Re-valuing Google: Three Scenarios

We are revisiting a prior piece of analysis we completed on Google (GOOG). It has been a popular piece of analysis and we wanted to update the analysis using our on-line valuation tool.

GOOG Valuation

Google grew revenues from US$3.2 billion in 2004 to US$16.6 billion in 2007 – a huge 73% compound annual growth rate. Our assumptions of revenues for the next three years are US$22.5 billion in 2008 growing to US$34.5 billion in 2010 – a 27% compound annual growth rate. Year-on-year revenue increases have slowed from 92.5% in 2005 to 56.5% in 2007. We are projecting revenue growth to continue to slow – 35.6% in 2008, 26.7% in 2009 and 21.0% in 2010.

We have projected EBITDA margins at a flat 40%.

We have used a terminal growth rate of 6.5%. We calculated this terminal growth rate based on year three growth (2009 to 2010) of 21% dropping to 18.5% in 2011 and then to a 5% stable growth rate over the next ten years.

We have used a WACC (discount rate) of 10.5%. The WACC (discount rate) has a material impact on a discounted cash flow valuation (as does the terminal growth rate). We think this WACC of 10.5% is reasonable but recognize that the actual number could be as low as 10% or as high as 12-12.5%.

We used a terminal capital expenditure number of US$4.25 billion.

Our analysis incorporates the cash on the Google balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$481.94 which is 11.1% below Tuesday's closing share price of US$542.30.  Our valuation is based on the current share price - it isn’t a target price for the future.

Valuecruncher Valuation GOOG – Base Case

We then created three separate scenarios:

1. Growth – where Google’s current dominance of on-line search and advertising is enhanced and revenues grow faster than anticipated in the base case. This scenario holds all the inputs from the base case constant except that we have increased the terminal growth to 7.0% – based on 2011 growth of 20% decreasing to 5% over ten years – and lifted EBITDA margins to 42.5%. This scenario has a valuation of US$590.39 per share. This is 8.9% above Tuesday's share price and 22.5% above our base case valuation.

Valuecruncher Valuation GOOG – Growth

2. Disruption – where Google’s current market dominance is reduced by changes in the competitive landscape. This scenario holds all the inputs from the base case constant except that we have decreased the terminal growth to 5.5% – based on 2011 growth of 15% decreasing to 4% over ten years – and dropped EBITDA margins to 37.5%. This scenario has a valuation of US$363.22 per share. This is 33.0% below Tuesday's share price and 24.6% below our base case valuation.

Valuecruncher Valuation GOOG – Disruption

3. Black Swan – where Google’s internal activities create a new growth business similar in value to Salesforce.com (CRM). The new business grows from US$250 million in revenues in 2009 to US$1.5 billion in 2012 and from $250m in losses to 50% EBIT margins in the same period. To reflect this we have increased 2009 revenues by US$250 million and 2010 revenues by US$500 million. We have reduced the 2009 EBITDA to 39%. We have also lifted the terminal growth to 6.65%. This scenario has a valuation of US$507.85 per share. This is 6.4% below Tuesday's share price and 5.4% above our base case valuation. Google creating a new business of the value of Salesforce.com adds just under US$26 to our base case share price.

Valuecruncher Valuation GOOG – Black Swan

Valuecruncher greatly respects Google’s current market dominance in search and on-line advertising. However – we can see both a situation where Google maintains this dominance and more advertising spend moves from traditional media to on-line and conversely one where new methods of discovery on-line disrupt Google’s current dominant position. We do not have a perspective on which of those might occur – but it is worth considering the impact of both scenarios from a valuation perspective. These are scenarios 1 and 2.

Our third scenario looks at the valuation impact if one of the internal Google R&D activities produces a material new business unit (say US$1.5 billion of revenues by 2012 at 50% EBIT margins). The value of this new business unit is ~US$8.1 billion in the valuation – comparable to the current enterprise value of a Salesforce.com.

Play with our assumptions – what does your analysis say?

Disclosure: None

Comments

[woodhorb]

I always thought that with discounted cash flows you used either the current and expected interest rate cost or your rae of return required to invest; if base rates are at 2%; OK histoprically low but still your 10.5% discount rate seems rather high; I took your $34.5 B revenue prediction for 2010 and your 40% EBITDA which gave me EPS for 2010 at $46 per share; then said OK it's a mature company growing at 6.5% a year with no new innovation (again your assumptions) so a PE of 15 gives me a value of $690 a share in 2 years time; that's a worthwhile return over the next 2 years using your bas case scenario; with their huge data storage vlume which can't be matched I expect competitors will struggle to disrupt GOOG from it's dominant position over the next 2 years; hence my long position at 1000 shares; would add more if I could afford it; there is always a downside risk but if GOOG delivers the profits each quarter or only misses by cents we will get to $700 in 2 years

[Alex Filonov]

Why 10.5% discount rate? GOOG isn't based in some third world country. I don't think you'd find many investable US companies at this rate (if any at all).