 14.7%, 16.9%, and 4.5%, respectively, for a group consisting of Google's peers in the internet research space. The company's EBITDA margin is forecasted to expand by 0.5% over the same period, which is slightly above the peer average of 0.4%. On the profit side, however, Google's margin and capital return metrics generally underperform the group averages. The company's debt level is above the par as reflected by its above-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, Google's free cash flow is below the average, but the figure remains at a healthy and robust level on an absolute basis. Both the firm's current and quick ratios are considerably above the par, reflecting a healthy balance sheet performance.
To summarize the financial performance, Google's relatively stronger growth potential would be the primary support to the stock valuation. However, given the company's weaker bottom-line profitability and capital return as well as its relatively matured stage compared to that of Yandex (NASDAQ:YNDX) and Baidu (NASDAQ:BIDU), I believe the stock's fair valuation should be somewhat on par with the peer-average level. The current valuations at 9.3x forward EBITDA and 16.6x forward EPS represent an average discount of 6.5% to the peer-average trading multiples (see chart above), suggesting Google's shares are reasonably valued but remain attractive provided the slight valuation discount.
Moreover, Google's forward P/E multiple of 16.6x is now trading at 15.6% premium over the same multiple of the S&P 500 Index, which is at 14.3x (see chart below). From my view, the trading multiple premium is completely justified and the gap could be even larger given that 1) Google's long-term estimated earnings growth rate of 15.6% is almost twice of the average estimate of 8.2% for the S&P 500 companies; 2) The company has been able to maintain a market-leading free cash flow margin over a long period; 3) It has a solid market position in both the internet research and mobile operating system markets.
From a historical valuation standpoint, Google's current valuation appears to be reasonable. Since early 2008, the stock's trailing P/E multiple has dropped by approximately 46.6% from 43.5x to 23.2x (see chart below). The trend is likely driven by the fact that Google's profitability and capital return have been trending down over the period and the company's top-line has also declined (see charts below).
I also performed a DCF analysis which incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2015 (see DCF chart below). The revenue growth rate from fiscal 2016 to the terminal year is set to gradually decline to 2.5% for conservatism, and the EBITDA margin for the same period is assumed to decline from 36.5% in fiscal 2016 to 35.0% in the terminal year. Other free cash flow related items including tax expense, depreciation and amortization, capital expenditure, and net working capital investment are projected based on their historical ratios relative to the total revenue as those ratios have been trending steadily over time.
A company-specific risk premium of 3.0% is applied in the cost of equity calculation to account for the financial projection risk. A normalized 10-year risk free rate of 2.5%, which is higher than the current 10-year U.S. Treasury Bond yield, is employed. As such, based on a WACC of 10.1%, a terminal growth rate of 2.5% (close to the U.S. long-term inflation rate), and an implied terminal EV/EBITDA multiple of 7.4x (currently at 9.3x as mentioned earlier), the DCF model yields a stock value of $843.44, which is 11.9% above the current share price at $753.67. Given the fairly conservative assumptions used in the model, the analysis suggests an undervaluation. To test the margin of safety on the valuation, the sensitivity tables indicate that an assumption mix of 1.0% terminal growth rate and 11.6% WACC would result in a stock value of $659.00 and that a mix of 1.0% terminal growth rate and 32.0% terminal EBITDA margin would drag down the share value to $696.50. Both scenarios represent a limited average downside of just 10.1% to the current share price.
Google recently reported its Q4 2012 financial results with EPS beating the consensus estimate but revenue falling short. The business fundamentals remain intact as commented by Morningstar's research analyst, Rick Summer, in a recent research note (sourced from Thomson One, Equity Research):
"With Internet search providing a strong foundation for Google's moat, pervasive products such as the Android mobile operating system and the Chrome browser protect its competitive position, even as users shift their behaviors from desktops to mobile devices. Increasingly, individuals are using Google services without typing into the search bar, providing new avenues for targeted advertising. We estimate mobile and content sales will contribute nearly $7.5 billion in revenue during 2013. Google is also grabbing more display dollars, leveraging properties such as video website YouTube and DoubleClick, an advertising technology platform. As more revenues come from non-search businesses, the company will have to exercise greater discipline to protect robust operating margins. We expect initiatives in display advertising and YouTube to represent multibillion-dollar revenue opportunities."
Bottom line, in the light of Google's reasonable but still attractive valuation as well as its healthy business fundamentals, I believe there remains a solid upside for the stock price and hence recommend acquiring the shares at the current price. To limit the investment risk, another trading strategy would be selling out-of-money put options to either collect upfront premium or take a potential opportunity to buy the shares at a lower valuation level.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts is sourced from Capital IQ unless otherwise noted.