Seeking Alpha

With a market cap of \$176 billion as of July 7, Google (GOOG) is the largest internet information provider in the world. Google is an immensely profitable company with a gross margin of 64.97% and a net profit margin of 26.82%. While the 5-year annual return of 4.81% is slightly better than the market average, the year-to-date return of -9.9% is disappointing. The company has a Beta value of 1.17 with a 14-day average true range of 10. As of July 7, Google was trading at \$546 with a ttm [trailing twelve month] P/E ratio of 20.8 and a forward P/E ratio of 13.4.

Google has a 4-star rating from Morningstar. Wall Street has diversified opinion on Google's future. The bottom line is 6.5% growth, whereas the top-line growth estimate is 25.9% for the next year. Average five-year annualized growth forecast is 18.5%.

What is the fair value of Google given the analyst estimates? In this article, the seventh in the technology series, I will show a step-by-step calculation of Google's fair value using FED+ (Future Earnings Discounted plus Equity) Model.

FED+ MODEL

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1/(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.

Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of \$25.75 along with the mean estimate of \$39.34 for the next year.

E0 = EPS = (\$25.75 + 39.34) / 2 = \$32.55

Wall Street holds diversified opinions on Google's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five year growth forecast is 18.5%. Book value per share is \$150.

The rest is as follows:

 V0 E0 \$32.55 V1 E0 (1+g)/(1+r) \$35.02 V2 E0((1+g)/(1+r))2 \$37.39 V3 E0((1+g)/(1+r))3 \$39.91 V4 E0((1+g)/(1+r))4 \$42.61 V5 E0((1+g)/(1+r))5 \$45.49 D E0(1+g)5/[r(1+r)5] \$413.55 BV Equals \$150 Fair Value Equals \$796

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. According to my 5 year discounted-earnings-plus-book-value model, the fair-value estimate for Google is \$796 per share. As of July 7, Google was trading at a price of \$546. Google is undervalued by almost \$250. While I do not expect this gap to be closed by this year, I think Google will beat the market returns for the next 5 years.

O – Metrix Confirmation

If the math above looks too complicated for you, try estimating the fair value using the O-Metrix as such:

O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5

Dividend Yield: Higher is better.

EPS Growth: Higher is better.

P/E Ratio: Lower is better.

The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as five years. I am also continuously checking on specific sectors, and the formula works very well so far.

What is the O-Metrix Score?

· Google does not offer any dividends. Therefore, no points assigned for dividends.

· Growth estimate is the same as the discounted earnings model and is equal to 18.5%.

· Since we are at the middle of the year, taking the average of ttm [20.8] and forward [13.4] P/E ratios will smooth the results. Thus, the average P/E ratio to be used in the model is 17.1.

O-Metrix = [(0 + 18.5) / (17.1)] * 5 = 5.41

Depending on the benchmark chosen, the market has an O-Metrix score range between 4 and 5. Google's O-Metrix score of 5.41 shows that the company is priced below its fair value. Back-testing of this ranking system shows that companies with higher-than-average O-Metrix scores beat the market with lower volatility. With an annualized expected growth rate of 18.5%, Google is fairly-priced with upper C-Grade, above-average-return zone.

Summary

As of July 7, Google was trading at \$546, which is 32% lower than my fair value estimate. Thus, I believe Google has 45% upside potential to reach its fair-value. While I do not expect this gap to be closed in a short period of time, I think Google will be an outperformer. Analysts also agree with my model. While not as bullish as the model suggests, the average analyst target price of \$708 suggests 30% upside potential. If the analysts’ estimates hold, Google will provide a better return than the market average.

Although the year-to-date return of -9.9% is a big disappointment, Google’s long-term shareholders experienced nifty returns. Google’s share price increased my more than four-fold in the last 6 years. Net income, which was equal to \$410 million in 2004, increased by 60-fold to \$26.31 billion by 2011. While I was on the bearish side when the stock was priced at \$640, the June 7 price of \$546 is a good entry point. One can easily see a large gap between \$540 - \$575 range, which I expect to be closed in soon future. If the upside momentum keeps on, the next target will be \$640.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.