Confronting The Google Growth Multiple

Feb.18.14 | About: Alphabet Inc. (GOOG)

In your journey of self-discovery, be wary of what you find, lest you lose yourself in what you have found.

I am first and foremost a value investor. When growth has outperformed value for an extended period of time, as is the case today, I look at growth. Not to buy, but to identify good stocks, appreciated by market participants, and which might during a period of market stress, or a period when value outperforms growth, represent good value.

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In the recent past I have looked at Tesla (NASDAQ:TSLA), Amazon (NASDAQ:AMZN), and Facebook (NASDAQ:FB), with optimism in the outlook, and pessimism in valuation. I own none of these stocks today, and what I am doing is building a watch-list of interesting names to own, should the opportunity present itself: one day, if ever.

Today I am looking at Google (NASDAQ:GOOG). I do not own it, though perhaps one day I will. For those of you who are looking for a view backed by a long position, stop reading now: there is nothing here for you. And for those of you who cannot bear the thought that Google might one day trade below its recent all-time high of over $1,204 for a sustained period of time, look away: this post will likely be too painful for you.

Who is Google & What Has It Accomplished?

Google is predominantly a technology company specializing in advertising, seeking to monetize search and information functionality.

At the end of this post, you will find several lists of companies, with annual revenues of over $100 million, identified as belonging to the traditional advertising industry, excluding Internet based advertising. From this data, we know that global traditional advertising industry was sized at about $125.5 billion during the 2012 fiscal year.

Google, which is classified as an Internet company, had revenues (excluding mobility) of $46 billion (including $43.7 billion from advertising) during 2012. Not only is Google the largest advertising company in the world, it is well over double the size of the largest global traditional advertising company.

This is disruptive innovation at its best. Google received first funding of $100k from Andy Bechtolsheim in August 1998, but the first major funding of $25 million came in June 1999. Google listed in August 2004, five years after its first major funding. In the few years since, Google is the largest advertising company by revenue today.

That is today, what about tomorrow?

How much more of the lunch of the traditional and print media advertising industry can be eaten by Internet based advertising? Internet based advertising continues to grow and capture a larger share of advertising revenues.

A report from ZenithOptimedia suggests that the total size of the advertising industry can be expected to grow at a rate of about 5% to 6% in the coming years. They also estimate that the desktop Internet based advertising will grow at 7% to 8% annual rates, and the total Internet based advertising (mobile plus desktop) share of advertising industry will grow to 24.6% from about 20.4% in 2013.

Thus if the advertising industry grows from $100 to $106, the share of mobile plus desktop is expected to grow from $20.4 ($100*20.4%) to $26.08 ($100*106% Industry Growth * 24.6% Internet Segment Share). Accordingly, Internet based advertising on desktop plus mobile can be expected to grow at an annual rate of 27.8% ($26.08/$20.4-1) in the coming years.

With desktop expected to grow at 7% to 8%, there are no prizes for guessing that the winners in market share shall be those whom successfully monetize mobile Internet based advertising. And with Google's dominance of the mobile eco-system via Android, they have a strong position.

But what about increasing competition for Internet based advertising dollars?

With Facebook, Twitter (NYSE:TWTR), Amazon, Linkedin (NYSE:LNKD) and Pandora (NYSE:P), amongst others, wading into Internet based advertising industry segment, the competition is intensifying. Google is huge. Growing will be much more difficult than it was. This together with the intensification in competition makes me believe that it will be near impossible for Google to grow at the 27.8% rate anticipated for the Internet based advertising segment.

I am looking for annualized growth of 16.89% during the five years between 2014 and 2018. Here is how I estimate growth.

Eleven years have passed since the end of 2002. And over the eleven years, revenue (excluding Motorola) grew from $439.51 million to near $55.4 billion, at an annualized growth rate of 55.22%. Revenue per diluted share, during the eleven year period, grew at an annualized growth rate of 49.28%. Can we expect similar growth rates going ahead? I'd say no.

