Google: A Hard Sell For Superior Returns

Oct.15.07 | About: Alphabet Inc. (GOOG)

The first step to valuing Google (NASDAQ:GOOG) using fundamental analysis requires coming up with a number for the Compounded Annual earnings Growth Rate [CAGR]. The table below looks at the growth rates priced in at different share prices, using the Discounted Cash Flow [DCF] calcuator at moneychimp.

Assumptions and Basis

  • Discount rate of 11.3%, set using the Capital Asset Pricing Model [CAPM] calculator, also at moneychimp with the following assumptions:
    • Benchmark return-11%, Risk-free return-5%, Beta – 1.05
  • Earnings in the last 12 months – 11.76
  • Google earnings and beta taken from the Google finance site.
  • Earnings growth will level off to 3% after the growth phase of 10 years in the table.

As made clear in the table, for Google stock to be worthy of the current market price, it has to grow earnings at 23% for 10 years. It is of immense value to assess the assumptions employed in the table. Specifically, beta (see definition) at 1.05 implies the return expectation to be only slightly better compared with the excess return (see definition) of the benchmark.

For Google to be a superior investment, the excess return compared to the benchmark needs to be elevated more which implies higher beta going forward. The following table manifests what Google’s CAGR will have to be, to justify the current price at higher beta levels:

A beta of 2.0 implies twice the excess return of the benchmark or an expected return of 17% (Risk-Free Return + Excess Return * 2 = 5 + (11-5) * 2). As the growth phase approaches maturity 10 years from now, Google will be bound to have earnings of $219.51/share ($11.76 earnings compounded over 10 years at 34%). Assuming an aggressive profit margin of 25%, Google’s projected revenue will have to approach $2.7 Trillion around 2017 (Earnings * Shares Outstanding * 4 = 219.51 * 312M * 4) .

Extending the same calculation for a CAGR of 23% for 10 years, the earnings and the projected revenue will translate to $93.21/share and $1.16 Trillion respectively. To place these numbers in perspective, the projected Gross Domestic Product [GDP] of US as a whole in the 2017 timeframe is $20 Trillion, assuming GDP growth rate will be comparable to the historical growth rate of slightly more than 3%. Thus, Google revenue will have to be 5-10% of US GDP 10 years from now – a definite impasse.

The calculators used here are fairly basic and bypasses a number of other variables. The in-depth analysis done by Dr. Aswath Damodaran 9/2006 will definitely appeal to those financially oriented.

Disclosure: We sold out of Google in August at about 20% below the current price…