WallStrip is touring the Google campus today. I just opened a position in GOOG a few days ago and have some more money slated to invest in it if the price drops from here or breaks up from here (and forces a MA crossover). Christian asks why I feel the need to invest in GOOG. The simple answer is that I think the price is going to go up… a lot.

People are scared off by the $500 price tag, but GOOG is actually a value play by my calculations. Let’s try this. E*Trade has GOOG’s 2006 EPS at $10.58. So what would GOOG’s EPS growth rate and average PE need to be to warrant a sticker price of $515? The answer is a 20% growth rate and average PE of 30. Here’s the math:

Starting EPS: $10.58
EPS Growth: 20%
EPS in 10 Years: $65.51 (This is simply calculated by compounding our starting EPS by 20% for 10 years)
Average PE: 32 (Or more specifically what we can expect the PE to be in 10 years.)
Future Value: $3,078.90 (Simply the future EPS x the future PE)
Sticker Price: $524.07 (In order to make a 15% per year return on my investment in GOOG, I’d have to buy at this price.)

So if you think Google will have 20% EPS growth and a future PE around 32, GOOG would look fairly priced to you. However, GOOG is going to grow much faster. And if history is an indicator it will have a much higher PE. How fast? How high?

E*Trade has the past 3 years EPS for GOOG at $10.58, $5.70, and $2.73 respectively. That’s an increase of 80% from 2005 to 2006 and an increase of 110% from 2004 to 2005. So GOOG is already growing much faster than 20%. Can it grow as much as 30% on average year-over-year for the next 10 years. I think so.

What about PE. The historic PE is somewhere between 60 and 250. Two times growth (a typical rule of thumb) would be 60. Let’s be conservative and say it will still be 30 and do our calculations again.

Starting EPS: $10.58
EPS Growth: 30%
EPS in 10 Years: $145.85
Average PE: 30
Future Value: $4375.63
Sticker Price: $1093.91

And if we wanted to do like Warren Buffet and buy $1 for $0.50, we’d only buy GOOG when it had a 50% Margin of Safety (MOS)… which would be at $546.95.

So if you expect GOOG to grow at 30% over the next 10 years and you think it could warrant a 30 PE in 10 years, you would be loading up on this guy at the fire sale price of $514… well below a comfortable MOS price. Ride it up to $1093 and double your money.

Before I end, I want to do one more calculation. A lot of times we talk about EPS and EPS growth rates, but don’t stop to think about what that really means for the company. The more typical question is “can GOOG sustain 30% growth year-over-year”? Let’s take a look at GOOG’s actual earnings (in dollars) and see what it would mean if they went up 1400% (EPS of $10.58 to $145.85).

Right now there are 312M shares of GOOG out there. So with EPS of $10.58, that gives us earnings of about $3.5 Billion. Now if we multiply that by 14, we’ll get what our growth rate puts GOOG earnings at in 10 years: $49 Billion dollars. That’s $49 Billion dollars per year… earnings. Exxon just made record earnings $36 Billion last year. So GOOG would have to trounce that.

I’ll leave this explanation for a future post. I need to gather my research, which will focus on the amount of advertising spending worldwide, how much of it is online, how fast it’s growing, how fast Google’s share is growing. Feel free to comment on it now.

That was a great evaluation. I hope your right. It’s unfortunate that the heads of google don’t reveal any worthwhile business news. They could give the investor guidelines on there future business adventures. Thus allowing more demand for the stock. Hopefully in the future they will open up a little more. thanks again. Hope all your investments work out.

I don’t ever look out 10 years but just doing 36 months looks like a clear buy. I actually have my single largest position here for this reason. I do fault management not only for the previously referenced lack of guidance but for their incredible disregard for ivestors this past quarter. They easily could have managed hiring expenses to make the quarter but chose to “run the business in the best long term interset of the company”- this is code for “we are smarter than anyone and will do whatever we want because we know all and you are all dopes”. My view is they need a savvy CFO who can “manage” senior management in the ares of investor relations and spending.

Looking forward to your ad analysis.

Google is rather dominant in their market space and will continue to grow as more and more companies move to utilize online advertizing.

How much growth that I cannot say and can they sustain a projected 30% growth per year over a ten year period it’s possible but i wouldn’t bank on it.

Great post. I really appreciate the breakdown.

To the market and growth question – How big is the TOTAL advertising market? 30% growth per year for 10 years would mean doubling every 27 months or so, which means taking what, based on the projections in your post, would be enormous market share. I suppose it is possible as more nad more people get their media through www sources and not their TVs, but as the previous comment says, how many businesses have achieved such spectactular growth over such a sustained period? As the base grows, the rate of growth tends to decline. Indeed, even Google’s growth rate has declined, albeit from an insanely high rate to a pretty insanely high rate.

Second question: Given that it appears priced for 20% per year growth, and given that nearly no firm grows that quickly over a sustained period, isn’t there a higher probability in the possibility that Google will *merely* grow 15% per year than significantly exceed the 20% growth rate already baked into the cake? After all, investors don’t earn a dime until the company grows faster than 20%. Great investments like Altria and XOM have been companies where people expected no growth, so exceeding expectations was easy.

Third question: how are you accounting for the options? I realize that the options and the restricted stock are only about 14 million shares between them, but the company awards about 1.2 million shares per year this way. So we should expect another 20-25 million shares outstanding in 10 years. While options will have some negative impact on the upside (by raising the actual return necessary to achieve the EPS growth expected), the real danger is on the downside. Companies tend to get “options happy” when things go less than smoothly, since the all-or-nothing component of options can leave those crucial knowledge workers rather unhappy when the bet goes against them.

Anyway, I am looking forward to the post – I hadn’t really given GOOG a look before I read this.

Thanks for all the comments. Great points. Great questions.

I will try to address all this in the follow-up article. Not sure when that will come out. I’m swamped. Thanks for hanging in there.

I wrote these comments to a techcrunch article, back in October:
http://www.techcrunch.com/2007/10/02/google-to-2000share-somebody-muzzle-blodget/

“The definition of insanity is doing the same thing over and over expecting different results. You must be insane or stupid to buy a price-to-perfection company like GOOG, just like all the other people who bought YHOO, CSCO, SUNW, at their peaks in the 1999-2001 periods.

Google has an enterprise value of $171 Billion and runrate Free Cash Flow of $2.6 Billion giving at an EV/FCF ratio of 65. Any financial analyst worth his salt would tell you that implies annualized FCF growth of 30-40% for 10 years! If you want to blow your money, why not just go to Vegas, you’ll have more fun!”

But, If I had listened to my own advice I would have bought PUTS on it. =)

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[…] Putting the Value in Active Value Investing The chapter on value has a cute story about "Tevye the Milkman" and his cow "Golde", which does a great job of explaining how stock evaluation work. It’s a bit elementary, but a fun read anyway. Later in the chapter VK gets into a discussion of "Relative" vs. "Absolute" valuation tools. An example of a relative valuation tool would be the P/E, which is a measure of price relative to earnings. Absolute valuation models are great because they ground your observation in the real world. This is similar to Peter’s Main Street vs. Wall Street analysis or my balking on my GOOG analysis (though I still went long GOOG then and am long now). […]