There are a relatively small number of truly outstanding companies. Their shares frequently can't be bought at attractive prices. Therefore, when favourable prices exist, full advantage should be taken of the situation. --Phil Fischer
In this article, I use Phil Fischer's criteria of sustainable growth to compare Google (GOOG) and Facebook (FB), and conclude that investors should take this opportunity to buy into Google, an extraordinary company that is also undervalued.
The Roots of Sustainable Growth
In his book Common Stocks and Uncommon Profits, Phil Fisher, one of the original growth investors, argued that the key attribute companies that grow for decades possess is not only the growth potential of its current key product, but also the ability of its management and employees to continually create new products that would grow into key ones.
The company that has most obviously fulfilled these criteria over the last decade is Apple (AAPL). The iPod, iPhone and iPad were all products that created new markets, and in doing so generated enormous value for Apple.
The same cannot be said for Facebook. Whilst Facebook clearly has significant growth potential over the next few years, it does not currently fulfil Fischer's criteria of being able to continually create new products. Indeed, Facebook only has one major product - its social network.
The graphs above show that Facebook's user growth is already running into significant diminishing returns. Of course, it is only beginning to monetize its social network, and this does make it a growth stock - but not a Fischer stock. If Facebook is to sustain its rate of growth over the course of a decade or more, like Apple and Google have, it needs to innovate. So whilst Facebook does offer growth potential, it has yet to show any ability to become a sustained, long-term growth stock.
Now consider Google. Over the last five years Google's revenue, profits and free cash flow have had average cumulative growth rates of 18%, 18% and 27% respectively - and these show no signs of slowing down. On the contrary, these figures are even more impressive when put into the context of a global economic crisis that has had a significant impact upon advertising expenditure by large corporations.
The reason I believe that Google is likely to experience sustained growth in the long run is because it has expanded into several markets, despite continuing to derive the vast majority of its revenue and profits from search related advertising.
Whilst its search business still has room to grow, it also numerous other products such as Android, Youtube, Google+, Chrome and Chrome OS that have yet to be monetized. Google's 70-20-10 model, where 10% of resources are devoted to start-ups, such as through giving staff one afternoon a week to work on their own projects, ensures that a steady stream of innovation is likely to be sustained into the future. Indeed, Google has adopted a deliberate strategy of making its products open-source in order to rapidly expand and capture their markets before monetizing them. YouTube, for instance, averages an astonishing 2 billion views per day, yet has only recently been monetized, with advertising revenues tripled last year.
Chart from Wikipedia.
Perhaps the best example of Google's philosophy is its mobile phone operating system, Android. Partly thanks to being open-source, around 700,000 Androids are being activated every day. The graph above shows clearly how this has given Google a dominant position in the growing market. Yet Google has not even begun to monetize the potentially enormous earnings power of Android.
One product that is a huge wildcard is Google's social network, Google+, which now boasts over 90 million users - more than double that in Q3 of last year. At the Q4 earnings call, Larry Page reported that "over 60 percent of [users] engage daily, and over 80 percent weekly." This number is expected to grow to near 400 million by the end of the year. Whilst this is still half of Facebook's 845 million, it allows Google to do two things:
- Gather data. The data generated by Plus will be used to improve Google's search engine, particularly through personalizing results. This is especially useful to fend off Microsoft's (MSFT) attempt to personalize results in its search engine, Bing. The data can also be used more generally to improve other products.
- If the best-case scenario occurred and Google+ became a match for Facebook, it would create huge value itself through advertising.
In other words, Google+ does not have to equal Facebook in order to be a success; the data itself is useful. It does, though, have a reasonable chance of becoming hugely lucrative.
It has been reported that Facebook's IPO will value it at $75-100 billion, meaning that Google's enterprise value is only $50-75 billion more. Yet Google has revenues of $38 billion and operating profits of $12 billion compared with Facebook's $3.7 billion and $1.8 billion, respectively. Moreover, Google has much broader range of growing products.
Market Capitalisation (30 Jan 2012)
Forward P/E (assumed 20% profit growth)
Whilst Google's P/E ratio of 19.3 may seem high for an 'ordinary' company, I believe the qualities discussed above make it a fair price. Indeed, if we assume that earnings grow by 20% next year we get a Foward P/E of 16.1. Furthermore, the net cash on Google's balance sheet means that it actually has the lower Trailing and Forward EV/E ratios of 15.4 and 12.8, respectively. Whilst these are clearly not distressed prices, they are more than reasonable for a company of Google's quality and potential.
Google has been growing at an extraordinary pace for the last decade. From its original position in search it has expanded into many other markets and is becoming an increasingly significant part of all our lives - it is one of the growth stories of our lifetime. Yet with so many potentially great products still to be monetized, coupled with the likelihood that more will be invented, I believe that we are still near the beginning.
Whilst Google isn't massively undervalued, this is a rare opportunity to buy into a great company at a relatively low price.