John Hussman's argument that Google (ticker: GOOG) is worth no more than $40 a share will no doubt stimulate further debate about the stock's valuation. Here, for the sake of contrast, is the valuation section of Citigroup analyst Mark Mahaney's June 8th report on Google, in which he justifies a Buy rating and $360 price target:
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We arrive at our $360 target price based on a combination of EV/EBITDA and P/E analysis. We acknowledge that the price target is intrinsically very high – as is the implied $100Bish market cap. But this valuation is derived from our published estimates and from what we believe are reasonable multiples given our estimated bottom-line growth projections for Google.
Our EV/EBITDA analysis generates a $351 price target, while our P/E analysis generates a $366 price target. We have rounded the average up to $360 to determine our price target.
EV/EBITDA: We apply a 31X multiple to our 2006 EBITDA estimate of $3.3B ($10.80 per share) to reach a $351 target price, adjusting for $3.5B ($11.76 per share) in cash. Our target multiple is largely driven off of growth assumptions, but we usually also consider historical multiple ranges, relative sector multiples, and intangibles like management’s execution track record. For context, we are estimating a 2004-2007 compound EBITDA per share growth of 40%, following 94% growth in 2004. We are also assuming 2006-2009 compound EBITDA growth of approximately 29%, so our target multiple implies an EBITDA multiple in line with the growth rate. We note that our 31X target multiple is slightly below GOOG’s 2005 multiple, so we are assuming no multiple expansion. GOOG’s trading history is too brief to meaningfully refer to its prior multiple range, but we would point to the EBITDA multiples that EBAY and YHOO have achieved over the past 18 months, which have largely ranged from 25X-40X. Finally, this target multiple is the highest among the Net Leaders, which is consistent with our assumption that Google has the strongest growth outlook in the sector.
We note that our 29% long-term growth outlook implies an acceleration from our estimated 26% 2007 EBITDA growth rate. We are assuming that the margin contraction we have modeled through 2007 will stabilize and then potentially expand as Google generates efficiencies in its core business and revenue returns on its non-core business investments. We also assume that new non-traditional search revenues – such as branded advertising and local search -- will begin to become material, supporting the revenue growth rate. If our assumptions are wrong, our growth outlook, and hence our valuation, would be at risk.
One of the sharpest business model differences between Google and the other Net Leaders is in FCF conversion. On a trailing-twelve-month basis, Google has converted 59% of its EBITDA into FCF, while Amazon has converted 70%, eBay 78%, and Yahoo! 83%. Our analysis shows that the biggest variance here is the cash tax shield that Amazon, eBay, and Yahoo! each benefit from on account of their material NOLs. Strip away this impact and the FCF conversion rates are fairly similar. This is a main reason we are willing to rely on EV/EBITDA comparisons instead of P/FCF comparisons.
P/E: We apply a 52X multiple to our 2006 proforma EPS estimate of $6.98 to reach a $366 target price. Our target multiple is largely driven off of growth assumptions, but we usually also consider historical multiple ranges, relative sector multiples, and intangibles like management’s execution track record. For context, we are estimating a 2004-2007 compound EPS growth of 45%, following 110% growth in 2004. We are also assuming 2006-2009 compound EPS growth of approximately 29%, so our target multiple implies a 1.8 PEG. (This PEG is in-line with the PEG’s we are using with other Internet stocks.) Further, the 52X target multiple is approximately in-line with GOOG’s 2005 multiple, so we are assuming no multiple expansion. Finally, this target multiple is the highest among the Net Leaders, which is consistent with our assumption that Google has the strongest growth outlook in the sector.
We present below the current valuation comps for AMZN, EBAY, GOOG, and YHOO. The key points are that GOOG currently trades above the group average 2006 P/E and EV/EBITDA multiples. We believe that GOOG currently deserves a premium to the group based on its current fundamentals and our projected growth estimates. We would shade that premium, however, because of some of the investment risks detailed above, particularly the company’s limited execution track record.
One final point on GOOG’s relative valuation. Although we do not rely on relative market multiples as sole valuation drivers, we do believe they can be useful. Our Buy argument on GOOG is based on applying the sector’s highest multiple (due to the highest growth rate) to our GOOG estimates. The open question is how realistic can the Internet sector’s lead multiple be? One way we think about this is to examine the recent history of eBay’s multiple. Up until eBay missed the Street’s December quarter proforma EPS estimate (the first time eBay had ever missed the Street), EBAY had very consistently for over two years been trading at between 55X and 75X forward Street EPS proforma estimates. In terms of selecting entry and exit points, this range was historically very useful with EBAY shares. While we believe that EBAY’s recent correction may have capped very high multiples (60X or 70x?) for the sector, we believe that GOOG currently trading at around 50X forward 12month Street estimates may provide relative valuation support.