Why Google Has More Room To Run

Mar. 5.13 | About: Alphabet Inc. (GOOG)

Google (NASDAQ:GOOG) shares have been making news of late for hitting all-time highs, including again yesterday. The stock is currently fetching $821.50, for a market cap of $271B, making it among the largest companies in the country. Even after the monster run shares have enjoyed, GOOG's forward P/E is only 15 and I will argue that Economic Value Added suggests GOOG has more room to run, despite the rally.

If you are unfamiliar with EVA, the basic premise is that the company's asset base, which is defined as total assets minus current liabilities, gets "taxed" by the company's weighted average cost of capital. After-tax earnings must exceed this "taxed" amount in order to produce positive EVA. If EVA is negative, it means company management isn't producing enough income from the company's asset base to cover its economic cost of financing the assets. Also, it is important to note that I chose an equity cost of capital of 11% for this analysis. You could make a case for a higher or lower value, but I chose 11% because that is my best estimate of Google's equity-risk premium.

First, we'll take a look at Google's nominal EVA since 2003. What we see here is that EVA was largely nonexistent when Google went public, but subsequently soared to over $3 billion in 2010. We then see EVA drop to $2 billion last year.

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This chart doesn't exactly look promising except that we see Google experienced a large percentage drop in EVA in 2008 and subsequently recovered quite nicely; I suspect this will happen again as R&D expenditures tend to cost a tech company earnings before the new products and services generate earnings. I won't get into all the new products Google is working on as that is not the point of this article but suffice to say, I think Google has been investing for the future and EVA has suffered a bit as a result in the past two years.

It is also important to remember that although EVA has dropped, it is still far above zero. This means that even if Google's management is spending money on R&D, the company is still producing a huge amount of economic value; it's important not to lose sight of that fact.

Another reason why we might be seeing EVA drop for Google is the simple fact that the asset base has been growing exponentially for the past 10 years.

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In 2003, the asset base was less than a billion dollars; last year, it was nearly $100 billion. Growth like that is difficult to keep up with and also keep in mind that Google has over $60 billion in current assets, most of which is in cash and cash equivalents. These assets are inherently unproductive and Google's massive cash generation ($16.7 billion just last year) is working against EVA as it becomes harder and harder to cover the growing asset base with earnings sufficient to produce positive EVA. As cash is not an EVA-producing asset, it becomes more difficult to produce positive EVA as the cash balance grows.

Next, a look at Google's return on assets shows a similar story. We see that as the asset base has grown, ROA has suffered somewhat. Google is still producing over 11% ROA, despite the fact that its asset base has grown exponentially since the company went public.

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Given the fact that ROA has suffered only a few hundred basis points from the peak and the fact that the asset base is still increasing in a parabolic fashion, this bodes well for future earnings.

Finally, Google's EVA as a percentage of total assets is perhaps the most telling.

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We can see that Google has bounced around between about 2% and 6.5% in terms of EVA as a percentage of total assets. Again, we see the parabolic rise in the asset base hurting Google's EVA as a percentage of assets in the past couple of years. However, I would argue that this is actually a positive going forward for Google as we have seen rough patches before. I suspect the dip in economic earnings in the past two years is due to investments in the future, such as Glass and the mobile space, and that those investments will begin to pay off in future years, raising EVA once more.

So what does all of this mean for earnings? First, if Google can return to a return on assets value of 14%, which is well within historical norms, coupled with the rising asset base, say $15 billion per year, we could see over $15 billion in net income this year from Google. Analysts are expecting more like $12.5 billion this year from Google. The point is, Google may not hit 14% ROA this year, but history tells us it will in the future and seeing how quickly the asset base is rising should be quite encouraging to shareholders. I'm not necessarily calling for $15 billion in net income this year, but I am suggesting that it is definitely possible, given Google's historical norms.

Another way to look at potential earnings for Google is EVA as a percentage of assets. We saw that last year's value was just over 2%, which is a historical low for GOOG. Once again, I believe this is transitory as Google invests in the future. Also keep in mind that during the last two years, Google has transformed itself into a mobile behemoth, requiring substantial investment, including Motorola Mobility. Once these investments begin to pay off, I believe we will see EVA as a percentage of assets rise once more to the 4%+ range. This implies that Google could be adding $4 to $6 billion in economic value per year starting this year and into future years, up from last year's value of $2 billion.

Regardless of whether my estimates prove to be right or not, we see that Google's EVA was near its historical bottom at the end of 2012, portending gains in the future, including this year. I believe the investments Google has been making in mobile and other areas, such as Glass, have resulted in decreased earnings and EVA in the past two years. However, once those investments begin to produce gains, Google's EVA will rise once more and shareholders will reap the benefits of increased economic value added. The point of this analysis is to notice the trends that have taken place in Google's EVA and see that the company is currently at the bottom of the range. This presents a great buying opportunity as it means EVA is almost certain to rise once more, producing positive returns to shareholders.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GOOG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.