Google Stock: Is It Time to Sell?

The value of Google's (NASDAQ: GOOGL  ) stock is soaring, but is the value of the business following suit? A simple discounted cash flow, or DCF, valuation suggests that investor expectations for the stock could be getting a bit too optimistic.

Growth expectations
What kind of growth can we expect from Google? In the trailing 12 months, Google earned about $12.7 billion in free cash flow, or FCF. This is a very large number to grow. Nevertheless, most analysts hold a buy rating on the stock, expecting meaningful growth over the long haul.

It's too simplistic to forecast FCF growth in line with revenue growth projections. Over the past five years revenue grew, on average, by 25% per annum. But profitability will inevitably decline as Google's revenue mix shifts away from Internet search on desktops to a highly competitive mobile environment.

Mobile search is tough business. There are a greater number of players with a larger share of control: handset manufacturers, wireless carriers, and application stores, to name a few. Google addressed this problem early in the game with Android, though it failed to carve out the type of dominance Google has on desktops. The evidence has already surfaced: Distribution traffic acquisition costs are on the rise, up to 7.9% of revenue in the company's first quarter from 6.4% in the prior year.

How does this all affect FCF growth estimates? FCF growth will probably more closely reflect the company's year-over-year first-quarter operating income growth (excluding the company's suffering Motorola Mobility segment) of 11%. Operating income, unlike revenue, is affected by margin contraction, making it a better indicator of Google's FCF growth trajectory.

Even 11% growth, however, probably isn't sustainable. Competitors such as Facebook (NASDAQ: FB  ) could continue to make inroads in the digital advertising market and could even pose a threat to Google's search business at some point; the launch of Facebook's recent Graph Search, for instance, could very well be the first of many moves by Zuckerberg and Co. Facebook is definitely a threat to be reckoned with; 30% of Facebook's first-quarter sales came from mobile advertising -- up from virtually nothing in early 2012.

So I'll assume growth will begin at 11% and then slightly decelerate over the next 10 years.

Year

Growth Rate

1

11%

2

10.7%

3

10.3%

4

10%

5

9.7%

6

9.4%

7

9.2%

8

8.9%

9

8.6%

10

8.4%

Valuation
Of course, Google probably won't cease to exist in 10 years. So we'll need a perpetuity rate to estimate the annualized growth beyond Year 10. To be conservative, we'll use 3% -- equal to the historical rate of inflation.

Finally, we'll discount these future cash flows by a 10% discount rate. The result? Google shares are worth $927. At this value, Google is trading at a 6% margin of safety -- leaving almost no breathing room for error. But if you're very confident in Google's economic moat, you may be willing to use a 5% perpetuity rate. In this case, Google's worth $1,160 per share, trading at a 25% margin of safety. Though a 25% margin of safety isn't enough to persuade the typical value investor to throw down on a tech stock, it might be enough for investors who are very bullish on Google.

What do you think?
Google definitely isn't the screaming buy it was, but it isn't a sell, either -- at least not for investors with Foolishly long time horizons. Whether the stock is a buy or not is highly dependent on your view of the company's competitive advantage.

I'd love to know what you think in the comments below. Is Google a buy? Or is it a hold after its recent run-up?

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  • Report this Comment On May 12, 2013, at 12:38 AM, Manlobbi wrote:

    Google's economic moat is wide and I agree wholeheartedly that this is the most important thing to consider in this situation. The price is starting to make this one less attractive. Back

    of envelope calculations:

    Trailing 12 month PE: 26

    Trailing 12 month PE ex cash: 22

    Assume earnings growth over 4 years of 15%,

    and no price change, ex-cash PE falls to 12.

    Comparing future earnings to today's price - how dare I? Well on the surface that's unreasonable however this is useful as a thought experiment. If you purchased at today's price and just

    waited four years, you would still have a

    business with a PE around the market average. So what? Well one must also be realistic about how the market would appraise the business in four years given an extra 4 years of 15% earnings growth - it would of course continue to assign a multiple (incorrectly or not) quite higher than the market average. There is the opportunity and the attractiveness of buying companies that are reliably growing IV (combination of increased cash holding on the balance sheet and on the whole creeping up earnings) at "reasonable" multiples.

    Another view is that in the event of a significant broad market decline (the S&P500 is overvalued to the tune of around 40% based on the current earnings being a lot higher than the trend earnings or CAPE whichever way you measure it) some time in the next few years, a company like Google is the sort of business to pay attention to and purchase a significant portion on sale.

    It is actually harder and harder to find anything attractively priced right now.

    I am less and less attracted by Google over the last year as the business' prospects have remain unchanged during the 60% price rise. I measure the attractiveness of an investment by two variables "D" and "I":

    - I - intrinsic value change rating. Based on adverse future

    conditions and expected change over 10 years. All about

    looking over very long-term and generally the rating is

    not effected by market price (except a very low price could

    actually boost the I rating slightly with buy-backs).

    Forces attention upon economic moats and sustainability

    of the business.

    D - discount rating. Based on the price discount to the

    instantaneously measured intrinsic value today. Estimated

    the normalised average expected earnings over the next

    five years and apply

    Business purchase method:

    - Select companies based on the score of 2 * I + D thus placing

    greater attention to the long-term prospects but factoring

    the current price discount.

    - Maintain high concentration, selling businesses only when

    the score deteriorates. Usually this will be owing to D rating

    falling owing to price rises rather than the I rating falling.

    This way of grading businesses emphasizes long-term IV growth and discourages investing in business that are "temporarily cheap" but not great business - the risk there is that while waiting for the price to correct you are put in a speculative position with attention to price and hope while the business underneath does not grow in value while you are waiting. On the other hand if the "I" rating is high and then you also buy at a discount then while you are waiting for the price to correct the IV continues to rise so there is no negative side effect for the act of waiting.

    In the case of Google I had a "D" rating of 4.0 and an "I" rating of 3.5 one year ago. Now the "D" rating is the same (business unchanged) however the "I" rating has fallen to 3. This give a score of 2 * 4 + 3 = 11. Good - but not as good as other opportunities so I'll likely move out if the price keeps rising. Even Berkshire Hathaway has the same "I" rating of 4.0 but a "D" rating of 3.5 (total score 11.5 ahead of Google). To take another very large one, Apple has an "I" rating of 3.5 and a "D" rating of "4" (total score of 11 - identical to Google). The S&P500 has an "I" rating of 2.5 (real earnings to slightly decline over the next 10 years) and a "D" rating of 3.0 (priced okay against "current" earnings) for a total score of 9.

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