Warning: Don't Jump On The Google Ship

Yesterday I wrote about the valuation of Starbucks, a great company that is costing shareholders money not because of any management failing, but rather because investors had bid up the share to levels that are sure to disappoint. Now we turn to another high flyer, Google (GOOG).

After a 2004 IPO Google has exploded to the upside with shares going from $100 a share to the $489 they sit at today. Revenues and earnings have also jumped. Earnings grew 243% in 2005 and in 2006, it looks like earnings will grow about 75%. Revenues doubled from 2004 to 2005 and are up about 65% from 2005 to 2006. The stock was a world beater in 2005, jumping $222 (115%) but in 2006 just meandered along, up only $17.92 for the year or a pedestrian 3.8%. It has a P/E in the stratosphere at 62 times 2006 earnings.

Thinking of jumping on this ship? Please don't. Why, you ask? Let's look.

Google cannot continue to grow at this clip. The law of large numbers tell us that at a certain point, percentage growth cannot continue. At this rate, Google will equal the $44 billion in revenue Microsoft took 17 years to achieve in the next 2. Won't happen. But, Google's stock is priced for this event. What happens when Google does not deliver this growth? The stock gets a haircut, not a trim but a haircut, who knows, maybe even a shave.

Now, just because Google does not deliver this growth is not by any means an indictment of management's ability. Quite the contrary: to take a company from $1.4 billion in revenue to approx. $10 billion in 3 years is quite a feat. To go from that $10 billion to $17 billion to justify the 65 P/E ratio based on current growth would require a revenue increase in dollars equal to the increases in 2004 and 2005 combined! If we extend this current growth out to 2008, that would require 2008 earning to grow an additional $11.4 billion dollars (more that all the revenue from 2006).

Management is not really helping its cause here either. In 2004 when it went public Google had 277 million shares outstanding, now today we stand at 311 million. That is a 12% increase in the shares outstanding which further dilutes results on a per share basis. In this respect they are slowing their per share growth due to the dilution. These factors are headwinds working against share appreciation.

Management's actions have assumed an overvaluation of the shares. When a company believes its stock to be undervalued, they will take excess dollars and buy those shares back believing that to be the best use of that dollar. The true value of the dollar of stock is greater than the cost of one dollar. When they believe the stock to be inflated, they use it for acquisitions, the thinking being that a dollar of stock has more purchasing power than a dollar of currency due its inflated level. Google recently purchased You Tube in a $1.5 billion stock transaction.

What does all this mean? Simple, the growth rates for both revenues and earnings for Google must diminish very soon. When that happens the multiple that buyers of Google's stock will pay will diminish with it. This will cause the price of Google's stock to fall and fall hard from its lofty levels. I want to stress that Google is NOT expensive because it is $489 dollars a share, it is expensive because that $489 in relation to its earnings and future growth is just too much.

The average of the estimates I can find for Google for 2007 are in the range of $13.85 per share. when you consider 2006 looks to end up around $10.30 a share, kudos to management, they are delivering 33% growth. Here is your problem. The stock price has growth of 60% factored into it. What does this mean? If investors will pay 60 times earnings for a stock growing 60% a year, why would they pay that for a stock growing 1/2 that? Answer? They won't...

You should expect the multiple for Google to contract to a range commensurate with its growth rate. If that rate this year is around 30% expect the P/E to shrink to about 30 times 2007 earnings. That give us a price for Google shares of about $450 a share. In other words, Google is overpriced. It is priced for its current growth rate, when that rate slows as it must (law of large numbers) its price will fall.

Google is a great company with a wonderful product -- its stock is just too expensive.

Comments

[Trading God...:]

Yikes!

According to your opinion, I will not be seeing my $550 price target in the near future, like I had planned!

I will pen a letter this instant and tell those GOOG boys to buy back some stock!

btw, is there any new info on the Orange GOOG phone?

