Google Valuation – Decidely Undecided

Posted on April 20, 2008

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In early April when Google stock was trading at the mid-$400s, I started thinking about its market valuation and price per share. Maybe it was a good buying opportunity since coming down from its all-time highs in the $700+ range late last year.

In the spirit of the analysis I’ve done in previous articles with valuations Facebook, Starbucks, Bear Stearns, and Yahoo!, I jumped into Google’s financial statements to see what I could find. Happily, I discovered mystery, love, and intrigue – certainly enough for a good story.

I’m drawn to an elemental approach that looks at intrinsic value, even with dynamic technology companies like Google. In taking this approach, I focused my research on the growth of Google’s assets, and more specifically, on the growth of Google’s shareholders’ equity. Because shareholders’ equity is what’s left after subtracting a company’s liabilities from its assets, it provides a clear of what is left for shareholders after debts are retired from a company’s assets (thus the term “shareholders’ equity”).

Starting with the 2003 year-end reporting through 2007, the growth of Google’s shareholder equity has declined fairly rapidly –

From their financial statements, Google’s Total Shareholder Equity (in 000s) over the past five years –

2003: $602,641
2004: $2,929,056 (an increase of 386% from 2003)
2005: $9,418,957 (an increase of 221% from 2004, but a 42% lower growth rate)
2006: $17,039,840 (an increase of 80% from 2004, but a 63% lower growth rate)
2007: $22,689,679 (an increase of 33% from 2004, but a 58% lower growth rate)

Notice the trend? Of course, maintaining triple-digit shareholder equity growth isn’t realistic, but it does show the effects of Google’s increasing company size and asset base.

There are about 313 million shares outstanding. If we divide the current shareholder equity of $22,689,679,000 equally among each shareholder, that comes to about $72/share. So if Google liquidates today and pays off its liabilities in full, there will be $72/share to distribute.

Google isn’t going out of business today, so looking at this number in comparison to a $450-550 share price probably isn’t the best option in determining the true value per share. Another option is to consider current and future Cash Flow/Share (CFS), with future cash flows discounted back to today using a reasonable required rate of return. Google’s Beta is 2.01 and the US Treasury 10-year bond yield is about 3.75%. Using the CAPM, that calculates to a 12.25% required rate of return. To account for the current economic downturn and innovation risk, let’s call it 15%.

Google’s CFS was $17.66 in 2007. If we assume a 10% growth rate per year for 10 years, how does that shake out in valuing its shares after discounting future cash flows to today? With a 15% required rate of return as the discount rate, the sum of the discounted CFS for the next ten years is $101.91. Again, not quite close to the recent $450-550/share trading range.

Extend this 10% growth rate in Cash Flows into perpetuity with the same 15% required rate of return and we get a value of $353/share. But is a 10% growth into perpetuity realistic? Probably not, but it’s hard to argue against it given their Quarter 1 results for 2008. Their ability to innovate is the wild card.

All in all, I’m still undecided about what to decide… I first contemplated this about two weeks ago when the price/share was in the mid-$400s. Now in the mid-$500s, I don’t have any better answers as to whether or not the valuation feels right. It seems a bit high based on fundamental research and intrinsic valuation.

There’s a nice article that looks at Google’s valuation in a similar, but different way using a “scenario approach.” It’s worth a read.

It’s clear that investors are flocking to the stock after selling off in recent months. But is in investing or speculating? That’s the part I can’t figure out…

Digg!