From breakthrough innovation to unpredictable consumer trends, technology is a high risk / high reward sector. In my view, Facebook (FB) is significantly overvalued and would need to more than mirror the growth experienced by Google (GOOG) when the search giant first went public. Of course, Google was a grand slam and should be assumed to be the exception, not the rule.
In this article I will run you through my DCF model on Google and then, to increase confidence, triangulate the result with an exit multiple calculation and a review of the social media fundamentals compared to Yahoo (YHOO) and Microsoft (MSFT).
First, let's begin with an assumption about the top-line. Google ended FY2011 with $37.9B in revenue, which represented a 29.3% gain off of the preceding year. Analysts model a 18.3% per annum growth over the next few years, and I view this as fairly reasonable for two reasons. First, Google's growth has been higher over the last 2 years and, second, because the 5-year industry growth rate is expected to be 20%.
Moving onto the cost-side of the equation, there are several items to address: operating expenses, taxes, and capital expenditures. I model that cost of goods sold will eat 35.5% of revenue over the next few years compared to 17.5% for SG&A and 12.5% for R&D. These estimates are roughly around historical 3-year average levels. Capex is estimated the same way, so I assume 9% of revenue over the next few years. Taxes are also estimated at around 22%.
We then need to subtract out net increases in working capital: we model accounts receivable as 15% of revenue; accounts payable as 2.1% of OPEX; and accrued expenses as 64% of SG&A.
Taking a perpetual growth rate of 1.5% and discounting backwards by a WACC of 10% yields an intrinsic value of $631.52, implying that the stock is basically fairly valued. However, since the company is a tech giant, a much more realistic perpetual growth rate would be just shy of 3%. That would peg intrinsic value at around $702.53, implying 13% upside.
All of this falls under the context of strong recent performance:
"I'm very happy with our results. Google had a very strong quarter with revenues up 25% year-on-year, 9% quarter-on-quarter, and we blew past the $10 billion mark for the first time. Pretty exciting…
With Google+, we shipped on average a new feature every day since we launched in June. That's more than 200 updates in total. And those things include a bunch of new Hangout features…
I'm also pleased to announce that there are over 90 million Google+ users, well over double what I announced just a quarter ago on our earnings call. Engagement on + is also growing tremendously. I have some amazing data to share there for the first time. + users are very engaged with our products. Over 60% of them engage daily and over 80% weekly"
But perhaps the biggest kicker for Facebook was this statement:
"We've now included personal [Google+] results in Search. So you can easily find information like photos and + posts that are super relevant to you, as well as the people you care about or are interested in".
Google has a tremendous arsenal to become the leader in social media. It has Yahoo, Android, Google+, Search, and Gmail -- all of which can be leveraged together for synergistic value. Just like how AOL email accounts became "out-cooled" by Gmail accounts, so too -- Facebook may collapse under Google. And why shouldn't it? I am not saying that Google+ will become hot this year, but just offering food for thought: it could very well happen. Facebook's value is ephemeral, Google's is not.
From a multiples perspective, Google is fairly attractive. It trades at a respective 20.9x and 12.4x past and forward earnings versus 18x and 16.2x for Yahoo and 11.6x and 10.7x for Microsoft. Assuming a multiple of 15x for Google and a conservative 2013 EPS of $46.50, the rough intrinsic value of the stock is $697.50.
Consensus estimates for Yahoo's EPS forecast that it will hold flat at $0.82 in 2012 and then grow by 12.2% and 9.8% in the following two years. Assuming a multiple of 12x and a conservative 2013 EPS of $0.90, the rough intrinsic value of the stock is $13.50, implying 8.3%. The stock has struggled to create value like Google over the years due to poor leadership. And the recent management shakeup is more of symptom of desperation than an actual cure. A smaller search business, called Infospace (INSP), represents a much more undervalued investment. Infospace uniquely aggregates search results from Google and other models while employing an algorithm to yield the best results.
Microsoft is much more attractive than Yahoo, as well. In my DCF model here, I demonstrate how the stock may easily hit $48.77 given current fundamentals. It should be noted how Windows 8, through its innovative user interface, makes a nice effort to grab share from Apple's (AAPL) artsy market. It's an unsuspecting foray from a company that Steve Jobs ridiculed as being so utterly devoid of imagination. It also creates a meaningful step towards adopting more of a social media motif. Like Google, however, the fundamentals are strong and have significant upside due to the perception of "maturity". So, in conclusion, I would like to reiterate my optimism for both Microsoft and Google.
Disclaimer: Gould Partners provides investor relations services, but research covered in this note is independent and for prospective clients only. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.