Investors in Google (NASDAQ:GOOG) have had a lackluster year. The stock has dropped about 1% year-to-date and since the company (rightfully) pays no dividend, investors have simply been in for an unrewarding and volatile ride. I believe that despite such an unfortunate year, future gains are in store for Google.
Cash (FLOW) is King
The first thing I have examined in order to determine the suitability of an investment in Google is free cash flow. Free cash flow is basically the cash a company is able to generate after accounting for costs to maintain the firm. In the below chart, the historic free cash flow of Google can be seen.
As can clearly be seen in the chart, Google has been steadily increasing its free cash flow. What this means from a business perspective is that it is able to not only pay for the assets required to run the business, but it is in a position to either expand operations or reward equity and debt holders of the firm. Traditionally, firms reward their stockholders with dividends; however, I truly hope that Google does not go down this path. Dividends are a powerful signaling device in that they show equity investors that the company believes the best value to shareholders is giving away their cash rather than investing in the future growth of the firm. Since Google is accumulating greater amounts of free cash flow and it currently does not pay a dividend, this shows that it understands that the best use of its capital is continued investment in revenue generating projects. If Google uses its added free cash flows correctly, it should be able to continue growth.
Putting Its Cash to Work
Since Google is aggressively growing its free cash flow, investors should be asking how Google is actually using its money. The chart below nicely answers this question.
Research and development expense is useful in that it shows us how much the firm spends on developing new products. Firms classify costs as research and development expenses if they believe that these expenditures will translate into new knowledge, products, or services that will generate future profits. In other words, Google is currently spending a significant chunk of its revenues on future economic growth.
What the Market is Ignoring
Google is steadily increasing its free cash flow and plowing its money back into future economic benefit. With such a simple but powerful picture in place, the astute investor must surely be asking why the stock price isn't responding. I believe that there are thousands of potential answers for this answer, but I choose to ignore them and focus exclusively on the firm. I believe that the market is fundamentally mispricing Google. And here's where we have to put on our thinking caps.
In the chart below, I have graphed revenues and the price to sales ratio. Revenues are simply the income of the firm. The price to sales ratio is basically what the market is willing to pay to own a piece of Google's sales.
The first thing to note is that revenues have been steadily increasing. This increase in revenues is so strong that over the past 5 years Google has not had a single year in which its revenues decreased. Compare this revenue growth with the price to sales ratio. The price to sales ratio basically tells us what the market is willing to pay to own a piece of these revenues. As revenues have been increasing, the market has been decreasing its value attached to these revenues. I believe this is where the market is fundamentally mispricing Google. Over the past 5 years, the market has decreased the value to own a piece of Google's sales by 60% while revenues have increased by over 300%!
This divergence in revenues and the price to sales ratios gives the prudent value investor an excellent opportunity to capitalize when the market "wakes up". I believe that as Google begins to reap the benefits from its relentless investment in research and development and its continual growth of free cash flows, the market will begin to remember the true value of Google. What this means, in my opinion, is that the market will value a piece of Google's sales at levels at least comparable to post-financial crisis highs. This allows us to mathematically back out what a fair value per share could be.
If the market were to value Google based on its 2010 levels on a price to sales basis, the fair price per share is $1,122 per share. This price is fair because at this level the market would be paying the same for a piece of Google's sales that it did at the end of 2010. The reason we use 2010 as our base case for valuation is because this point in time represents the value of Google in a conservative, risk-conscious, post-crisis world. As Google begins to reap the benefits from its robust fundamental situation, I believe that the market will wake up and favor Google once again. In such an environment, I see it as entirely possible that Google could increase in value once again.
Even though the fundamental picture of Google is very bullish, we can position ourselves best by factoring the technical picture into our decision making. As can be seen in the below chart, Google has been in a meandering uptrend for the past 3 years. I believe that this trend will continue and that investors will be rewarded in the future; however, I do not believe that non-shareholders should go out and haphazardly purchase the stock today. I believe that investors should wait until price breaks through $670 before initiating a new position. There are several strong reasons for waiting for this price level. The first reason is that this point represents the highest price that the stock has attained in three years. Since our analysis is based on a three year window of history, we should allow this three year high to trigger our position. Another reason that $670 is a prime participating point is that this level has acted as both support and resistance during the past 4 years and it is an area which, when broken, may lead to rapid price gains. As a floor to this analysis, I consider $550 to be the cutoff point. If prices fall below here, I consider this analysis ill-timed.
Here's a recap of the analysis from a payout perspective. If I'm right, we stand to earn $450 per share. If I'm wrong, we lose $120 per share. The reward to risk ratio is very favorable in that for every dollar you risk, you stand to potentially gain $3.77 in reward. Probabilistically speaking, if there is even a 21% chance that this analysis is correct, you stand to greatly benefit from trading the revaluation of Google.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.