Why Buffett Would Not Buy Google

This weekend on TickerHound.com, a member asked, “Would Buffett really buy Google (GOOG)?”

The question was based on a Fool.com article that quoted this year’s Berkshire (BRK.A) Annual Shareholder Letter where Buffett writes, “It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.”

I could see why this led some to wonder – and the Fool.com even wrote an article about it – if Buffett could potentially invest in Google. This made me laugh if for no other reason than Buffett mentions Microsoft (MSFT) in the same sentence, a company he knows intimately (considering Bill Gates sits on Berkshire’s board) but has yet to ever invest in.

But let’s leave that part out of the equation for a moment. Let’s just look at the Google angle and try to answer the question: Would Buffett really buy Google?

For consistency’s sake, I’m going to analyze this in the exact same way the Fool.com article did:

Is The Business Simple and Understandable?

Definitely!

Google is an ad broker – plain and simple.

We can talk about its technology all we want – and believe me, that’s what makes its ability to broker ad dollars so effective – but at the end of the day, the way the company makes 99% of its money is by putting publishers and advertisers together.

That’s a pretty plain vanilla business to me (regardless of all the sophisticated search technology it has on the backend).

Does It Have Favorable Long Term Economics?

I’m going to skip this for a moment and come back to it at the end. You’ll see why below.

Is Management Candid and Competent?

I’d have to give the affirmative answer on this one as well.

The founders, Larry Page and Sergey Brin, both have the better part of their net worths tied up in Google stock. That means management’s interests and the shareholders’ interests are certainly aligned – something Buffett always looks for in a company he’s buying.

And in terms of candor and competence, their execution speaks for itself. If you’ve read Google’s annual reports and even its S-1 filing, you’d know that they’re candid and up-front about how they manage their business.

So this item gets checked off the list as well.

Is The Price Right?

Here’s where we run into problems…

Buffett’s brilliance isn’t based on the fact that he knows how to value an asset…I know a lot of folks who can value an asset.

My father knew exactly what we should pay for our home when I was a kid.

I could tell you right off the bat how much I’d pay for a new car.

In fact, Finance 101 teaches people basic asset valuation models – more specifically, Discounted Cash Flow analysis.

The ability to value an asset isn’t difficult, you just plug some numbers into the equation and you get your value.

The difficult part is making sure the NUMBERS themselves are the right numbers.

So now you’re probably asking, “How do we know if the numbers we’re using are correct?”

Well, you’ll never be able to tell if the numbers are EXACTLY correct, you’ll have to use your best judgment. And even then you’re probably going to be off, and that’s why in Ben Graham’s infinite wisdom he taught Buffett – and thousands of other value investors – to apply a “margin of safety” approach to business valuation, but that’s another story.

But here’s the caveat (and this goes back to the “Does the business have favorable long term economics?” question). According to the Fool.com article, because the internet has favorable long term economic characteristics, and Google is by far and away the leader of the internet pack at the moment, they assume that Google will therefore have favorable long term economic characteristics as well.

But that just isn’t so. The tech sector is predicated upon the process of creative destruction. Companies must find new and innovative ways of doing things or they’re destined to become obsolete. I mean, how many times have we seen this happen in the last 10 years?

To argue that Google will ALWAYS maintain a competitive advantage in a space that changes by the hour is foolish (no pun intended).

That’s why Buffett only invests in mature companies that compete in mature industries. It makes the tough part of business valuation (using the right numbers) much, much easier.

So to answer the original question as simply as possible, Would Buffett ever buy Google?

In my opinion…Not anytime soon!

Comments

[invest2008:]

buffet isnt exactly the kind of investor for google though - he lives in the same house and drives the same car, etc. he's all about slow and steady. i dont think it's a fair headline, and misleads readers into thinking buffet came out with this statement himself without reading your article.

as of now, there is no evidence to suggest that google will lose its competitive advantage anytime soon, so I dont see the logic behind that statement, aside from an elementary 'what goes up must come down' mindset.

2008 Mar 18 09:57 AM

[Sharp45:]

Interesting piece, but this is incorrect:

"the way the company makes 99% of its money is by putting publishers and advertisers together"

Google makes the vast majority of its profits from Adwords (ads that are on search results). There are no publishers involved in this aspect of their business, at any point. If you search for "car insurance" and click on a Geico ad, $5 (estimate) goes directly to Google.

The smaller part of their business is Adsense, which are text-ads on publisher sites. Lots of revenue here, but not nearly as much profit as Adwords. With Adsense, they pay publishers about 60-90% of the revenue generated per-click from advertisers. They keep 100% with Adwords.

So as long as Google dominates search (which should be a very long time, I think) their main source of profits will be intact and growing healthily.

2008 Mar 18 10:09 AM

[Dan Ellis:]

I believe the answer lies somewhere between Mr. Sharp's comments and Mr. Mulligan's presented position, though suggest that someone posit the question to Mr. Buffett driectly. In lieu of that we can only argue the basis on which we presume to know Mr. Buffett's mind.

Mr. Sharp's description of Google business model is much more accurate than Mr. Mulligan's. Currently, market share dominance for search is the Google's primary asset. So, from my perspective the real question is, "how secure is Google's market share dominance for search?"

I tend to think it a bit more tenuous than Mr. Sharp. I believe there is great room for improvement in the search engine technology space, and that users will switch very rapidly if there is a substantially better option available. The ad dollars will chase the searchers.

2008 Mar 18 10:35 AM

[Wayne Mulli...:]

Adam, you're obviously correct...I was trying to illustrate a point and probably could've been more accurate in my description of what Google does. In any case, the company makes its money selling ads -- it's a "simple" business to understand as opposed to trying to understand how the company's search solution works.

I merely meant to "check off" the simple/understandable business part of "Buffett's checklist".

Thanks for the great comments though!

-Wayne

2008 Mar 18 03:50 PM

[gwinner:]

“Favorable long term economics” for a software business are a direct result of how many developers are actively writing to your APIs and how well you monetize the platform. No business analysis I've read appreciates what an Internet operating system is, what Google is doing in that regard, and how well it is positioned to monetize the platform.

Microsoft was king of the PC revolution an will maintain that franchise for decades because if this. Google is the Microsoft of the Internet operating system. Multiply Microsoft's current success by some yet unknown order of magnitude and you have Google in 10 years.

2008 Mar 19 01:31 PM

[mkreisel:]

Google at 30 times earning is quite vulnerable in a recession.

Back in 1973, Buffett picked up WPO at 4 times earning, 4!

2008 Mar 21 12:06 AM

[Deef:]

Finally someone who looks at DCF from a critical point of view. DCF is a very good technique, but as mentioned in the article, the result of your DCF is 100% dependent of the input. DCF is based on estimates and to do a good DCF, you have to be able to make good estimates. In a volatile and unpredictable sector like the tech sector and especially the Internet sector it is just so much harder to make correct estimates. The odds that a DCF analysis on the internet sector equals garbage in garbage out are far greater than those of a DCF analysis on lets say the transportation industry. Especially the Garbage in Garbage out concept is very often forgotten!

2008 Mar 22 06:34 AM