The Power of Earnings: Google

Chartists, momentum investors, and palm readers may disagree, but at The Motley Fool we know that a stock is worth only the cash flow its underlying business generates. But as investors, how do we know if we're buying those cash flows on the cheap or if we're paying too much for future expectations?

Try using the earnings power value, a quick way to calculate the value of a company's current earnings. Once we've crunched the numbers, we can then compare the EPV to a company's stock price to determine the value that investors are giving its earnings growth. Then you can make the call if it's worth paying up for that future growth.

If you're new to the EPV way, check out our primer here. Don't worry: You don't need a Ph.D. in finance -- just a few numbers you can easily find at Fool.com. Let's take a quick look at the EPV for Google (Nasdaq: GOOG  ) .

First: What it does
Google is the king of the Internet search world. Google provides targeted Web advertising and Internet search services. But, at its core, Google is an ad placement service. The brains behind the advertising model are AdWords and AdSense, Google's tools for auctioning off ad space to the highest bidder. Last year, 97% of Google's $23.7 billion in revenue came from searchers like you and me clicking on the sponsored links generated by AdWords and AdSense.

Second: The value of today's earnings
Using our handy EPV primer from above and a 10% discount rate, we get the following for Google:

EPV Cash Flow (TTM)

Current Earnings Value Per Share

Current Stock Price

Value of Growth Per Share

% Growth Implied in Stock Price

$8,378 million

$357

$498

$141

28%

TTM = trailing 12 months.

Third: Is it worth it?
I was a little surprised to see that "only" 28% of Google's current valuation is attributed to growth. But then I remembered that Google is absolutely not just a bet on the future, but it's a company that's generating a ton of cash right now -- $8.4 billion in free cash flow and $26.5 billion in cash and investments. Google also has many paths for growth, including ad placement, mobile search, and cloud computing. Over the past five years, Google has grown revenues at an impressive 38% annual clip. Earnings per share have done slightly worse, coming in at a 37% annual growth rate. Analysts expect continued, although somewhat more modest, growth for the near future. Consensus estimates currently see Google growing at 15% a year for the next two years.

Fourth: Google's EPV vs. three competitors
Let's see how Google stacks up against three of its competitors. Running these three companies through our EPV calculator gets us:

Company

Current Earnings Value Per Share

Current Stock Price

Value of Growth Per Share

% Growth Implied in Stock Price

Yahoo!

$8.90

$14.30

$5.40

38%

Microsoft (Nasdaq: MSFT  )

$27.20

$25.20

($2.00)

NA

Apple

(Nasdaq: AAPL  )

$157.50

$259.25

$101.75

39%

The most interesting thing that jumped out at me is that Microsoft, yes Microsoft, is trading at a discount to the value of its current earnings. That means you're getting all of Mr. Softy's future growth for free. Now before you log on to your discount broker to make a quick trade, it's important to look more closely at Microsoft's latest earnings to see if they are sustainable or even inflated. Also, Microsoft cut capital expenditures dramatically in fiscal 2010, so that could be affecting the analysis as well. Remember, EPV is a handy tool to see what price investors are putting on a company's future. But it's just a starting point.

Do you agree? Does Google's future growth potential justify its stock price? Is Microsoft a bargain? Let us know your opinion by posting down below.

At the time of publication, Ron Gross owned shares of Microsoft. Ron is advisor of the Motley Fool Million Dollar Portfolio. Microsoft is a Motley Fool Inside Value pick. Google is a Motley Fool Rule Breakers recommendation. Apple is a Motley Fool Stock Advisor selection. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Google. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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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.

  • Report this Comment On August 10, 2010, at 10:42 AM, Henry3Dogg wrote:

    To grow, Google need to find new markets, as do Microsoft, because they already dominate the markets that they are in. Neither have shown potential for creating new markets recently.

    Apple, on the other hand, has both growth potential in it's existing markets, and a first rate record for moving into new markets.

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