As part of our process at Valuentum, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) case, we think the firm is fairly valued at nearly $650, offering material upside to investors. In this article, let's walk through how we value Google and why we like the shares.
But first, a little background on our research firm to help with some terminology in this piece. At Valuentum, 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 is the best way to identify the most attractive stocks at the best time to buy. This analysis pretty much runs the gamut of equity research.
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. The more positive qualities a firm has going for it, the higher the rating. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). We think the stocks that are liked by the most investors have the greatest chances of price-to-fair value convergence. Said differently, more investors that like a stock leads to more buying leads to a higher stock price, all else equal. This is just the nature of the stock market.
At the methodology's core, if a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Google posts a Valuentum Buying Index score of 4, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bearish technicals. It had been a pristine 10 in previous updates, and because the firm has registered a high score on the index in the past, it remains in the Best Ideas portfolio until it registers the equivalent of a "we'd sell" rating, or a 1 or 2 on the Valuentum Buying Index. It has been a great performer. For relative valuation purposes, we compare Google to peers Yahoo (NASDAQ:YHOO), Facebook (NASDAQ:FB), and Baidu (NASDAQ:BIDU). Let's now dig into our report on Google.
Our Report on Google
• Google's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• 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 $600 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 24.1% in coming years. Total debt-to-EBITDA was 0.3 last year, while debt-to-book capitalization stood at 5.7%.
• Google has a strong future in search-both on the desktop and via mobile devices. The company recently announced that it will sell Motorola Mobility, a value-creating move as it can now allocate more capital to high-return opportunities or new concepts such as self-driving cars, Glass, Fiber, or other innovative ideas.
• Google is a holding in the portfolio of the Best Ideas Newsletter. We like its valuation, growth potential, cash-flow generation and competitive profile. Very few firms are more attractive on a fundamental basis.
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 (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 85.9%, 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 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 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 24.6% 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. There's some great information there. At Google, cash flow from operations increased about 23% from levels registered two years ago, while capital expenditures expanded about 114% over the same time period.
Our discounted cash flow model indicates that Google's shares are worth between $518-$776 each. Google's shares are trading at the low end of this range. The margin of safety around our fair value estimate is driven by the firm's LOWValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $647 per share represents a price-to-earnings (P/E) ratio of about 35.9 times last year's earnings and an implied EV/EBITDA multiple of about 21.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 14.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 26.8%. Our model reflects a 5-year projected average operating margin of 30.3%, which is above Google's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 6.6% 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 $647 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 $518 per share (the green line), but quite expensive above $776 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 $647 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 $904 per share in Year 3 represents our existing fair value per share of $647 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
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score, as it relates to firms in the Best Ideas portfolio:
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. GOOG is a position in the portfolio of the Best Ideas Newsletter.