I looked at the change in the year-on-year growth rate over the past several years. The change in year-on-year growth rate is a second derivative of growth. Watching it closely helps in identifying trends early. It helps to estimate the level of deceleration in growth rates. Thus if a company is growing at an annualized rate of 20%, with a 6% deceleration rate, the growth rate can be expected to decline to 18.8% [20% * (1-6%)] in the year following, 17.67% [18.8% * (1-6%)] in the next year and so on until its growth rates are consistent with industry growth rates.

My main interest is to project a decline or deceleration rate to determine where revenue might go in the coming five years. At median levels the year-on-year growth rate has declined at 21.86%, while on average it has declined at 6.04%. I believe the 6.04% deceleration rate is a reasonable estimate of what we shall see going ahead.

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Source: My Analysis and Estimates based on historic Data & trends from Google Investor Relations Tables.

As the revenue grows larger, it gets more difficult to grow the business at the prior growth rates: deceleration is inevitable unless growth comes from new business segments. In this exercise, I am looking only at continuing operations and not additional growth from presently un-contemplated sources. Thus, over the coming five years, using a 6.04% decline in the year-on-year growth rate, I expect to see Google revenues in 2018 to be $120.9 billion. Further details are noted in the chart below.

Do note that the trend in year-on-year revenue growth rates is expected to go from 20.29% in 2013, to 14.86% in 2018, always keeping in mind that this exercise is looking at present continuing operations only. The annualized revenue growth rate projected for the next five years is 16.89%. This implies that Google will grow at a rate of 60.66% of the 27.8% Internet based advertising growth expected.

Also note that the revenue per share number displays year-on-year growth at 12.88% in 2018, compared with a 14.86% year-on-year growth rate for the company. This occurs because of an expectation that dilution will continue at the average 1.76% eleven year annualized dilution rate seen between 2002 and 2011 - this rate is also reasonably consistent with the dilution seen during the past two years. The annualized per share revenue growth rate projected for the next five years is 11.32%.

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Source: My Analysis and Estimates based on historic Data & trends from Google Investor Relations Tables.

On a per share basis, I am assuming that the fully diluted share-count will rise at a rate of 1.76% per year. The per share forward annualized dilution expectation is estimated based on the median annual dilution seen since 2002. It is also reasonably consistent with dilution rates of 1.56% and 1.96% seen in 2012 and 2013 respectively. Below is a chart displaying historic diluted share count data together with projections for the coming few years.

Source: My Analysis and Estimates based on historic Data & trends from Google Investor Relations Tables.

What does this mean for earnings?

In the eleven years since the end of 2002, Google managed to maintain an annualized diluted earnings growth rate of near 49%.

What is equally interesting is the fall-through rate. The fall-through rate looks at how much of the incremental revenue falls through to the bottom line. It is mathematically expressed as Current Year Diluted EPS Less Prior Years Diluted EPS Divided by Current Year Revenue Less Prior Years Revenue. At median levels it has been 17.97%. In 2014 I am looking for $52.11 in diluted earnings. This is not frightfully optimistic, coming after three recent years of relatively subdued earnings growth: during 2011, 2012 and 2013, Google diluted earnings grew at 13.11%, 9.07% and 11.06% respectively. The payback for the investment in growth made during these years should start in 2014.

In the subsequent years, I have projected earnings in a manner such that 17.96% of incremental revenue falls through to the bottom line. Overall, the target diluted EPS expected for 2018 is $76.50. With 2013 diluted EPS from continuing operations coming in at $36.05, the $76.50 2018 expectations represents a 16.24% five-year annualized growth rate.

Source: My Analysis and Estimates based on historic Data & trends from Google Investor Relations Tables.

