This is the latest installment in my series on internet search - having already discussed the economics of search along with my value for Yahoo (YHOO) I am now tackling the hard challenge of coming up with an implied present value for Google (GOOG). Valuing Google through conventional ways is extremely challenging because using methods such as a Discounted Cash Flow model is highly dependent on correctly predicting future growth in a rapidly evolving industry.
Google is a leader in online advertising and is the leading online search provider, continually taking more market share in the online search industry. Along with providing search services Google provides many free products for its online users. Google’s revenues come from two main sources: advertising revenue from sites owned by Google and advertising revenue created by Google network sites. Along with these two revenue sources Google makes a small amount of revenue from licensing. Google-owned sites generated $2.73 billion or 65% of total revenues in the last three month earning period. Google’s partner sites generated $1.45 billion or 34% of total revenues in the last three month earning period.
Google is truly a global company with 48 percent of total revenues coming from the international markets in the latest quarter. This number is up from 44 percent for the same time period from the year before. The increase in revenue from the international market is a result of faster growth in internet users in the international markets along with local Google brands being more widely accepted. Going forward, international markets provide a significant growth opportunity even beyond their current large contribution.
So how do we value Google? In order to come up with an implied fair value target we will discount past cash flows based off of future growth rates. The main things that are needed in order to arrive at a target price are: operating free cash flow, capital expenditures, a discount rate, future growth projections, and terminal/exit multiple. For a company like Google, figuring out the correct growth rate is going to pose the biggest problem as Google has the ability to grow and increase cash flow in so many ways. Because of this I will be finding the implied value based off of my growth assumptions and then figure out what growth is needed in order to justify the markets current pricing of Google.
For operating free cash flow we take the combined operating free cash flow from the previous four quarters and the subtract that number by capital expenditures from the previous four quarters. The number that we arrive at is the initial free cash flow, which is $2.9 billion.
The next question in determining present value is finding out the rate at which Google will grow free cash flow over the next five years. This is the hardest part of valuing Google because of how diverse its web presence is along with its ability to adapt and grow its internet presence. With the assumption that internet search is only going to grow and with Google taking more market share all the time we must factor in this growth. We also must factor in Google’s willingness to acquire new websites, such as when Google bought Youtube. These two areas, along with the ever growing Content Network, provide Google with the perfect position to take advantage of the growing web industry. Given these factors, our growth rate will be 35% annually over the next five years.
In order to find the discount rate the use of Capital Asset Pricing Model is used. This model is R=Rf + B(Rm-Rf) where R=discount rate, Rf=risk free return, B=Beta of security, and Rm=expected market return
In this situation we will have:
- Rf=3.35%, the rate of the 3-month T-Bill
- Rm=6.6%, rate of return from S and P 500 plus dividends
Using this model we get an implied discount rate of 7.315%. In order to determine an exit multiple, we take 1 and divide it by the discount rate. This gives us an exit multiple of 13.7x. The model below shows the price targets of Google by using the method described above. By using the CAPM discount rate of 7.315% we get a price target of $494.30 after adding in Google’s net tangible assets of $18.3 billion. This value is approximately 27% below today’s close. The diagram below gives target prices with sensitivity toward changes in growth and discount rates.
Now I realize that this number is much lower then what the market is currently pricing Google stock and because of this I decided to work backwards in order to figure out just how much growth Google needs in order to justify its current price levels. When I adjusted Google’s growth to 45% annually for the next five years I came up with a price target of $677 a share. Can Google continue to grow cash flow at a rate of 45% a year? It is possible but it will be extremely hard. Overall, if you buy into Google now you are betting that Google will be able to keep up its insane level of growth, and that isn’t a high-probability bet no matter how good the underlying company may be.