August 23, 2004
Google is Probably Worth About $24 a Share (over and above IPO proceeds)
[Post-note: In response to questions about the calculations below, the figures in this article refer to the expected discounted value of operating cash flows that will be delivered to investors by the business. That is, the figures assume a 100% purchase of the operating assets. The distinction is this - if a company issues stock and just holds the proceeds in cash, the value of the company is the value of the operating business plus the value of the cash proceeds from the stock sale. Trivially, if you invest $1 billion in a lemonade stand, the proceeds can be deposited in the bank and the business will be worth $1 billion, even if nobody ever makes lemonade. The lemonade stand itself, based on operating cash flows as a standalone entity, might be worth only $24, which you would add to the "cash and marketable securities" to get the value of the company. This is important because Google has been aggressive in issuing additional shares of stock since its IPO, so the per-share value of issuance proceeds invested in "cash and marketable securities" reached about $60 in 2007. Note also that these comments imply nothing about near-term price direction, only about disappointing long-term returns that investors will probably earn by purchasing the stock a price far greater than those stock issuance proceeds plus a conservative amount for the operating business itself.]
But let's get down to business.
The simple fact is that a security is nothing more than a claim on a future stream of cash flows that will be delivered to investors over time. It's unfortunate that investors regularly don't seem to grasp this, because it creates inefficiency in the market. I can't complain too much, because that inefficiency is one of our sources of alpha. It's just that I'd always rather see speculative losses limited to speculators who can afford them. In recent years, too many of the losses have been in the portfolios of average investors who were depending on their investments for financial security. To that extent, it's preferable to have a more efficient market, even if it means somewhat lower returns for investors who know what they're doing.
From the looks of it, investors really don't know what they're doing in Google.
Before reviewing valuations, I should note that Jack Ciesielski of the excellent Accounting Analyst's Observer backed out an implicit price of about $91 for Google, based on data in its financial reports on stock-based compensation. But you've got to understand that Jack is making no assessment of the value of the company when he does that – he's doing forensic accounting, not securities analysis. He's not saying that the stock is actually “worth” $91. He's saying that's about the per-share value that the company was assuming for accounting purposes when it granted stock-based compensation.
So what's the stock actually worth? Let's take a look. What follows here is a back-of-the-envelope calculation, rather than a detailed exposition of our own valuation approach. Enough to provide some insights that I hope will be useful, but certainly not enough to compromise anything proprietary.
For 2001 to 2003, Google's revenues were $84.6 million, $439.5 million, and $1465.9 million, respectively. Heck, for the six-month period ended June 30, 2004, the company's revenues were $1351.8 million. That's clearly explosive growth, but anybody who projects past rapid growth rates from a low base into the future, once a high market share has already been attained, is endearingly naive.
In order to get a handle on future growth, you've got to look at the industry itself. According to Juniper Research, the search industry had total revenues of about $1.6 billion in 2003, and is projected to grow to over $4.3 billion by 2008. Those figures seem plausible, representing about 20% compound annual growth over 5 years.
Still, one has to remember Warren Buffet's warning that “for a major company to predict that its per-share earnings will grow over the long-term at, say, 15% annually is to court trouble.” Very few companies, much less entire industries, can pull off growth rates like that over extended periods. Given that Google already holds a large market share, only a very charitable valuation would assume a 20% growth rate for Google's revenues over a decade or more. Our own approach wouldn't let Google off so easily, but let's go ahead and do it anyway.
Now comes more trouble, which is translating revenues to profit, and translating profit to free-cash flow – the money that can actually be delivered to investors over time.
Despite Google's extraordinary growth in recent years, a closer look demonstrates that those revenues have come at rapidly increasing cost. In 2001, the cost of revenues (traffic acquisition costs such as referral fees, etc) reported by Google represented 16.8% of revenues. In 2002, 29.9%. In 2003, 42.7%. In the six months ended June 30, 2004, costs of revenue acquisition represented a full 47.5% of revenues. In short, as Google has penetrated the search market, its cost of doing so has increased rapidly as a percentage of revenues. Google's prospectus puts this plainly: “We anticipate that the growth rate of our costs and expenses… may exceed the growth rate of our revenues… We may not be able to manage this growth effectively.”
So, OK, the company pays up for growth. Isn't it still profitable? Yes, the net profit margin for Google in the most recent six-month period was 10.6%, up a bit from the 7.2% net profit margin in 2003, but down from 22.7% in 2002. Assuming (and these are kind assumptions) that aggressive competition and maintenance of future revenue growth don't eat much further into this margin, we'll assume a sustainable profit margin of about 10% of revenues. Again, our own approach would take more into account here, but I'm being nice because Stanford holds a chunk of this thing.
Next, we have to ask how much of this profit can actually be claimed by shareholders as free cash flow. A stock is not a claim on earnings. The company's capital expenditures for 2002, 2003, and the past six months were $37.2 million, $176.8 million, and $182.3 million, respectively. Its depreciation for these periods was $29.0 million, $55.0 million, and $54.7 million. So as the company has grown, capital expenditures required to sustain revenues have stabilized at about 12% of revenues, while depreciation has stabilized at about 4% of revenues. The depreciation is netted out as part of costs, but the new capex over-and-above depreciation is not. In other words, the company spends about 12% - 4% = 8% of revenues as new investment. These funds come out of profits, leaving just 10% - 8% = 2% of revenues available to shareholders. Leaving aside a lot of other important deductions, we can conclude that shareholders actually have a claim to about 2% of revenues as free cash flow.
