As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Google's (GOOG) case, we think the firm is worth over $1,000 per share. Let's find out why we don't think this is too far of a stretch. Remember, we had been calling for Google's meteoric rise for a while (check out this gem when Google was trading in the mid-$500 range).
For those that don't know us, we're the firm that lets the numbers tell the story. We're not salespeople selling ice to Eskimos. We love straight talk, and we put more weight in numbers than anything else. We think numbers tell the whole story -- analysts can lie, management can commit fraud, authors can be biased, the board can be incompetent, but the numbers -- well, they don't mislead.
As such, we think a comprehensive analysis of a firm's discounted cash-flow valuation is the best way to identify the most attractive stocks. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. It's complicated, but it's also very simple. We prefer the latter.
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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 6 on our scale. We compare Google to peers Baidu (BIDU), Facebook (FB), and Yahoo (YHOO). In the spirit of transparency, we show how the performance of our strategy has stacked up relative to that of peers:
• 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 $1,000
• 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 20.5% in coming years. Total debt-to-EBITDA was 0.4 last year, while debt-to-book capitalization stood at 7.2%.
• 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).
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 (GM: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 11.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart to the right, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey 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. For more information on the differences between these two measures, please visit our website at Valuentum.com. 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.
Our discounted cash flow model indicates that Google's shares are worth between $823- $1,301 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $1,062 per share represents a price-to-earnings (P/E) ratio of about 31.8 times last year's earnings and an implied EV/EBITDA multiple of about 19.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 19.3% 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 25%, which is below Google's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 6.1% for the next 15 years and 3% in perpetuity. For Google, we use a 11.7% 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 $1,062 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 $823 per share (the green line), but quite expensive above $1301 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 $1,062 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 $1484 per share in Year 3 represents our existing fair value per share of $1062 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
Additional disclosure: GOOG and BIDU are included in our Best Ideas portfolio.