Google (GOOG) has been an anomaly for me recently. I've read various articles on the company on SA and found that I can classify most of the valuation articles into one of four categories:
- The company is undervalued because of a DCF valuation.
- The company is undervalued because of innovative prospects.
- The company is overvalued because of cheaper alternatives.
- The company is overvalued because of recent stock price movement.
In my opinion, a well-written article in any of these categories could be accurate, but I think readers deserve more. To deny the truth of any of the other views or fail to mention them would be shorting readers. For me, articles written with an objective, universal perspective tend to be the most helpful. I think Google is missing that right now. In this article, I'm going to attempt to provide objective analyses and present and back up every argument of the four categories above.
Undervalued Because of DCF Valuation
I performed several discounted cash flow valuations of Google with a variety of inputs and found the company to be slightly undervalued in every circumstance I assumed. The valuations are below with their respective assumed values.
Assumed: Analyst consensus of 13.58% annual growth next 5 years, Terminal Growth of 6%
Result: Undervalued. Margin of Safety = 35.66%. Fair Value = $1294.57 per share.
Assumed: 17% annual growth next 5 years, Terminal Growth 6%.
Result: Undervalued. Margin of Safety = 43.91%. Fair Value = $1484.90 per share.
Assumed: 10% annual growth next 5 years, Terminal growth 5%.
Result: Undervalued. Margin of Safety = 13.56%. Fair value = $963.52 per share.
A few clarifications: I used a relatively high terminal growth rate above that of inflation because I don't believe Google will be fully mature in 5 years and I think the nature of the online advertising industry provides for some growth as the industry grows. I also used Enterprise Value in my calculations to account for Google's large cash stash.
I believe analyst estimates are pretty conservative given Google's growth in the past, but stock-based compensation and the company's size keep per-share growth below 15% in my opinion. What's important here is that even if the analysts and I are wrong - even if Google only grows FCF by 10% per year - it's still slightly undervalued.
There has been much debate over whether Google is worth $1000 per share. My calculations suggest the company could be worth as much $1500 per share. That's enough to get some of you to stop reading and put all your money in the company but I beg you please read on. There is more to this story.
The Company is Undervalued Because of Innovative Prospects
This is an argument I will not delve too deeply into because it is not my nature to value based on abstract information. I do, however, believe the company is undervalued if it can follow through on some or all the innovative projects it has in its pipeline and monetize them. If Google Glass is popularly accepted and becomes a big money maker along with a few other projects (known or unknown), then valuations based on Ad and Mobile revenues alone become understatements of the company's true value. Entire new divisions would be created in the company and marketplace. When Apple (AAPL) innovated like that, the company was growing much faster than the 13.58% that analysts currently have Google down for. If the company can make a go of any of these big ideas, the growth estimates I used in my DCF valuations become understatements of what the company could actually achieve. The valuations we see now become pretty inaccurate. Here's a more detailed innovation-based argument on SA.
The Company is Overvalued Because of Cheaper Alternatives
This argument is based in valuing Google relative to similar companies. The company used is typically Apple. Google can be seen as overvalued by comparing its recent price movement to Apple's move before September of last year.
(Click to enlarge)
The charts are remarkably similar and we all know what happened after that for Apple. The argument is that Google is destined to the same 40% correction.
There's also the DCF peer comparison valuation. Let's take Apple again, a company I'm very familiar with and one of Google's closest peers. If I perform a conservative DCF valuation of Apple assuming 12% FCF growth (below estimates) and 3% terminal growth and leave all the other factors constant from my Google valuation, Apple is 67% undervalued. That's significantly cheaper than even my most aggressive valuation of Google.
This discrepancy is why many investors claim Google is overvalued, because there's a significantly cheaper stock sitting right next to it.
The Company is Overvalued Because of Recent Price Movement
Many investors argue that Google is overvalued now simply because it was for sale much cheaper only a few months ago. Indeed last June, you could have purchased stock in Google significantly lower at $556 per share.
This does make sense. Yes, Google's prospects have changed significantly since June but have they really gotten that much better that the stock deserves such an increase? Most likely not. The thinking is also that one cannot accept purchasing something now that he knows he could've purchased much cheaper in the past. And really if you think of what value is - what you receive per dollar spent, Google was a better value back then. You were getting the same stock for much less and many investors just can't accept that.
Beauty Lies in the Eyes of the Beholder
So what argument is correct? Well by now I'm sure you've figured out that all the views are internally valid. Google's valuation is subjective as is any stock valuation.
If you are looking for absolute value and don't wish to invest in Google's competitors, then Google is fundamentally undervalued. Even on conservative estimates the stock still passes the test and that's enough for many investors. Many investors also are excited about Google because of all the innovative hype surrounding the company. If what they are expecting occurs, they will certainly make a lot of money.
For other investors who consider relative value and the opportunity costs of not being able to invest in cheaper companies if they were to buy Google, Google seems quite expensive. Whether you agree with my valuation method or not, I used the exact same method for Google and Apple and clearly Apple is cheaper. Many investors cannot rationalize having their money anywhere but in the best value possible. Many investors also act as bargain hunters, only buying when they find things at their cheapest. For them, Google is unattractive because they could've got in months ago for much less.
This is what makes a market. Investors will always disagree on a company's prospects and value. If we didn't disagree, then there wouldn't be a market because no one would buy what someone else was selling.
It's also interesting to see how subjective a valuation, something most understand to be objective and solid, can actually be. Humans are stubborn. Once we decide whether to do something or not to, we will go to great lengths to back up why we made the right decision, even if we don't truly believe it.
I believe this article is helpful for anyone considering investing in Google because it presents various perspectives. The best investors are aware not just of what they think, but also of what those around them think. Do your research and take some time to consider which view you support and why. Try to be as objective in your analysis as possible. Whatever you decide, good luck to you.