This is an optimistic assessment. Squeezing out an estimated $76.50 in diluted earnings from an estimated $326.98 in revenue per share implies a net income margin of 23.4%. This compares with 22% in 2013. In times when competition intensifies, it is difficult to increase margins. So I'll re-iterate that I am being optimistic in outlook and shall be a pessimist in valuation.

Is there more optimism ahead?

Google is creating free cash flows at a rapid pace. It is re-investing these in new revenue streams and in the next cycle of innovation. We have the investment in Android, which positions Google as the first amongst equals in mobile advertising in the coming years. Then there is the much talked about wearable devices which could be a source of future growth. Then there are investments in networks and the cloud, which are additional sources of future growth. And then there are investments in social networks - I would not say this has been a huge success, but with the integration of Google Plus with other Google products, the information Google has on users is far higher quality. And that, notwithstanding privacy concerns, is an advantage that gives Google an edge in attracting advertising $'s.

I believe the biggest opportunity ahead for Google lies in eCommerce where so far they have made no great strides. Google has disrupted the advertising industry. Advertising is tiny when compared with retail, which is over $2 trillion in size. Disrupting retail is something where others are doing a better job than Google today. But if they successfully create a marketplace eco-system, driven by data and information gathered by Google, they could gain share in a huge market, though perhaps with a thin margin.

The high growth and expectations of continuance of high growth means Google is valued as a growth stock. Which brings me to confronting the growth multiple.

Confronting the Google Growth Multiple

I did a recent post on the Math of the Market Multiple, which you can read here. I strongly recommend that you read it, because if you don't, I might lose you as we proceed through this part of the post: in many ways, this is a direct continuation of that post. I had ended that post saying:

"Look at the mathematical expression: $1 * (1 + G%) * (1 - Rr)/(VLT ERP + Rf - G%). We know that VLT ERP + Rf is the market return expectation. What would we do if the market return expectation was lower than or equal to growth? We get either an incoherent or an insolvable value!

Approaching growth multiples is different, and I'll get into it in a post another day. We have all seen situations where buying a high multiple paid out manifold, as well as situations where buying a high multiple ended in tears. What occurs is not a result of the multiple: the multiple simply is what it is. The outcome is influenced by the accuracy of the various estimates included in the components of the multiple.

Working through the math of the multiple gives you a better chance of seeing whether today's high multiple, will become a lower multiple and a profitable investment tomorrow."

In the above extract:

  1. G% means the growth rate to perpetuity
  2. Rr is the reinvestment rate, which can be calculated as G% divided by the return on equity (RoE%)
  3. (1-Rr) is the notional payout [NP]
  4. VLT ERP is the very long-term equity risk premium which is calculated as Beta * (Rm - Rf)
  5. Rm is the market return expectation
  6. Rf is the risk free rate
  7. VLT ERP + Rf is equal to Rm

This post on Google seemed like a nice place to confront the growth multiple.

History tells us that the market exists for a period of sufficient duration to consider perpetual existence. This presumption of perpetuity does not hold true for stocks. When considering individual companies, stock selection, diversification and valuation are our friends.

With Google, I am reasonably confident that we have a residual life which will be sufficiently long to consider perpetual. But I would not consider owning Google as the only stock in my portfolio: I'd certainly want diversification. And I'd want to own it at a good price.

What does the math of the present multiple imply?

$1 * (1 + G%) * (1 - Rr)/(VLT ERP + Rf - G%) calculates present value of future cash flows an investor can expect to receive from each $ of earnings. It is the multiple of earnings a person with certain expectations should be willing to pay. This can also be expressed as $1 * (1 + G%) * NP/(Rm - G%).

The return on equity for the advertising industry is about 16.5%. For a market return expectation, I will work with 10.25%, made up of a 4.5% long-term risk free rate and a 5.75% long-term equity risk premium.

With Google trading at near $1,200, it is trading at a multiple of 33.29 times 2013 earnings. What growth to perpetuity and notional payout does that imply for a person with a return expectation of 10.25%, and a long-term return on equity expectation of 16.5%?

