A Closer Look at Google's Valuation

Jun.12.07 | About: Alphabet Inc. (GOOG)

The price action in Google (NASDAQ:GOOG) has been good lately, no question. In general, there has been a market rotation into technology.

As interest rates rise, tech is viewed as being less interest rate sensitive, and more removed from a feared economic slowdown which will affect the consumer first.

As to Google's valuation, it all comes down to what decision is made about the terminal multiple. In Insight's 30 year discounted cash flow analysis [DCF], a 25% return on invested capital in year 30 has been assumed, as has been a 3% required growth rate. The big question is how to estimate capital expenditures (cap ex) in the terminal year of the DCF.

I believe the formula: EBIT * (Required Return/ROIC) is a good one for estimating cap ex. So, Multiplying EBIT by (1- required (growth of 3%/roic of 25%)), dividing by the perpetuity of the discount factor minus 3%, and discounting thirty years back gets you to a stock price of about $525, in Insight's analysis.

Now it so happens that this is equivalent to a terminal EBITDA multiple of about 5.5 times. MSFT currently has an EV/EBITDA multiple of about 12X. So if you believe the argument that Google should have the same EBITDA multiple in year 30 as Microsoft (NASDAQ:MSFT) currently has, a stock price of $800 per share would be indicated. However, I believe that the market is using a higher discount factor to value tech companies than is suggested by the Capital Asset Pricing Model [CAPM].

One possible reason for this is that as interest rates rise, tech companies may be disproportionally affected since so much of their valuation stems from the out years. (It is ironic that as interest rates rise presently we are seeing a rotation into technology stocks).

Still, based on a PE ratio to growth [PEG] analysis and a DCF sensitivity analysis, the argument for a $600 stock price for Google does make some sense. Insight does hold some Google in its client portfolios.

Yet, with a forward PE of about 27X, Google is not cheap and does have significant potential downside. Insight in general feels more comfortable investing its clients' assets in stocks with cheaper enterprise values/EBITDA and cheaper PE ratios.

GOOG 1-yr chart: