Google above $500: A look at valuation
Google Inc. (GOOG) crossed above $500 today. Yawn . . . Sure, it’s an exalted level. Of the more than 8,000 companies in our domestic stocks database, only 16 others can make that claim. Of that batch, only six have market capitalizations above $1 billion. Two companies, TouchTunes Music Corp. (TTMX) and NewAx Inc. (NWXJ) were below $10 million. It goes to show that if a company has a sufficiently small number of shares outstanding, 1,034 and 7,414 respectively, getting up in price can be pretty easy. Even bigger, better-known firms in the $500-plus club, such as Berkshire Hathaway Inc. (BRKa) and Chicago Mercantile Exchange Holdings (CME) get there by having a small number of outstanding shares and steadfastly refusing to split their shares.******The real issue is whether Google’s valuation is high. As it turns out, the stock is not cheap: It’s priced at about 36 times estimate 2007 earnings per share. But as valuations go, there are others at or above that level: 337 as of Monday.******Right now, Google’s forward price/earnings (P/E) ratio is nearly double the S&P 500 level. Let’s assume that shrinks to a 25 percent premium five years hence. Assuming further a risk-free interest rate of 5.5 percent and a future S&P 500 P/E of 18.2 (1 divided by 5.5, based on the “Fed” model which suggests that over time, fair value of the S&P 500 has been the inverse of the risk-free rate), we might assume Google’s five-year-hence P/E will be 22.75.******Now let’s assume investors holding Google require a 15 percent annual return. This sort of thing is always hard to nail down. But if we keep our assumption of a 5.5 percent risk-free interest rate, add in an assume 4-5 percent annual equity risk premium (consistent with long-term historical experience), and apply the traditional capital asset pricing model, 15 percent would work as an appropriate “required annual return” for Google if the Beta, the measure of share price volatility relative to the S&P 500, comes in at 2.11. We don’t have a long-enough history of trading data to compute a beta for Google, but we do note that the figure for Yahoo is 1.91. So 2.11 for Google seems in the ballpark.******Going further, let’s take $500 as a starting point for Google stock. Assuming no dividends, if it returns 15 percent per year over the course of five years, that would mean its future price will be $1,005. If the P/E is 22.75, we’d need Google’s 2012 EPS to come in at $44.17 for today’s $500 price to turn out, in retrospect, to have been reasonable.******Can Google reach that target? It would represent a 26 percent annual growth rate starting with the $13.79 per share analysts assume the company can earn in 2007. On balance, analysts think it’s do-able. The consensus Wall Street long-term EPS growth-rate forecast is 34.31 percent, ranging from a low of 15 percent to a high of 61.80 percent.******Obviously, there are many unknowns here. Would one feel crushed if Google, instead of reaching $1,005, winds up at, say, $805, which would represent a 10 percent annual return? That would require a growth rate of 20.75 percent. On the other hand, if Google’s relative (to S&P 500) P/E comes in at 1.5 instead of 1.25, it would mean a growth rate of “only” 14.6 percent per year would suffice.******What-if scenarios can go on and on and on. But one thing is clear. The kinds of numbers we’re talking about, while high, are not nearly as spectacular as one’s first impression of a $500-plus stock price. Bottom line: Skip the stock-price headlines. Worry about the growth rate.