An investor with a return expectation of 10.25% should be willing to accept a multiple of 33.29 times earnings, for a stock with a notional payout of 47%, and growth in perpetuity of 8.71%.

A perpetual growth rate of 8.71% would imply a notional payout of 47% (1 - 8.71%/16.5%) assuming a return on equity of 16.5%. The multiple is calculated as $1 * (1 + G%) * NP/(Rm - G%). Thus if G% is 8.71%, RoE% is 16.5%, NP is 47.22% (1 - 8.71%/16.5%), and Rm is 10.25%, the multiple is 33.29 ($1*108.71%*47.22%/(10.25% - 8.71%).

A growth rate of 8.71% does not seem much of a challenge for a company like Google. But this growth rate is almost 140% of market growth expectations of 6.25%. And we are not talking about delivering this premium to market growth rate for one year, or two years, or five years, or even ten years. We are talking about delivering this premium to market growth forever. This is a very aggressive expectation.

In my view valuing optimistic expectations over the reasonably foreseeable period, and valuing the period beyond in-line with broad markets is acceptable. Paying for optimistic expectations in perpetuity is not. Thus I would not be willing to pay $1,200 for Google.

Google is a good company, and one I would want to own at a good price.

What is a good price?

If something akin to a crisis approached and I was able to buy Google at $505, I would buy it. A buy price of $505 implies a multiple of 14 times 2013 earnings. This multiple is where I see the market as rightly valued. But Google is a growth stock, and it earns its higher than market multiple by virtue of its performance.

Google has a Value Line Beta of 1. The capital asset pricing model suggests that investors accept a return equivalent to market returns for such a stock. I arrive at a target rate of return for the market of 10.25%, based on a long-term risk free rate of 4.5%, a beta of 1, and a very long-term equity risk premium expectation of 5.75%. Since Google has a beta of 1, this return expectation applies to both the market and Google. This return expectation can be revised upward or downwards depending on an investor's personal target hurdle rate. I will work with the 10.25% return expectation, made up of a 4.5% long-term risk free rate and a 5.75% long-term equity risk premium.

For the broad market, I estimate a re-investment rate (Rr) of 47%. One way to estimate the re-investment rate is by using growth rates and the return on equity we expect companies to earn on incremental equity invested. Simply take the growth rate and divide it by the return on incremental equity invested. If the market can be expected to grow at a 6.25% rate, and it earns a return on incremental equity investments of 13.25%, then it must re-invest 47% of its earnings to generate that growth. The remaining 53% is a notional payout available to shareholders through dividends, buybacks, or re-investment to generate faster than market growth.

One day in the future, Google will be a value stock, growing at rates consistent with market growth expectations of 6.25%. But Google operates in a segment where the return on incremental equity is high. The return on equity for the advertising industry is about 16.5%. Thus, assuming long-term growth of 6.25%, for Google we can look for a re-investment rate of 37.9%. This implies a notional payout of 62.1% (1-Rr), which is what I will work with.

This formula calculates the present value of future cash flows which an investor can expect from each $ in earnings, assuming constant growth in perpetuity: $1 * (1 + G%) * (1 - Rr)/(VLT ERP + Rf - G%). For Google, because current growth expectations are higher than the VLT ERP plus risk free rates, we have an unsolvable equation: and that is because the growth rate is a present growth rate not a constant long-term growth rate to perpetuity.

And because I am unwilling to rely on a projected perpetual growth rate, I will value optimistic expectations over a reasonably foreseeable period, and value the period beyond in-line with broad market growth expectations.

The Greedy Investor might value it at $650. That is 2013 Earnings * (1 + Forward 5 Year Growth Rate) * (1 - Rr)/(VLT ERP + Rf - Market Growth Rate) or $36.05 * (116.24%) * 62.1%/(5.75% + 4.5% - 6.25%).

