Why Google Is Worth North Of $1,000

| About: Alphabet Inc. (GOOG)

We love reading about stocks. We love hearing everyone's story about why a company is going to move higher. But at the end of the day, stock prices are driven by expectations of future earnings and cash flows. And that's what we like to pay the closest attention to. Let's see what Google (NASDAQ:GOOG) is worth on a discounted cash-flow basis in this article.

But first, a little background on the "research jargon." We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators are the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Google posts a VBI score of 7 on our scale, reflecting our 'undervalued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We compare Google to peers Baidu (NASDAQ:BIDU), Facebook (FB) and Yahoo (NASDAQ:YHOO).

Our Report on Google

Investment Considerations

Investment Highlights

• Google earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 101.4% during the past three years.

• Once known exclusively for its search dominance, which it maintains, Google has become a tech company focused on a number of things: social, Android, ads, YouTube, Chrome and research. We think the company will have some megahits in the years ahead, and the shares are worth over $900 each.

• Google has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 24.8% in coming years. Total debt-to-EBITDA was 0.4 last year, while debt-to-book capitalization stood at 7.2%.

• The company's stock price has outperformed the benchmark during the last quarter, and its valuation still looks interesting at these levels. Investors could be accumulating shares as the stock continues to trade at bargain-basement levels.

• Google has a strong future in search-both on the desktop and via mobile devices. However, we think the Motorola Mobility acquisition will destroy value, and we continue to remain bearish on Android's profit potential (not market share potential).

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Google's 3-year historical return on invested capital (without goodwill) is 101.4%, which is above the estimate of its cost of capital of 11.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Google's free cash flow margin has averaged about 26.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Google, cash flow from operations increased about 50% from levels registered two years ago, while capital expenditures fell about 19% over the same time period.

Valuation Analysis

Our estimated fair value for Google of $1038 per share represents a price-to-earnings (P/E) ratio of about 31.1 times last year's earnings and an implied EV/EBITDA multiple of about 18.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 14.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 28.5%. Our model reflects a 5-year projected average operating margin of 30.3%, which is below Google's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 6% for the next 15 years and 3% in perpetuity. For Google, we use a 11.6% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $1038 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Google. We think the firm is attractive below $804 per share (the green line), but quite expensive above $1,272 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Google's fair value at this point in time to be about $1,038 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Google's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $1,450 per share in Year 3 represents our existing fair value per share of $1,038 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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.

Additional disclosure: GOOG is included in our Best Ideas portfolio.