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The internet industry consists of companies that provide a wide range of products and services primarily online through their websites. The industry is not particularly capital intensive, although some participants must continually invest in their operations to remain competitive. Many companies have a healthy cash flow, which can be used for capital expenditures, to make acquisitions, and to repurchase shares. The internet industry is inherently risky, as it is characterized by rapid technological change and low level of barriers to entry. But high risk can lead to higher return, and that is the very reason that this industry is found attractive by growth investors. To evaluate this industry we select four big players, including Google (GOOG), Yahoo (YHOO), Facebook (FB) and Tencent Holdings Limited (OTCPK:TCTZF).

Google

Google is a multinational corporation that provides internet-related products and services, including search, cloud computing, software and advertising. Google's acquisition of Motorola Mobility enhanced revenues, although adverse effects can also be seen on the margin side. The rapid shift to mobile affects the margins, dragging EPS growth down. Its fourth-quarter "Paid clicks" growth (YOY) fell 10 percent attributable to increase in mobile search. Gross Margin dropped 8.1 percent due to the consolidation of Motorola (MSI).

Analysts believe that Google's mobile business is becoming a source of increasing confidence in the company, and that mobile trends are in the right direction. Google makes and distributes free Android software to mobile device makers in order to make "Google it" more widely available. The decline in popularity of Apple indicates a shift in the market share of other OS like Android. Android is set up to feature Google's search engine and other services, giving Google a greater chance to sell ads on mobile.

An analysis of key Google valuation measures like Price-to-Earnings, Price-to-Book and Price-to-Sales shows that the company is currently undervalued with high margins with respect to the industry.

Key Stats

Stock

Ind Avg

Price/Earnings TTM

25.8

27.7

Price/Book

3.8

3.9

Price/Sales TTM

5.4

5.7

Rev Growth (3 Yr Avg)

28.5

-

EPS Growth (3 Yr Avg)

16.6

-

Operating Margin % TTM

25.4

17

Net Margin % TTM

21.4

18.7

ROE TTM

16.5

13.6

Debt/Equity

0

0.1

Analysis of key valuation ratios favors Google, as they are below industry average and S&P 500.

Key Valuation Ratios

GOOG

Industry Avg

S&P 500

GOOG 5Y Avg*

Price/Earnings

25.8

27.9

16.2

23.9

Price/Book

3.8

3.9

2.2

4

Price/Sales

5.4

5.7

1.4

5.9

Price/Cash Flow

16.2

20.3

9.4

15.2

Google's lower forward price-to-earning indicates higher earnings growth in the future.

Forward Looking Estimates

GOOG

Industry Avg

S&P 500

Forward Price/Earnings

16.4

-

13.9

Yahoo Inc.

Yahoo Is an American multinational corporation, widely known for its web portal, search engine and related services, including Yahoo Directory, Yahoo Mail, Yahoo News, Yahoo Finance, advertising, online mapping, video sharing, fantasy sports and its social media website.

Yahoo's revenue growth driven by Search continues to improve on a year-on-year basis. But its own growth is currently well below industry average, and it is lagging behind in the shift to mobile. The company made significant improvements to two of its core products, Yahoo Mail and Flickr, to cater to the shift to mobile. Yahoo Also signed a distribution and branding deals to strengthen Yahoo Sports and NBC Sports. It acquired mobile app developers Stamped and OnTheAir, accelerating the efforts to build a world-class team of mobile engineers, product managers and designers. All these developments will translate into increased future cash flows.

Analysis of key indicators leads to the conclusion that Yahoo is currently undervalued, with a low risk level, as debt-to equity ratio is zero.

Stock

Ind Avg

Price/Earnings TTM

6.9

27.9

Price/Book

1.7

3.9

Price/Sales TTM

5.5

5.7

Rev Growth (3 Yr Avg)

-8.3

-

EPS Growth (3 Yr Avg)

98.4

-

Operating Margin % TTM

11.4

17

Net Margin % TTM

79.1

18.7

ROE TTM

29.1

13.6

Debt/Equity

0

0.1

Though Price-to-Earnings, Price-to-Book and Price-Sales ratios favor Yahoo but negative price-cash flow ratio indicates that the company is burning extensive cash in operations.

YHOO

Industry Avg

S&P 500

YHOO 5Y Avg*

Data as of 03/11/2013, *Price/Cash Flow uses 3-year average.

Price/Earnings

6.9

27.9

16.2

25.3

Price/Book

1.7

3.9

2.2

1.6

Price/Sales

5.5

5.7

1.4

3.7

Price/Cash Flow

-96.2

20.3

9.4

-16.9

Dividend Yield %

-

-

2.3

-

Facebook

Facebook is a social media platform that connects people with friends, families and others who work, study and live around them. After eight months of increased volatility in the public markets, Facebook did well in the fourth quarter of 2012 by aggressively ramping up advertising revenues which include revenues generated from the mobile phone advertisement. Its financial results also beat analyst expectations. It is also making efforts to generate additional revenues by rolling out several new options, including app install ads, Sponsored Results and Gifts.

The analysis of Facebook multiples, indicates that it has aggressive multiples, which basically means that Facebook is highly overvalued as compared to the industry. A higher price multiple, as shown in the table below, indicates that investors are anticipating hyper growth in the future, which is difficult for Facebook to achieve in such a competitive environment.

FB

Industry Avg

S&P 500

FB 5Y Avg*

Price/Earnings

2500

27.7

16.2

-

Price/Book

5.7

3.9

2.2

-

Price/Sales

11.9

5.7

1.4

-

Price/Cash Flow

37.6

20.2

9.4

-

Dividend Yield %

-

-

2.3

-

Tencent Holdings Limited

Tencent Holdings is a Chinese investment holding company whose subsidiaries offer entertainment services - online gaming, Internet, mobile phone value-added services and online advertising in China.

Tencent Holdings' recent quarterly results show attractive margins and returns. But with the increasingly uncertain economic environment in addition to competition from online game leaders, like NetEase and Shanda, increase risks involved.

Tencent Holdings' key valuation multiple analysis decreases it's attractiveness as these ratios indicate overvaluation.

Stock

Ind Avg

Price/Earnings TTM

36

27.7

Price/Book

11

3.9

Price/Sales TTM

10.8

5.7

Rev Growth (3 Yr Avg)

58.5

-

EPS Growth (3 Yr Avg)

53.6

-

Operating Margin % TTM

37.4

17

Net Margin % TTM

29.9

18.7

ROE TTM

30.9

13.6

Debt/Equity

0.3

0.1

Conclusion

The above analysis of the selected companies, indicates that Yahoo is undervalued but its negative cash flow decreases its attractiveness and will be of concern to investors. Cash flow measures actual cash and not the accounting profits, which makes it less subjective as compared to the earnings. Facebook is found to be expensive and requires hyper growth in the near future to justify its earnings. Tencent Holdings is also overvalued and increase in online gaming competition further decreases its appeal. Our analysis shows that Google offers the most attractive investment opportunity as it is currently undervalued with comparatively higher margins relative to the industry.

Source: Picking The Star From The Information Technology Universe