Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.
Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheet of Google GOOG, in order to get some clues as to how well this company is doing.
I will go through the balance sheet, reviewing the most important items, in order to assess Google's financial condition. The information that I am using for this article comes from Google's 10-K filing for 2012, which can be found here.
Note that this article is not a comprehensive review as to whether Google should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.
Before I go any further, I should mention that not everyone is going to derive a benefit from this article. Many of you who are already familiar with the workings of Google might say that this article has about the same effect as saying that Michael Jordan was a good basketball player. That's fine. However, for those who aren't that familiar with Google and are starting to consider it as an investment, and new investors who are trying to formulate an approach toward researching stocks in general, this article may help them understand some of the things that they need to look for prior to making a final decision.
Google is known more than anything else for its search engine that helps people find the information that they need on the internet. However, 87% of last year's sales came from online advertising, where Google places advertisements for businesses on its search engine, as well as on other websites in their network. In exchange, companies will normally pay Google a certain amount of money every time someone clicks on one of their advertisements.
Google also provides the mobile software platform, known as the Android, which is found in many smartphones. In May 2012, the company acquired Motorola Mobility Holdings, a producer of mobile devices like smartphones and tablets. According to the company's 10-K filing, they did this "to protect and advance our Android ecosystem and enhance competition in mobile computing."
Google has a market capitalization of $265B and has recorded over $50B in sales over the last 12 months. 53% of its sales come from outside the United States.
Cash and Cash Equivalents
The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, pay down debt, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.
As of Dec. 31, 2012, Google had $48.1B in cash and short-term investments, which can be easily converted into cash. This is a substantial amount of cash for a company that has a market cap of $265B. This means that the company is trading for less than six times its cash position, which may be very attractive for value-oriented investors. The company also has a very strong free cash flow of $13.3B in 2012. Google has not paid out dividends or repurchased stock in the last couple of years.
Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.
In its most recent 10-Q filing, Google reported a total of $7.89B in net receivables on its balance sheet, which represents 15.7% of its trailing 12-month sales of $50.2B. For 2011, 14.3% of its sales were booked as receivables, while that percentage was at 14.5% for 2010.
While close to 16% of sales is a substantial number for receivables, I'm not too concerned about it as that figure is fairly consistent with what the company has reported in the past.
Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of its operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.
If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.
The current ratio of Google is 4.23, which is outstanding. Google should have no problems at all in meeting its short-term financial obligations.
Property, Plant, and Equipment
Every business requires a certain amount of capital expenditure. Land has to be bought, factories have to be built, machinery has to be purchased, and so on. However, less may be more when it comes to outlays for property, plant, and equipment, as companies that constantly have to upgrade and change its facilities to keep up with competition may be at a bit of a disadvantage. However, another way of looking at it is that large amounts of money invested in this area may present a large barrier-to-entry for competitors.
Right now, Google has $11.9B worth of property, plant and equipment on its balance sheet. Items that are included here are information technology assets, land, buildings and construction in progress. The amount of property, plant, and equipment on Google's balance sheet is up from the $9.60B that the company reported at the end of 2011 and the $7.76B that it reported at the end of 2010. This is due to the fact that Google made approximately $6.6B in capital expenditures over the last two years on facilities, data centers, and related equipment.
Goodwill is the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case by case basis, as good companies are rarely purchased at or below book value.
For the reason discussed above, I generally don't like to see goodwill account for more than 20% of a company's total assets. Google has $10.5B worth of goodwill on its most recent balance sheet, accounting for just over 11% of the company's total assets. This amount of goodwill is higher than the $7.35B that it reported at the end of 2011 and the $6.26B that the company reported at the end of 2010.
The $3.15B increase in 2012 is due to $2.5B in goodwill that came from its acquisition of Motorola Mobility for $12.4B, as well as the $733M in goodwill that the company allocated from 52 smaller acquisitions that occurred in 2012, worth a total of $1.17B.
The roughly $1.1B dollar increase in 2011 came from the acquisitions of flight information software company, ITA Software, and 78 other small companies in which a total of $1.1B was allocated to goodwill. Total purchase price of these 2011 acquisitions came in at around $2.0B.
Given that goodwill currently accounts for just 11% of Google's assets, I don't see much to worry about here.
Intangible assets that are listed on the balance sheet include items such as licensed technology, patents, brand names, copyrights, and trademarks that have been purchased from someone else. They are listed on the balance sheet at their fair market values. Internally-developed intangible assets do not go on the balance sheet in order to keep companies from artificially inflating their net worth by slapping any old fantasy valuation onto their assets. Many intangible assets like patents have finite lives, over which their values are amortized. This amortization goes as annual subtractions from assets on the balance sheet and as charges to the income statement. If the company that you are researching has intangible assets, with finite lives, that represent a very large part of its total asset base, then you need to be aware that with time, those assets are going to go away, resulting in a reduction in net worth, which may result in a reduction in share price, unless those intangible assets are replaced with other assets.
