Google's Ghoulish Trick

Google (Nasdaq: GOOG  )
trading at $181.80 as of 10/26/04

Google is like a treat that's wonderfully sweet when you first eat it but leads to indigestion. The trick isn't the company: It has a dominant position, smart management, growing revenues, and decent margins. Rather, the trick is its devilish valuation.

Quick back-of-the-envelope calculations can be valuable to see whether a stock price is remotely sensible. Google's market capitalization is about $50 billion. What sort of return do investors expect? 100%? 300%? A 100% return would result in a market cap of about 100 billion, higher than all but 25 companies. A 300% return would yield a $200 billion market cap, more than all but seven companies -- way bigger than IBM (NYSE: IBM  ) or Intel (Nasdaq: INTC  ) , and approaching Wal-Mart (NYSE: WMT  ) . That's possible, but seems about as likely as Tom Gardner growing cloven hooves, sprouting horns, and starting a power generation and trading company.

A more formal valuation model doesn't make the stock look any more appealing. Suppose Google's revenue will grow at 50% for five years, then 25% for five years, 12% for 20 years, and 5% thereafter. These growth assumptions are optimistic for a couple of reasons. Analysts expect a 33% growth rate for the next five years, and these assumptions lead to Google's 2008 revenue equaling the projected revenue of the entire search engine market. But analysts can be wrong, so let's be confident.

If Google's net margins remain at 15%, option dilution is 3.5% per year, and earnings are discounted by 12% a year, Google's fair value is about $34 billion, or $125 a share. If you use more realistic growth rates of 35%/20%/12%/5% and assume net margins fall to 10% after 10 years, then the fair value is about $14 billion, or $50 per share. If you expense stock options, as you really should, the numbers begin to look diabolic.

Google deserves some premium valuation, but the valuation should reflect the fact that Google still has major challenges ahead of it.

The search engine market does not have the beneficial networking effects that are characteristic of many other technology markets. Networking effects occur when the value of the technology increases exponentially with the number of users, causing a virtuous cycle that makes it extremely difficult for competitors to displace the leader.

For instance, eBay (Nasdaq: EBAY  ) has strong networking effects: The more people who use the site, the more attractive it is to both sellers and buyers. Microsoft (Nasdaq: MSFT  ) , too, has networking effects. Everyone using the same operating system and file types simplifies support and makes it easier to share documents. The search engine market does not have these networking effects. It's irrelevant to me whether a million other people are using Google or whether I'm the only one. That property allowed Google to displace Yahoo! (Nasdaq: YHOO  ) as the preferred search engine but also makes it possible for Google to be displaced.

A further challenge is the strong competition from Yahoo! and Microsoft. Google's newest technology, allowing users to search for files on their PCs, seems ill-fated. Microsoft has demolished numerous companies, the most notable being Netscape, by taking technology and integrating it into the operating system. It seems unlikely that Google can beat Microsoft at that game. In fact, there's a chance Google will convince people that there's no difference between searching PCs and the Internet, only to lose the entire market as Microsoft implements the technology in Windows. The stock price does not seem to be discounting that risk at all.

So, if you're looking for a fast grower, you might want to tiptoe past Google and check out David Gardner's Rule Breakers newsletter instead. Google seems like a trick you'd be better off avoiding.

More Motley Fool Tricks and Treats:

Related Fool Links:

Get the inaugural issues of David Gardner's ultimate growth newsletter -- without risk.Take a free trial.

Richard Gibbons owns a skull, six quarts of blood, two bats, and a box of Count Chocula, but none of the stocks discussed in this article.

The Motley Ghoul's Tricks or Treats represent the opinions of each Fool only and should in no way be taken as the opinion of either The Motley Fool, Inc. or any company in question, or as representative of anyone or anything other than that specific Fool's thoughts. So do your homework and review The Motley Fool's disclosure policy.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 502916, ~/Articles/ArticleHandler.aspx, 10/24/2014 2:02:35 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement