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Executive Summary

We believe that Google (NASDAQ:GOOG) is a high quality company with a Business Quality Score of 7 based on a scale of 1 to 10 (10 is best). Also, shares of Google appear to be undervalued based on a discounted cash flow analysis. Google stock would need to rise about 42% to reach fair valve based on the closing price of $773.95/share for Google shares on 02-07-2013.

Business Description

Google is in the internet search and advertisement business. Due to the complicated nature of their operations I thought it best to refer to the company's 10-K annual report in order to best describe their business.

(Source: 10-K)

Google is a global technology leader focused on improving the ways people connect with information. We aspire to build products and provide services that improve the lives of billions of people globally. Our mission is to organize the world's information and make it universally accessible and useful. Our innovations in web search and advertising have made our website a top internet property and our brand one of the most recognized in the world.

Our Motorola business is comprised of two operating segments. The Mobile segment is focused on mobile wireless devices and related products and services. The Home segment is focused on technologies and devices that provide video entertainment services to consumers by enabling subscribers to access a variety of interactive digital television services.

We generate revenue primarily by delivering relevant, cost-effective online advertising. Businesses use our AdWords program to promote their products and services with targeted advertising. In addition, the third parties that comprise the Google Network use our AdSense program to deliver relevant ads that generate revenues and enhance the user experience. We also generate revenues from Motorola by selling hardware products.

Business Quality Analysis

Google has a Business Quality Score of 7 out of 10 based on an analysis of historical data. We assign a Business Quality Score to each company undergoing analysis. The score is based on a scale of 1 to 10 with a value of 10 indicating the best possible Business Quality Score. Our Business Quality Score is a proprietary metric, which takes into account the 10-year historical performance of the company. Performance is measured considering the absolute performance (and trends) in revenues, earnings, profit margins and returns on assets/equity.

Low Business Quality Scores (3 or lower) indicate companies that are in a cyclical or commodity business. These businesses have erratic revenues and earnings with associated low profit margins and poor returns on capital. Low quality companies operate in highly competitive/cyclical businesses where consistent profits are nearly impossible to achieve.

High Business Quality Scores (7 or higher) indicate companies that are in high-quality businesses with some type of durable competitive advantages that keep competitors at bay. These businesses typically have steadily rising revenues and earnings with associated high profit margins and good returns on capital.

Revenue:

Google's revenues have preformed extremely well over the last 10 years growing at an annualized rate of 42.2%. Revenues have risen steadily each year with the exception of 2009 where revenues only grew 8.5% year over year. However, revenue growth in 2009 was not bad considering the horrible economic conditions at the time. In 2012, revenues grew 32.4% rising from $37.905 billion in 2011 to $50.175 billion in 2012. We believe the future annualized revenue growth will be in the 15% to 17% range over the next 10 years.

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Earnings per share:

Google has steadily grown earnings over the past 10 years at an annualized growth rate of 51.5%. This is a very high growth rate, which can not continue in the future. We believe that the future earnings per share annualized growth rate will be in the range of 17% to 19%.

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A company's earnings per share is a measure of profitability for a company. The earnings per share is calculated by dividing the net income attributable to the common stock by the average number of common shares outstanding. One drawback in using earnings as a profitably measure is that it does not consider the amount of assets needed to generate the earnings. Earning the same profit using fewer assets is more profitable but this is not captured in the earnings per share calculation.

High-quality companies will have steadily rising earnings that do not vary greatly through a full business cycle (expansion-recession-expansion). Investing in high-quality companies is fairly easy assuming an investor has realistic profit expectations and has the patience to wait for a reasonable stock price relative to the company's value.

Lower quality (cyclical) companies will have earnings that vary greatly over a business cycle. Often these cyclical companies will experience a drastic reduction in earnings during economic recessions. Investment profits can be had with investments in cyclical companies but the timing of the buying and selling of the investment must be in sync with the ebb and flow of the stock market. Typically, the stock market will start to recover about six months before the economy comes out of recession. However, this point in time is not obvious in the moment and is only known later with the benefit of hindsight. Furthermore, timing when to sell a cyclical stock is even more difficult. Timing the stock market is a matter of luck so it is best to stick with the higher-quality stocks where market timing is not as critical to investing success.