Google currently has $7.47B in intangible assets on its balance sheet. This is well above the $1.58B that the company reported one year prior, as well as the $1.04B that the company reported two years ago. The increase in 2012 is due to $6.2B of intangibles that were acquired in the Motorola Mobility acquisition, as well as $462M that came from its other acquisitions. Of the intangible assets acquired in 2012, most of them were patents and developed technology with a weighted-average life of 8.9 years. There were also some acquired customer relationships that carry a weighted-average life of 7.4 years.
The slight increase in 2011 came from nearly $1B worth of intangibles that came from the 2011 acquisitions mentioned above.
Of the total intangible assets on the company's balance sheet, 80% are from patents and developed technology. 16% are from customer relationships, and 4% are from trade names and other intangible assets. All of these assets have finite lives.
While the amortization of more than $7B worth of intangible assets over the next 8 or 9 years isn't a good thing for the balance sheet, I am not too concerned about it, as these assets account for just 8% of the company's total assets. They may also represent a barrier to entry for would-be competitors.
Return on Assets
The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:
Return on Assets = (Net Income) / (Total Assets).
For Google, the return on assets would be $10.7B in core earnings over the last 12 months, divided by $93.8B in total assets. This gives a return on assets for 2012 of 11.4%, which isn't bad in absolute terms. I also calculated Google's returns on assets over 2011 and 2010 for comparative purposes. This can be seen in the table below.
Table 1: Returns On Assets At Google
One thing that stands out here is that while the company is generating double-digit returns on assets, this figure has trended down over the last couple of years. This is due to the fact that while Google's annual earnings rose by 26% from 2010 to 2012, the company's asset totals rose by 62% over the same time frame. This isn't necessarily a bad thing, and not something of immediate concern to me. However, investors should follow this item over time, in order to make sure that management is still being efficient with the company's assets.
Short-Term Debt Versus Long-Term Debt
In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.
However, this isn't much of a problem for Google, which has a total of $2.55B in short-term debt. This figure is dwarfed by the company's cash reserves and free cash flow.
Long-term debt is debt on borrowed money that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.
Right now, Google is carrying only $2.99B in long-term debt, which like its short-term debt, is dwarfed by its cash flows. With an average of $9.65B in earnings over the last three years, it would take well below one year's worth of earnings to pay off this long-term debt, so Google has nothing at all to worry about in this department.
The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Google stacks up here.
Debt-To-Equity Ratio = Total Liabilities / Shareholder Equity
For Google, it looks like this: $22.1B / $71.7B = 0.31
Google has a superb debt-to-equity ratio. Remember that while the company doesn't have much in the way of short-term and long-term borrowings, it still does have liabilities such as accounts payable and accrued expenses that need to be taken into account. When calculated this way, the debt-to-equity ratio does that. To see how this figure has changed over time, I have included it from the ends of the last three fiscal years in the table below.
Table 2: Debt-To-Equity Ratios At Google
From the looks of this table, the debt-to-equity ratio of Google has been consistently good over the last three years. From this, it can be concluded that Google isn't financially-distressed in any way, shape, or form.
Return On Equity
Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.
Return On Equity = Net Income / Shareholder Equity
Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. However, Google is not one of these companies.
So, the return on equity for Google is as follows:
$10.7B / $71.7B = 14.9%
In the table below, you can see how the return on equity has fared over the past three years.
Table 3: Returns On Equity At Google
Once again, while the company has reported double-digit figures here, we see a downtrend over this time frame. This is due to the company's earnings growth being outstripped by growth in the company's equity position, which grew by a cumulative rate of 55% since the end of 2010. Due to the fact that the company is still growing its earnings while improving its equity position, I'm not overly concerned about this, but investors should still follow this in the years and quarters to come in order to make sure that management is making efficient use of the company's equity.
Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:
Retained Earnings = Net Income - Dividend Payments - Stock Buybacks
On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends. In the table below, you can see how retained earnings have fared at Google, which as of now has not paid out any dividends or participated in buybacks. It shows the retained earnings at the ends of the last four fiscal years.
Table 4: Retained Earnings At Google
From the end of 2009, retained earnings have grown by 140%, more than doubling. Needless to say, this is outstanding growth, which is exactly what you want to see from a company like Google.
After reviewing the most recent balance sheet, it can be concluded that there is much to like about the financial condition of Google. It has a large amount of cash and short-term investments that can be used for acquisitions, dividends, and share repurchases, in addition to a strong level of free cash flow. An excellent current ratio shows that the company can meet its short-term financial obligations, even in the event of an unlikely disruption of its operations. Google doesn't have much in the way of short or long-term borrowings that it needs to service. The company has also shown impressive growth in retained earnings over the past three years, which translates into more money that the company can plow back into its business.
The only potential concerns that I see are the possibility that the returns on assets and on equity continue to trend downward. Investors should follow these two items carefully to make sure that management is making efficient use of the assets that it has at its disposal.
While this is not a comprehensive review as to whether Google should be bought or sold, it can certainly be said that Google is in excellent financial condition.
Thanks for reading and I look forward to your comments!