## 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.

Hi, Marc,Thanks for the analysis which helps a lot in making some sense out of the seemingly high price for Google’s stock. Just a couple of quick follow-up thoughts and questions assuming you have the numbers handy, what have Google’s growth rates been in the last two to three years, and considering the growth cycles of a new company and the winding down of its rate of growth, what would you think the average growth rate be for the next five years?I understand it is mostly assumptions, but I think you guys have better intuitive sense on these things than most people…Thanks much for your time.Bennett

Google attracted such attention and crowds simply because there’re not many nasdaq companies which can claim to enjoy such a growth since the dot-com burst.Those which were sustaining a good growth despite the burst inclusive of big-boys such as IBM, HP & Microsoft. Apple at earlier age before Steve Jobs were suffering – same with Sun Microsystem, EMC and so on.Then came these new kids from Stanford with a search engine competing with existing giant Yahoo and a bunch of start-up. When Google were being offered to Yahoo for $ 3 Billion, Yahoo refused and the rest is history.The success of Google, in my opinion is its’ simple and easy to use interface – not much products to confuse the market.And based on online-advertising spending annually, it seems the sky is the limit for Google.Hence, it’s all about “perception” that Google will continue to be the leader in web search business and only single digit of advertising spending is currently spent on-line. As long as Google continue to beat earning estimate, the stock price will continue to go upwards.You need a single quarter which Google miss the earning to create a free-fall.

[…] Google above $500: A look at valuation by Marc Gerstein [ Reuters blogs ] […]

The valuation above is based on eps growth sensitivities in 5 yrs, but considering that the trade volumes per unit outstanding share for google is much highr than market, the valuation would have been richer and more usable if was ws done for shorter period returns.ANuj VarshneyBaruch College

a 4th grader can trade google. Learn flags and pennants. Here is last weeks google chart with technical analysis.http://www.naughtyconnect.com/z .jpgI trade goog once per day. 70% of the time i am right.Happy trading.-Chris