On Google's Valuation

As Google's stock blasts through $400 en route to ?, it makes sense to revisit the (in)sanity of the company's market value.  And, in doing so, it also makes sense to review what is and isn't relevant to this exercise.

First, what isn't relevant: How much Google is worth relative to other companies, some of which have been around ten times as long.  Yes, it's easy to appall general-interest readers by observing that Google's market value dwarfs that of Time Warner, Verizon, SBC, Viacom, etc., but, in this case, it's also meaningless.  If Time Warner were growing nearly 100% a year and had 35% profit margins and a 100%-plus return on capital, it would have a mind-boggling market cap, too.  And the same goes for everyone else. 

Another thing that is irrelevant: How much Google is worth relative to trailing GAAP net income.  Given Google's enormous non-cash expense of stock-based compensation (the value of which was set back when the stock was $85 instead of $400), combined with its astounding growth rate, ratios based on trailing net income don't tell you much. 

What does?  Ratios based on cash flow.

The first step in calculating such ratios is determining what value the market is actually placing on Google these days.  Based on Q3's fully diluted share count of about 290 million and today's closing price of $416, the answer is about $121 billion.

The next step is getting a handle on current and expected free cash flow.  Google has generated $1.2 billion of cash so far this year, and after a big Q4 (strongest quarter of the year), will probably end 2005 having generated $1.7-$1.8 billion.  This is an absolutely fantastic sum of cash flow for a seven year old company.  It is also, however, slightly less than I expected a couple of quarters ago, back when the stock price was $250ish (because the company is spending an almost equally fantastic amount of money on land and Googleplexes).

Combine these two numbers, and Google's market value is now about 70-times current free cash flow.  This is undeniably expensive, especially for a company this large.  Of course, given the 100%-plus year-over-year growth rate, the current ratio is not as meaningful as it might be.  More meaningful is Google's 2006 cash flow.  If Google were to, say, double its free cash flow next year--to about $3.5 billion--the stock would be trading at 35-times free cash flow.  This is a more reasonable but still hefty multiple. 

For comparison, the relatively moribund Time Warner, which will generate about $4 billion of free cash flow this year and perhaps 20% more next year, trades at about 20-times that (still a high multiple compared to historical means).  If we KNEW Google was going to generate $3.5 billion of FCF next year, and we ALSO KNEW that Google was going to continue growing much faster than Time Warner into 2007 and beyond, the 35X versus 20X multiple would be eminently reasonable.  Alas, we don't.

What's more, based on the company's massive capital expenditures of the last couple of quarters, combined with the current estimate of another $800 million in 2006, it seems unlikely--to me--that Google will double FCF next year.  More likely, if all goes well, the company might throw off another $2.5 to $3 billion (which means the multiple is closer to 40-45 times, VERY hefty for a company this size).  And what the company's growth prospects will look like in another 12 months is anyone's guess.

Valuation, unfortunately, is next to useless in predicting near-term stock movements, which result from the difference between near-term expectations and reality.  It is, however, helpful in assessing risk. 

The bottom line: Relative to its cash flow and growth rate, Google's market value is still far from insane: If the rapid growth continues (and the stock stops skyrocketing), in a couple of years, the multiple could be quite reasonable.  On the other hand, the chances that the company will continue its rocketship trajectory for the next couple of years without any sort of stumble are, in my opinion, small.  Furthermore, although the company has blown away top-line estimates in the last two quarters, it has not exceeded (my) expectations for free cash flow.  On the contrary, the free cash flow estimates have decreased, which suggests, to me, anyway, that the company is less likely than it once was to blow away numbers on the high side.

All of which means that, although I obviously wish I'd gotten aboard this rocket ride a few hundred dollars ago, I'm now happy watching from the ground.

Disclosure and Reminder: I don't own Google, and this is not investment advice.  Please see Why I Don't Own Google and the "About" tab for some details.

Comments

[Sam S. Park]

I couldn't agree with you more on Google's valuation. Google's future isn't yet written, and it could very well maintain the incredible growth. But it's really hard trying to justify the current market value.

People keep saying that this is a mega growth story, but fail to mention that it's going to take alot of capex to maintain that growth which, like you said, will directly hinder free cash flow growth.

I like how you point out that even if they did grow 100%, the multiple would still be high. The funny thing is that if Google did realize a 100% growth, the price will probably continue to rocket, which wouldn't change multiples that much anyways.

No matter how you look at it... like you, I'll enjoy the view from the ground. That's one risky rocket ride. One wrong move, things could really go bad.

[Dimitar Vesselinov]

Henry, where will the next Google come from? What do you think? I'll bet on robotics, augmented reality, virtual worlds, simulations and predictive markets. Do you want to see the future? I do.

[Ron Belt]

What I used to do around 99 and early 2000 is to make an analysis of what 'the market' is actually going for. I've done this for Google using a model in which I make a guestimate for the numbers for the next five years, use the current value to determine the growth for the next ten years and assume a terminal growth rate of 3% beyond 2020 (!). (you can get the model at:
http://blogofiles.blogo.nl/121/Google%20model.xls).

Guess what, I had to tweak the first five years quite a bit in order to explain the current value. On top of that, the model that 'explains' the value assumes a Compound Annual Growth Rate of 28% for the free cash flow for the next 15 years..

[boonaun]

Popular dillusions and the madness of crowds...charles mackay