Google: 'Wave' of the Future?

Historical Valuation

Since going public just over five years ago, Google (GOOG) has grown to over a $120 billion dollar market cap powerhouse. Today Google trades at what is historically a very low valuation. In Figure 1 below we plot Google’s earnings per share growth since its public debut (i.e. green line with white triangles). With earnings compounding at almost 73% per year, Google has typically commanded a normal P/E ratio of almost 56 times earnings (i.e. blue line with asterisks). Therefore, at a blended P/E ratio of 24.6, it currently trades at more than a 50% discount to its normal value.

Fig. 1. GOOG 7yr EPS & Price Correlation

In Figure 2, we show Google’s historical price to sales ratio. It’s clear from the graph that seven times sales is historically very low for Google’s shares.

Fig. 2. GOOG 7yr Price/Sales

Our final historical measurement of value based on fundamentals looks at operating cash flows (orange area). With no debt on the balance sheet and powerful operating cash flow that exceeds net earnings, Google is clearly a financially healthy enterprise.

Fig. 3. GOOG 7yr EPS and Operating Cash Flow

Finally Figure 4 shows that even at today’s historically low valuations, Google shareholders have been well rewarded. It is also clear, that the stock market had little to do with Google shareholder returns and everything to do with Google’s business success.

Fig. 4. GOOG 7yr Price Performance

The Future

In Figure 5 below, we plot the consensus forecast 23.5% five-year earnings growth for Google by 28 leading analysts reporting to Zacks. Therefore, on a future expectation basis, Google trades at an attractive PEG ratio of just over one (i.e. orange arrow).

Fig. 5. GOOG 5yr Earnings Forecast

The most important point to be gleaned from the above forecast graph is that investors cannot buy Google’s past, only its future. Therefore, the important question is – how accurate is the consensus forecast? Because, if correct, then Google today is a sound and attractive buy for investors seeking long-term above-average growth of capital.

Clearly, Google at $120 billion dollar market cap cannot continue to grow at a 70% plus rate. On the other hand, how realistic is the 23-25% five-year forecast? Although the recession has had an effect on Google’s top-line growth, we believe it should prove temporary. Search, in our opinion, remains a future driver of growth for Google. Also, their healthy finances have allowed Google to remain active in developing and introducing new products. Some of which have enormous promise. Much has already been written about Android, Gmail, and Web maps, not to mention dabbles in more creative advertising initiatives in conjunction with YouTube, etc. Of course, there are many other projects and developments, too numerous to cover here.

Disruptive Technologies

Google itself is, and has been, a disruptive technology. One of their newest products promises to be even more disruptive than Google was itself. If you haven’t heard of the latest wave crashing across the internet, it is Google Wave, by the same developers as Google Maps. The Wave was released to 100,000 initial developer users on September 30^th. There are an additional 800,000 invites available to the initial group, bringing the total first-run users to near one million. Google Wave is a new way of organizing and handling communications across the internet.

The Wave technology is essentially a near real-time integration of email, instant messaging, blogs, wikis, search, and document collaboration, including real-time language-independent context-sensitive spell checking and translation. Wave changes the way in which we think of communications, in that we will no longer need to be concerned about whether it is a blog, or an email, or an instant message, or a document we are working on. They will all become one under the Wave.

Wave is both a product for users and an open-source platform and protocol for developers. It has already been in development for a few years, but once fully released, it should grow rapidly, due to its open-source nature. A little less than a “googol” of developers in the internet cloud will be building new web apps with all sorts of new interconnectivity. The Wave design should work well with current blogs and social networking sites because it is fully embeddable into most any web environment.

This is very early in the complete development process, but the concepts of Google Wave are far reaching. The monetization of Google Maps is still in the development stage and so will be Google Wave for many years. This technology has the potential to eliminate or change some of the current services which are on the internet. Among those threatened is Google’s own Gmail. All of the current technologies which the Wave works with, it could also replace. This Wave may cause many companies to be gasping for air, some to be running for cover or at least concerned about how wet they will get as the Google Wave comes rolling over them.

Conclusion

Investing in common stocks implies dealing with uncertainty. With technology stocks in particular, uncertainty is heightened. Let’s not forget that just a decade ago, Google was irrelevant. Today it’s ubiquitously used across the globe. “Why don’t you Google it?” has become a common everyday phrase. Let’s also not forget that the long-term earnings prospects of technology businesses will more often than not be derived from products that don’t even exist today.

Google is a very strong and healthy company with the resources and smarts to continue to grow. You can’t achieve the success that Google has without expecting competition to enter your market. However, the first to market usually maintains a profitable and dominate share. We like Google’s chances long term, and feel the price is right at today’s levels.

Full Disclosure: Long GOOG at time of writing.

Comments

[NW Tech:]

Trees never ever grow to the sky. The problem with the analysis here is that GOOG is still 210 points BELOW it's all time high, as of this morning.

Oct 08 05:30 AM

[modelportfo...:]

@Chuck
@NW Tech
Nice summary, esp of Google Wave. It is clearly a disruptive technology and has the potential to be really big for Google. I like Google's "beta" approach on this one as it is clearly building a ground-swell of support in the developer community. The integration with other open source apps from Google, esp Android and Chrome, add to the credibility of the Wave which you can, because of cloud computing, carry on with many devices--PCs, mobiles, MID, etc.
Yes, the shares are still below the all time high reach before the Great Recession, but when they re-establish this "high", which I believe they will do, they will have diversified from being a one product company, text search, to other cash cows, display, YouTube, mobile, etc

Oct 08 10:23 AM

[Tom B:]

Goog has one income stream that will ever be of any value-- advertising revenue. But it's a big one. I'm inclined to believe that the recession will eventually end (what's the point of not slitting your wrists if you believe otherwise?) and when that happens, Goog SHOULD pass it's previous high.

The "cloud" stuff stuff is kind of "blue sky", to mix my metaphors, but if anybody can eventually do "the cloud" and make money on it, GOOG has a better shoot than MSFT, because MSFT does NOT do "data security". "The internet ate my homework."


On Oct 08 05:30 AM NW Tech wrote:

> Trees never ever grow to the sky. The problem with the analysis here
> is that GOOG is still 210 points BELOW it's all time high, as of
> this morning.

Oct 08 10:33 PM

[Gregman2:]

The wave of the future may not be indexed search. See...www.Yebol.com.

Oct 09 12:20 AM