So Safa Rashtchy of Piper Jaffray upped his Google price target from $445 to $600. Is he INSANE?
No. He simply assumes that Google's recent growth trends will continue in pretty much a straight line for the next two years and that the market will put the same multiple on the stock next January as it does now. And unlike most of the pantywaist Google analyst herd, he's bold enough to stick his neck out. (If Google reports another bombshell of a quarter, watch the rest of the targets creep up to Safa's--and watch the world yawn.) This is what valuable sell-side analysts do: Take positions that make you think--even if your thinking leads you to conclude that they are morons. So raise your glass to Safa and team, regardless of what happens.
Of course, "bold" does not necessarily equate to "prescient" or "wise," and anyone can plug numbers into a spreadsheet. So it's worth analyzing Safa's key assumptions. According to the report, which John Battelle kindly links to, these include:
- Search spending grows 41% next year and at a 37% CAGR for the next five years.
- Google continues to gain share, thus growing faster than the market.
- Google's operating profit margin continues to increase modestly, ending at 57% in 2007.
None of these assumptions are ridiculous. They do strike me, however, as more likely aggressive than conservative. Safa also does not address (or forecast--at least in this report) the metric that I think is most relevant to Google's valuation: free cash flow. Google's capex spending is so out of hand (an estimated $800 million or more this year) that EBITDA does not provide a fair picture of the company's value, and neither does pro forma EPS. But on to the assumptions:
Search has grown phenomenally over the past six years and is now a $10 billion global business. Safa's growth assumptions call for it to nearly triple again in five years, to nearly $30 billion. I don't object to the $30 billion assumption so much as the corollary assumption that search will then have experienced an entire decade of phenomenal growth without so much as a hiccup. Most online advertising projections back in 1999 looked very similar to Safa's current search projections: up and to the right (with the slope of the line getting steeper with every amazing quarter). And, on average, that's what the market has done. But 2001 and 2002, we all remember, were anything but up and to the right.
What could slow the growth of search? Click fraud, for one. An economic slowdown. And probably about a dozen other factors that, if they occur, will be screamingly obvious in hindsight. In my opinion, the conservative assumption is that something will cause a hiccup in search growth in the next few years, even if we don't yet know what.
On to Safa's second assumption: Google will continue to gain share. Seems likely to me.
And the third assumption: Google's profit margin will continue to increase from an already incredible 50%-plus. If you believe that search will grow steadily to $30 billion, this will probably happen (Google's incremental revenue in search is probably as profitable as Microsoft's with Windows--i.e., 95%-plus). If you believe, however, that market growth will stumble, and that what might cause the stumble would be something like click fraud, then the assumption is aggressive. Additionally, if you believe that Google will one day add other services, the margin assumption seems even more aggressive. It is hard to believe that any other product Google could roll out in size would have profit margins like search.
As for the market maintaining a 50X forward EPS multiple on the stock for another year, this is anyone's guess. If the future unfolds as Safa predicts, and the rest of the stock-market holds its valuation, then 50X is perfectly reasonable. Of course, 25X or 30X or 60X would be perfectly reasonable, too.
So, no, Safa's not nuts. In my opinion, there's about a one in three chance that Google's future will be as good or better than he predicts. But that leaves two chances in three (again in my opinion) that it will be worse--and at least one in three that it will be temporarily disastrous.