Besides all the bluster of the mobile and tablet wars, Google (NASDAQ:GOOG) has quite a simple business model. Organize data, derive advertisements from that data, and make the advertisements work. As its 10-K states:
"We generated 96% of our revenues in 2011 from our advertisers." (p. 10)
Google has been at attractive relative valuations for the last few years. Had one bought every time the shares fell below $600 -- to good result -- one would have been buying at valuations similar to those of today. One can see this below, as Google has straddled a PE of 20+ and a free-cash-flow yield of 5%+:
(click images to enlarge)
With the prospect of future growth and an economic moat of substantial proportions, the free-cash-flow  yield of 5.6% represent a good value when judged from the probable future prospects -- including growth prospects.
When considering Google as an investment, one needs to specifically understand it as an information finding service. It's easy to get caught up in the tablet and mobile wars -- but, really, it's all about the ads.
Android is built to serve Google ads and apps. And given the staggering statistic that Android represented 75% of all smartphones shipped last quarter, Google's does not lack a feedstock of search queries -- with which it is able to match with advertisements and curated information (i.e., the recent and useful "knowledge graph"). Some point out the declines in "cost-per-click," but the geometric increase in clicks make the falling cost-per-click nearly immaterial in absolute terms.
Further, Google's Youtube.com property was purchased because of the vast possibility as another source of ad revenue. As pointed out by others -- including in the Merriam-Webster dictionary -- our habit is to call the action of finding information on the Internet "googling," because, frankly, that is the service most us use . And if one thinks it probable, as I do, that such a habit will continue into the future, then Google's core business looks intact and any undue pessimism appears to go counter to the facts.
It is certainly true that some of Google's cash flow from its successful advertising business will be shifted to support and grow its new mobile phone hardware business (i.e., Motorola), which suffered a non-GAAP operating loss of some $151 million in the most recent quarter.
For a company with the prominence and importance of Google, the standards of value shift, allowing for a lower free-cash-flow yield to be considered "safe" because of the moat of Google's business -- that is, you use a lower discount rate.
It's all about the core ad search business: it has significant market share on laptops, and it has 96% of mobile query volume. But once we consider its investments in YouTube and Motorola -- and last, but not least, its Android operating system -- today's price looks quite cheap.
"To Google" is synonymous with "to search." This little characteristic of the English language signifies the moat (sort of like how we use the word "Kleenex" -- as in, the product by Kimberly-Clark (NYSE:KMB) -- for tissues). If the reader cannot see the ways in which Google has embedded itself into the way we use the Internet, they will not understand the implication of such an advantage over the long-term course of business.
One danger of the moat, which ought to be noted, is that the majority of Google's revenue comes from the United States (percents are the amount of revenue per geography):
(Source: Google 2011 10-K, p. 31)
And while the "rest of the world" category is growing as a percentage of revenue, the U.S. still makes up 46% of revenue when it only accounts for (at most) 11% of the world's traffic. This imbalance ought to make us look seriously at Google search competitors like Baidu.com (NASDAQ:BIDU). Note the balance of world Internet traffic below:
With a TTM free-cash-flow yield of approximately 5.6%, if a proper discount rate to use on Google is below 5.6%, it would be undervalued. If the proper discount rate to use on Google's future cash flow is above 5.6% -- then it is overvalued. So let us discuss the various elements that ought to enter into the valuation. We will be using John Burr Williams' going-concern discounted cash flow (growth) formula , or this one:
Value = Net Cash Flow / (Discount Rate - Growth)
Let us consider "Net Cash Flow" to the business to be free-cash-flow. We will discuss the discount rate and growth rate below. With those things, we can demonstrate that Google is currently undervalued by the market -- that is, if you think Google is worth the present value of its future cash flows.
First, since the risk of failure in the core business is very low, we ought to use a low discount rate, given the high probability that future cash flow from advertising will be at least equal in quantity to today. That is, it is hard to propose the Google's cash generating abilities will be impaired in the future due to its established control over the internet.
And, I should say, that even if we used a higher discount rate of, say, 15%, things would still look attractive because of Google's historic growth rates. For instance, take a look at his historic revenue growth rates:
If you notice, only for a short period during 2009 did year-over-year growth rates dip below 10 percent. So if we had used a discount rate of 15% and then subtracted the growth of 10% (as the equation above suggests we should), we would end up with a figure equal to a simple discount rate of 5% -- which, since it is lower than the free-cash-flow yield, would make the security undervalued. (I also just assumed the free-cash-flow growth could pace with revenue growth.)
Yet, as I noted above, a discount rate of 15% would be unnecessary and unwarranted . Furthermore, a greater than 10% growth rate may be appropriate. Therefore, (1) given that Google is poised to continue to grow, (2) given that Google's core business is protected by human habit and Google's high quality service, and (3) given the relative valuation of the market place -- Google is a buy at the present level and any price level below the current one.
One one last note, Google holds a significant portion of its retained earnings in cash and marketable securities, or about $45.7 billion as of September 30, 2012. That figure equates to approximately 20% of the current market capitalization.
Google made a big bet on Android, and as we survey the U.S. mobile phone market, we see basically two different camps: The Apple (NASDAQ:AAPL) iPhone and Android devices -- with Android capturing 75% of sales last quarter as noted above. And remember, 96% of Internet search queries still go to Google, even while Android was sold on 75% of the mobile market last quarter (basically, iPhone still uses Google search -- although, as we know, Apple ditched Google Maps). Google CEO Larry Page pointed out the growth of mobile monetization in the most recent conference call on October 18, 2012:
"This time last year, I announced that our run-rate for mobile advertising hit $2.5 billion. That seemed like a pretty big number even for Google. But now we have built up additional mobile revenue from users paying for content and apps in Google Play. Including these new sources grossed up, I can announce our new run-rate for mobile is now over $8 billion. That's quite a business."
The Google story is a simply one, if only you focus on the core of its business. When discussing the mobile and tablet wars -- including the operating systems of those devices -- one is liable to misunderstand the most important point of Google, which is, simply, its search. Barring a major cataclysm, Google is a buy.
- Free-Cash-Flow = FCF = Cash From Operations - Capital Expenditures (for many tech companies it is smart to include other things in "capital expenditures," depending on the situation).
- Google has an estimated search market share of 66.8%. See here.
- As stated in The Theory of Investment Value.
- Besides on what could be called a "required return basis."