As the growth phase of the company slows in the coming decades, we can assume that extra capex over-and-above depreciation will fall substantially. Depending on the amount of time it takes for that transition, you have a situation where the amount of free cash flow available to shareholders gradually grows as a percentage of revenue, even though the growth rate of revenues declines. This is not unusual for a maturing company. Given that we're already assuming at least a decade of growth at 20% annually without further deterioration of profit margins from competition and revenue acquisition costs, it turns out that transitional assumptions don't do much to our valuation figure (as long as we avoid the implicit assumption that the company will gobble up the entire U.S. economy over time).
Finally, we go ahead and discount the future free cash flows to present value. There are a lot of considerations in our own approach that I'm going to skip, and simply make the assumption that no sane investor would take long-term risk on the stock if it were priced to deliver a long-term return of less than 10%. Using that (again very charitable) discount rate, the expected future cash flows have a present value of about $6.5 billion. This compares with a current capitalization of $29.4 billion at a stock price of 108.
So on charitable growth assumptions, Google's value (not including proceeds from stock issuance invested in cash and marketable securities) would be roughly $24 a share if it were priced to deliver long-term returns of even 10% to investors. This isn't necessarily a forecast about the future direction of the stock price. Rather, it's a statement that in my view, the stock is probably priced to deliver unsatisfactory long-term returns at current levels.
In any event, 24 bucks is somewhat less than 108.
Market valuation and long-term returns
Looking at the stock market as a whole, the S&P 500 currently trades at about 21 times peak earnings (we use peak earnings – the highest level of earnings previously achieved on the S&P 500 – because they remove the uninformative swings in the P/E due to earnings volatility during recessions). Keep in mind that the historical median price/peak earnings ratio is just 11 (last seen at the unremarkable 1990 bear market low), and that the historical average is about 14. Again, this is not a statement about future direction, but it does say a lot about the long-term returns that investors can expect.
It is axiomatic that the lower the price you pay for a given stream of cash flows, the higher your long-term rate of return as those cash flows are delivered. The higher the price you pay for a given stream of cash flows, the lower your long-term rate of return.
Without going over the algebra that I usually use to explain this in these weekly remarks, a quick look at history will suffice.
Historically, when the S&P 500 has been priced at less than 12 times peak earnings, the annualized total return on the S&P 500 over the following two years has averaged 14.85% (17.84% in data since 1950). The total return over the following decade has averaged 11.82% (15.25% in data since 1950).
When the S&P 500 has been priced at less than 15 times prior peak earnings, the annualized total return over the following two years has averaged 12.72% (15.80% since 1950). The total return over the following decade has averaged 11.28% (14.44% since 1950).
When, in contrast, the S&P 500 has been priced at more than 15 times prior peak earnings, the annualized total return over the following two years has averaged just 3.77% (6.79% since 1950). The total return over the following decade has averaged 6.69% (7.39% since 1950).
Finally, when the S&P 500 has been priced at more than 18 times prior peak earnings, the annualized total return over the following two years has averaged 0.14% (3.37% since 1950). The total return over the following decade has averaged 5.33% (6.30% since 1950).
Suffice it to say that stocks don't always earn 10% annually. Below-average valuations are associated with above-average long-term returns, and vice versa.
Now, even the two-year returns quoted here should not be taken as sufficient evidence that high valuations always lead to disappointing short-term returns (as long-term investors, even a two year period is a fairly short-term horizon). That's because the two-year figures are averages and mask a lot of variability. Our investment approach recognizes that valuations can be irrelevant to market direction provided that investors have a sufficiently robust willingness to take risk. We read that willingness out of market action, so our investment stance is always driven by the combination of valuations and market action.
Still, it is important for investors to recognize that stocks are not priced to deliver strong long-term returns at present. The market is best treated as being situated fairly early within a secular bear market (a long period of alternating “cyclical” bull and bear markets where the bear market troughs occur at successively lower and more normal valuations).
I have no idea whether the current cyclical bull market has peaked or not. We simply don't invest based on that sort of determination, which can be made only after the fact. Still, our current measures of valuation and market action are enough to hold us to a defensive position here. If market action improves sufficiently, we'll take a more constructive stance (though not aggressive in any case, given valuations). For now, we're defensive.
The Market Climate in stocks remains characterized by unusually unfavorable valuations and market action so tenuous that it is indistinguishable from a negative condition. Still, last week's market action did not deteriorate further, so there remains at least a possibility that investors will retain a speculative attitude toward stocks (Google's reception was at least some evidence of this). For that reason, the Strategic Growth Fund continues to retain a modest exposure to market fluctuations. Presently, I would estimate that exposure to be about 20%, with the potential to increase to about 35% if the market continues to behave well, and to decline toward 0% if the market declines sufficiently for certain put options held by the Fund to move in-the-money.
In short, Strategic Growth maintains a relatively defensive stance toward stock market risk, but we do retain a modest amount of exposure to market risk. Technically, this is established by hedging about one-third of the Fund's stock portfolio with put options only, rather than matched short call / long put combinations. We do have a modest amount of risk from time decay in this position (well under 1% of net assets), but with option volatilities quite low, I continue to believe that the potential benefits from “curvature” (the tendency for our exposure to market rallies to increase as the market rises, and decrease as the market falls) outweigh the potential extent of time decay.
In bonds, the Market Climate remains characterized by unfavorable valuations and unfavorable market action. The Strategic Total Return Fund maintains an overall portfolio duration of about 2.3 years, primarily in Treasury Inflation Protected Securities. The Fund also has about 16% of assets invested in precious metals shares, which is the source of most day-to-day fluctuation in the Fund. Until we observe more evidence of economic slowing, I do not anticipate any substantial increase in our exposure to precious metals shares. For now, the Fund remains defensively positioned in bonds, with a moderate position in precious metals shares being our primary risk allocation.
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