2007 Jan 23 06:28 PM

[jack daniels:]

Google has been the greatest investment I've ever known and continue to know. Many like Todd Sullivan perhaps thought Google was too expensive at $300.00. Those people bought Microsoft or Yoohoo a couple years ago as a value investment. And today...well you would of done better sticking your money in a bank and Yoohoo's case sticking your money under your mattress. I don't get your logic. You want to pay the same PE ratio for a high growth as you do for a value stock. The reason you pay value price for a value stock is because it doesn't have the growth rate. So if you could get Google for the same value as MS or Yoohoo which have terrible slow growth rates, then why the hell would you invest in those others to begin with? Value investor thinking discounts future PE and future faster than normal growth rate from the equation. Value investing is often deceiving. The value which seems like a good deal is actually a deal many investors who actually want to make money would not take even at a steep discount. With no demand and no growth the price goes down and the PE ratio is even lower than the low PE ratio you started out with 2 years later. So the deal of say for example of a cheap 10 PE could go down to 4PE 2 years later. These loser companies then need to buy their stock back as a pathetic artificial way to add value to their stock and boost it. Todd Sullivan and many value investors knows this but, oh he likes to sweep such details under the rug and pull the would over your eyes.

2007 Jan 23 09:15 PM

[manfred kan...:]

Why Have I heard ths same story before on GOOG, circa Barrons about a year ago that in the end has been wrong to the tune of 100 points, and from Doug Kass before that about 200 points ago. Why dont we comment on the overvaluation of the exchange stock such as CME or BOT, which grow no where GOOG's valuation but yet have p/e's 10 pts higher? That seems like the the real stock bubble at the moment.

2007 Jan 23 10:37 PM

[Dave12:]

When does logic have anything to do with stock prices?

Google's stock price doesn't make any sense - and it is not the only stock that has acted like this. Look at QCOM in the late 1990's - the stock ran up ten fold in one year. Or more recently, look at CME - the stock is up even more than Google over a slightly longer time frame.

Until we get analysts to cool their comments, stocks like GOOG will continue.

2007 Jan 24 01:28 PM

[Informed I...:]

Warning: Don't jump on the Todd Sullivan ship

Todd your argument is weak and inaccurate. I must disclose that I do own Google and bought it at $190 so I have some bias. However, your evaluation is innacurate and lacking some important information.

"P/E in the stratosphere at 62 times 2006 earnings". 2006 earnings have not yet been reported. The 2006 numbers will be complete once they post 4th quarter numbers at the end of this month. You do accurately state later that the 2006 numbers are estimated to be $10.30/share. This would make the P/E (based on $489 share price) 47 times 2006 earnings or 24% less than you quoted. To say a P/E ratio of 62 is in the stratosphere is quite baseless. Growth stocks trade with P/Es that are 2 times growth quite often (see SBUX, BIDU, even value play MSFT does). So looking at "~30%" growth for Google in 2007 would have a P/E of 60 be in the ballpark. If you follow the stock, you may remember it wasn't long ago that the P/E was ~130 or roughly 2 times the 65% revenue growth rate expected for 2006, which will likely be exceeded.

If you use this math and say earnings for 2007 are 13.85 (~34% growth not the 30% growth you quoted) and you go with the estimates that earnings will grow 32.5% for 2008 that would put you at a $900 per share price. I by no means expect Google to go to $900 this year but to say it is overpriced may be a stretch.

I don't claim that what I've written is something to base an investment on. You must do your own due diligence and consider numerous factors. P/E is one very telling factor, but not the only and can easily be manipulated to justify just about any price target.

Look at the historical chart for MSFT. From 1995 to 1997 it tripled (and I'm sure many "warned not to jump on the MSFT ship", from 1997 to 1999 it nearly tripled again. In 2000 MSFT did get a nice haircut and dropped nearly 50%. No, investing in growth stocks is never safe, and there is always the risk of such a correction. However, I believe these warnings are a bit premature for Google and it remains a solid growth company. The search market is increasing, they have the dominant, almost monopolistic, position in the market (see article below).
www.thestreet.com/_yah...;cm_cat=FREE&c...

To end my warning, I would say don't solely trust soemone who writes with sensational claims like Todd Sullivan, but include the sound, research-based price targets of research analysts. And of course it is always valuable to consider all viewpoints.

2007 Jan 24 02:55 PM

[brkr nmx re...:]

I believe GOOG is only slightly overvalued but for different reasons. The large investment in YouTube may now seem sound to some but with rapidly changing technology and little to cement an audience to any particular media site this early in the game, I'm not recommending investment at this time. The next six months will be critical in terms of watching the rollout of other major platforms that are claiming faster video conveyance speeds based on the latest technological advancements. No doubt Google/YouTube will take advantage of these technologies also but competing start up companies backed by the recent infusion of new capital will certainly impact their market share in this wide open enormously growing online media arena.

2007 Jan 27 04:50 PM

[ob1y2k:]

hm..
I think we didt see all from Google yet..
And you cant look on Google like on anything else..
time will tell..

2007 May 08 04:37 PM