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Summary

  • Google's growth story is amazing and investors who got in early probably experienced a once in a lifetime investment opportunity.
  • Google has provided returns in excess of 12 times the initial investment since its IPO and I wonder if it can do it again.
  • Despite very optimistic earnings growth projections, the stock looks slightly overvalued.
  • A shortfall in earnings could adversely impact the projected returns on the stock and cause a sharp correction.

It's not hard to imaging investors being googly eyed over Google (NASDAQ:GOOG). The stock is up from about $100 in 2004 to a high of $1228.88 in February. Getting 12 times return on your initial investment over a 10 year period could be a once in a lifetime event. It's no wonder investors keep trying to figure out not if to buy more Google, but when to buy more Google.

When I saw the chart below I became hopeful that it had pulled back just enough to take another nibble. The RSI indicated that the stock had reached oversold levels. Meanwhile, the price had dropped below the 2 standard deviation Bollinger band and then flattened out. On a technical basis, it looked good.

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But what about on a fundamental valuation basis?

Over its 12 year history, Google has had earnings growth of over 30% annualized. The numbers are somewhat skewed by the first three years but there is no arguing the phenomenal growth in the company's earnings over the period. Earnings per share reached $36.64 in 2013 and are expected to be $52.88 in 2014, according to 22 analysts covered by S&P Capital IQ.

At first glance, the chart below indicates that Google's stock price closely tracked the growth in earnings. From 2004 until about 2008, the black line (price) hovered around the orange line, which indicates the company's earnings. Then in 2009, the stock price started declining after earnings grew just 18% in 2008. When earnings growth recovered in 2009 to 29%, the stock recovered too, but never got back up to its previous levels. Fast forward to 2014, and the stock begins to reach the normalized level of earnings but is still slightly below its normal PE ratio. It looks like a buying opportunity.

(click to enlarge)

But before I pull the trigger again, let's analyze the performance of the stock over a shorter period of time so we can eliminate those early years of hyper growth!

Looking at the 6 year chart, the picture looks a bit different. The price does track the level of earnings from 2010 to 2013, but then the stock begins to outpace the level of earnings growth. In fact, today the stock looks slightly overvalued despite an expected earnings growth of 44% for 2014. With a PE ratio of 27.7 and a normal PE ratio of 24.8, earnings would have to grow at an even faster rate (unlikely), or the multiple would have to expand by about 12%.

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The earnings estimates of 52.88 seems a bit high to me, so I looked for additional resources that reported analyst earnings estimates. The chart below was obtained from msn.com and provides the earnings estimates for 2014 of 17 analysts covered by MSN (16 analysts provide a 2015 estimate). I couldn't confirm whether some of the analysts included in these estimates were the same as those included in the S&P Capital IQ estimate. In any case, the earnings forecast is considerably lower for both 2014 and 2015. Even the high estimate from msn.com is below the S&P Capital IQ consensus.

Going back to the original estimates provided by S&P Capital IQ, we could see from the chart below that if forecasted earnings are realized, Google will generate a total return of 9.9% through 2018. See the highlighted area below and the red box indicating a target price of $1753.38 and a 9.9% return.

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If I take a more conservative approach by using the lower estimates obtained from msn.com, I already know that my potential return will be lower. The question is, how much lower? To evaluate the potential price for Google through 2018, we used the msn.com analyst estimates for both 2014 and 2015, and then applied a 17% earnings growth rate for the remaining years. 17% seems to be the consensus long-term growth forecast for both analyst groups.

The result is a potential return of 6% instead of 9.9%. I highlighted the row for 2018 because of a flaw in the Fastgraph chart that does not allow for changing the 2019 earnings forecast.

(click to enlarge)

Conclusion

Google is a great company. I hold a position in the portfolio and have been looking to add more. I thought this was going to be the right moment to do so, but after further analysis it looks like there could be some additional pullback in the stock. Unless earnings growth surprises to the upside, my opinion is that there is a lot of good news priced into the stock. I'll continue to hold my current positions but I'll keep an eye out for a good time to add to my position.

Disclosure: I am long GOOG. 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: Optimism Is Built Into The Current Price