The Greedy Investor is willing to pay for one year of the growth premium versus the market growth, but no more. A Greedy Investor with high conviction that 2014 earnings will be at $52.11 might be willing to pay $810 (2014 Earnings * NP / (Rm - Market Growth) = $52.11*62.1%/(10.25%-6.25%).

A Growth at a Reasonable Price (GARP) Investor might estimate the stock value (not price) in 2018, and discount it back to 2013 value to determine a target buy price. That is the value (not price) expected in 2018 multiplied by the discount factor, where the discount factor is one divided by 110.25%^5.

The 2018 value of $794 is calculated as 2018 Earnings * (1 + Forward 5 Year Growth Rate in 2018) * (1 - Rr)/ (VLT ERP + Rf - Market Growth Rate) * Discount Factor, or $76.50 * 109% * 62.1% / (5.75% + 4.5% - 6.25%) * 1/(110.25^5) = $794. The GARP investor is willing to pay for six years of growth premium versus the market growth, and no more.

An allocator, a person who wishes to maintain an allocation to equity, and who wishes to own Google, might be willing to consider relative valuation. After all the market is trading at 17 times 2013 expected operating earnings, which is over the 14 times multiple I compute for the market. With Google's quality and low beta, if nothing else, downside would be protected in difficult markets. Thus the Greedy Investor might be willing to pay $790 (17/14 * $650), while the GARP investor might consider $965 ($794 * 17/14).

I position myself as the GARP investor, willing to add as a Greedy Investor, and with a willingness to give due consideration to relative value. Thus for me the first buy target would be $965, followed by $790 being the level at which I'd add, and then $650 and lower being areas to add further positions.

Perhaps I am setting myself up as the disappointed investor. But that is okay: In my journey of self-discovery as an investor, I am wary of what I find, for fear of losing myself in what I have found.

I will end with my customary caution: I have looked at and liked Google. I do not own Google. I have no intention of initiating a long position in Google at present, and as a long only investor, I do not short stocks. This post is not a recommendation of any sort. Nor is it research. Nor can it be considered due diligence. It is merely an idea, or an investment thought-piece: if you like, it is a penny for my thoughts! I'd be delighted if you enjoyed it and it got you thinking, but if you buy, or if you sell, be sure to do your homework, research and due diligence first. If you did not like the post, or the thought that Google does not represent an interesting pick, that is fine too. There are two sides to every trade. We need a seller and buyer for two parties to walk away satisfied: if you are a buyer of Google, be glad that there are sellers available.

Additional Information - Global Traditional Advertising Industry Historic Data

U.S. Listed Companies

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Note: Revenue in $ million last fiscal year is for 2012.

Source: My analysis of data made available by Dr. Damodaran, a Professor of Finance at the Stern School of Business at New York University, who makes available a world of wonderful data each year which is available for Download here.

Japan Listed Companies

Note: Revenue in $ million last fiscal year is for 2012.

Source: My analysis of data made available by Dr. Damodaran, a Professor of Finance at the Stern School of Business at New York University, who makes available a world of wonderful data each year which is available for Download here.

Europe Listed Companies

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Note: Revenue in $ million last fiscal year is for 2012.

Source: My analysis of data made available by Dr. Damodaran, a Professor of Finance at the Stern School of Business at New York University, who makes available a world of wonderful data each year which is available for Download here.

Emerging Market Listed Companies

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Note: Revenue in $ million last fiscal year is for 2012.

Source: My analysis of data made available by Dr. Damodaran, a Professor of Finance at the Stern School of Business at New York University, who makes available a world of wonderful data each year which is available for Download here.

Rest of World Listed Companies

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Note: Revenue in $ million last fiscal year is for 2012.

Source: My analysis of data made available by Dr. Damodaran, a Professor of Finance at the Stern School of Business at New York University, who makes available a world of wonderful data each year which is available for Download here.

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.