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Google (NASDAQ:GOOG) stock has been one of the better performers over the last 1 year generating a return of 46% compared to the 21% return of the NASDAQ index. The stock also outperformed the broader markets over the last 6 months and 1 month period. Trading at approximately $870 a share, the stock is significantly closer to its 52-week high of $920.6 compared to the 52-week low of $556.52 a share. In this article, we will examine the company's fundamentals and perform a valuation analysis to determine if the stock is cheap at current levels.

Growth:

GOOG has delivered an accelerating growth rate with annualized growth rates increasing from 19% over the past 3 years to 31% on a quarter on quarter basis. The net income and EPS have however trailed these growth rates and that is a negative in my opinion. Year over year, EPS was up 7% compared to the 10% increase in net income. Going forward, analysts expect a long term growth rate of 15% below the projected growth rate of the industry. I hold a slightly optimistic view than the average analyst and based on a fundamentals based growth rate estimate, I predict that GOOG will sustain a long term growth rate of 16% over the next 5 years.

The growth rates are presented in the table below:

Growth Rates

3 Year

YOY

QOQ

Revenue

19%

32%

31%

Income

6%

10%

16%

EPS

6%

7%

14%

    

Growth Estimates

GOOG

Industry

S&P500

Next Year

16.00%

28.90%

12.10%

Next 5 Years

14.93%

19.27%

9.40%

Profitability and Operations:

GOOG has experienced a moderate reduction in all of its profitability metrics that I usually consider. Gross margin fell from an average of 63% over the last 3 years to a TTM margin of 57%. A similar trend could be seen in both operating margin and net margin. Additionally, return on equity and return on assets declined from 19% to 16%, and from 15% to 13%, respectively over the last 3 years. Overall, I see room for improvement when it comes to operational efficiencies. The profitability and operational metrics are shown below:

Profitability & Operations

3 Year

1 Year

TTM

Gross Margin

63%

59%

57%

Operating Margin

31%

25%

24%

Net Margin

25%

21%

21%

Return on Equity

19%

17%

16%

Return on Assets

15%

13%

13%

Competition:

To compare GOOG to its competitors, key operational and valuation metrics for its peers were obtained. The peer group selected for analysis included Baidu (NASDAQ:BIDU), Yahoo (NASDAQ:YHOO), Facebook (NASDAQ:FB), and Microsoft (NASDAQ:MSFT). The table below presents the peer analysis results.

 

 

Ticker

Price

P/E

P/S

ROA

ROI

GM

OM

BIDU

97.28

19.62

9.27

30.12

38.36

71.09

49.54

YHOO

26.07

7.64

5.72

20.54

22.35

67.5

11.36

FB

24.1

2028.62

11.55

0.49

0.54

73.2

10.57

MSFT

35.02

18.05

3.88

14.77

20.15

76.22

29.92

GOOG

881.27

26.24

5.77

12.97

15.08

59.13

25.43

As shown above, GOOG appears slightly expensive compared to its peer group.

Valuation:

Valuation analysis was performed using residual income analysis and three scenarios identified below:

- Optimistic Scenario: In this scenario, I assumed that GOOG would report 2013 and 2014 EPS meeting the high end of analyst expectations. A growth rate of 19% was assumed for the next 5 years beating market expectations.

- Realistic Scenario: This scenario is based on my expectations. I started my analysis in this scenario employing the average 2013 and 2014 EPS estimates. A long term growth rate of 16% was used as part of this analysis.

- Pessimistic Scenario: In this scenario, I assumed that the company would miss average forecasts for 2013 and 2014 and report an EPS matching the low end of analyst expectations. A long term growth rate of 14% was assumed as part of this analysis.

A cost of equity of 11.4% and a stable growth rate of 3% was applied in the case of all three scenarios. The analysis results are present below:

Optimistic Scenario:

EPS 2013 - $48.2

EPS 2017 - $95.6

PV of Residual Income = $257

PV of Terminal Value = $390

Existing Book Value = $228

Intrinsic Value = $875

Realistic Scenario:

EPS 2013 - $45.8

EPS 2017 - $82.7

PV of Residual Income = $205

PV of Terminal Value = $305

Existing Book Value = $228

Intrinsic Value = $738

Pessimistic Scenario:

EPS 2012 - $33

EPS 2021 - $68.5

PV of Residual Income = $127

PV of Terminal Value = $179

Existing Book Value = $228

Intrinsic Value = $534

As shown in the above, GOOG's fair value is in the broad range of $875 to $534. Even assuming that the optimistic scenario holds true, the stock still trades at a slight premium to fair value. On the pessimistic side, a decline of 40% is possible. I would avoid the stock at current levels and look to open a short position if the stock appreciates further.

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Source: Google: A Downside Risk Of 40%