Operating Profit Margin:

Google has had consistently high operating profit margins in the range of 26.8% to 41.6% over the last 10 years. This is excellent performance; however it would be better if there was an upward trend in the operating margin instead of a random distribution in the previously described range.

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The operating profit margin is earnings before interest and taxes are paid divided by net revenues. As a rule of thumb, consistent operating profit margins in the range of 15% to 20% or higher is an indicator of a good company with some type of durable competitive advantage. One exception to this rule of thumb is the retailing sector where operating margins in the 5% to 10% range are the norm even for great companies. One thing to look for is the trend in the operating profit margin. Ideally, the operating profit margin should be steady and rising over the past 10 years.

Net Profit Margin:

Google has had consistently high net profit margins in the range of 7.2% to 29.0% over the last 10 years. This is excellent performance as the net profit margin has been consistently above 19.0% over the last 8 years.

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The net profit margin is net income divided by net revenues. For non-retailing companies, a consistent net profit margin of 7% or higher is an indicator of a good company with some type of durable competitive advantage. In the retailing sector a net profit margin in the range of 3% to 6% is the norm even for the best companies. Ideally, the net profit margin should be steady and rising over the past 10 years.

Return on Assets:

Google has had a consistently high return on assets in the range of 13.0% to 21.6% over the last 10 years. This is good performance but it would be better if the return on assets showed an upward trend instead of bouncing erratically within the described range.

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Return on assets is a measure of how much profit is generated from a company's assets independent of how much debt is used to finance the acquisition of those assets. The return on assets is sometimes a better measure of profitability than return on equity because the return on equity can be significantly increased by adding more debt to a company's balance sheet. Adding more debt to a company can inflate profits but comes at the price of a greater risk of bankruptcy. Measuring profitability using the return on assets does not have this problem because to calculate the return on assets the net income plus the interest expense net of income tax savings is divided by the average total assets of the company. Thus, by dividing the net income (adjusted for the affects of debt financing) by the total assets (debt + equity) of the company it cancels out the positive effects of debt. The return on assets is great for comparing the profitability of companies with different levels of debt in their capital structures. Generally speaking, a consistent return on assets of about 7% or more is a good indication of a good business with some type of durable competitive advantage. One exception to this rule of thumb is the banking sector where a return on assets of just 2% is considered exceptional.

Return on Equity:

Google has had a consistently high return on equity in the range of 16.6% to 31.4% over the last 10 years. This performance is good but the fact that the trend has been steadily downward is an item of concern. The problem is that Google is hoarding cash (48 billion as of Q4 2012) thus increasing shareholder's equity, which drives down the return on equity. Consider that about 67% of Google's shareholder's equity consists of cash, cash equivalents, and short-term investments. However, the most recent return on equity of 16.6% is a good return on equity especially considering the amount of cash Google has on its balance sheet.

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Return on equity measures a company's performance in financing and using assets to generate earnings. In contrast to the return on assets, the return on equity considers the affect of financing in generating profits. To calculate the return on equity the net income (minus dividends paid on preferred stock) is divided by the average common shareholder's equity. As a rule of thumb, a consistent return on equity of 15% or more (assuming a reasonable level of debt financing) is an indicator of a good company with some type of durable competitive advantage.

Valuation:

A discounted cash flow analysis reveals a fair value for Google of $1097.93/share. We use the percent of revenue method in our discounted cash flow analysis. The model assumes an average weighted cost of capital (OTC:WACC) of 10.7%. Our WACC is calculated using a proprietary formula unique to our firm. An average revenue growth rate of 16% is projected over the next 10 years. An average revenue growth rate of 5% is assumed for every year thereafter.

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Conclusion:

Google appears to be a high-quality company with an undervalued stock price. Based on a fair value of $1097.93/share and Google closing stock price of $773.95/share (on 02-07-2013) the stock must rise 41.9% to reach fair value.

Disclaimer: Ulfberht Capital is not an investment advisor. This article is not a recommendation to buy or sell securities. Always consult your investment advisor before making any investment decision.

Source: Google: 42% Upside To Reach Fair Value