### Hate to spoil the Google party, but...

As we've argued before, the "PE ratio" is the granddaddy of all yardsticks used to measure the stock market's value. It measures the price of a stock for every dollar of annual earnings, or profits, per share of the company. A PE of 100 means that investors are willing to pay $100 for every dollar per share of profits made by a company.

Traditionally, a stock is considered fairly valued if its PE ratio is the same as the rate its earnings are growing. So a company with profits growing 100 percent a year would be fairly valued when its PE is 100. Right now, Google's stock is trading at a PE of around 68 (taking a market cap of $56 billion and annual earnings run-rate of $816 million) but the company's executives and other analysts point out, correctly, that it gets harder to grow as quickly when you're a bigger company.

According to a recent AP story, David Garrity, an analyst Caris & Co., argues that a price target of $300 is reasonable for Google. That would give Google a PE of 100, meaning that Garrity is essentially predicting Google will *continue* to double its profit growth.

That *is* bullish. We wish Google all the best, but this analyst math is hard to square. The same AP story says analysts predict earnings will increase by more than 60 percent this year, excluding accounting charges for items like employee stock compensation. That's not exactly doubling. So Garrity's $300 sounds a bit high, no?

As the saying goes, this company is "priced to perfection," in other words, only if it performs flawlessly will it hit $300, and even then it may not get there. As Janco Partners analyst Martin Pyykkonen tells AP: *"There is virtually no margin for error." *

Google is undervalued relative to Yahoo. I don't know if Yahoo is fairly valued.

Here is why:

In the last quarter (Q4 2004) Google and Yahoo had almost the same revenue base (1,032 vs. 1,078).

Google however has much bigger profit margins -> 35% vs. 21%. So we have 361 vs. 226 million in operating profits for Google and Yahoo respectively. We will assume an effective long term tax rate for both companies to be about 35%.

Now we have 234 vs. 147 million in net income. All other things being equal Google's market cap should already be 59% more than that of Yahoo simply because they make more money (234 / 147 = 1.59).

However not everything is equal and we should consider the last two and probably the most important factors in the valuation that concern the future - the earnings growth rate and the discount factor (aka required return or the riskiness of the investment).

Google is growing earnings much faster than Yahoo (about 25% vs. 15% sequential growth in the last 8 quarters). We can safely assume that Google is growing at least 5% per quarter faster than Yahoo and at least 10% per year faster in the long run. The analysts are giving 35% long term annual growth for Yahoo, so we can assume 45% for Google.

The discount factor or the required return for Yahoo is about 22%. Google is considered more risky due to low diversification, engagement in risky projects, lack of experience as a public company and a dual class stock structure. We can then plug a higher required return of 32% per year (that is a pretty high required return).

The revenue growth for Google is higher by 10% but we require about 10% higher return because it is more risky, so these two factors actually cancel each other out.

Bottom line is that Google's market cap should be about 70% larger than that of Yahoo. Yahoo's market cap is 48 billion at the moment, so Google should be worth about 82 billion which is $300 per share. Google however is trading at $210 a share so it is a buy and no lockup expirations can stop it from reaching that price very soon. On the contrary, the institutions will finally start buying as much as they want when they know that they will find enough supply at higher prices. And no one will dump 30bn worth of stock upon lockup expiration just because they can. If all Google millionaire employees decide to dump one million dollars worth of stock each, such operation will take only about one trading day.

We can even explain why Google is undervalued relative to Yahoo. Simply because people love simple magic formulas like a P/E ratio and when someone says that Google's P/E ration is sky-high (it is) they think they have a simple answer to a very complex question. Analysts love to say that Google is priced to perfection and they are right. But they fail to see that Google is actually more perfect than the price implies. And that failure will cost them money...

jivko rusev on February 4, 2005 3:38 AMComment link

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