2 Lessons Investors Can Learn From Google's Last 10 Years

Valuing "growth" is hard, but getting it right can pay off big time.

Aug 25, 2014 at 11:30AM

On Aug. 19, 2014, Google (NASDAQ:GOOG)(NASDAQ:GOOGL) celebrated its ten year anniversary as a public company. Over that time, Google's share price appreciated over 1,000% while the S&P 500 increased about 120%, meaning Google stock outperformed the market by nearly 10 times. Google-like returns can lead to a very comfortable (and possibly early) retirement, so this got me thinking about the lessons we can learn from Google's success. I came up with two big ones.

Valuation Is Hard, Especially for Fast Growing, Disruptive Companies Like Google
Google reported net income of $143 million for the first six months of 2004 and IPO'd with a market capitalization of $23 billion. Depending on how much you thought Google could earn in the back half of 2004, Google was trading at a price-to-earnings (P/E) ratio of about 75x to 80x at its IPO. Most value investors would claim that's an astronomical valuation, but anyone who avoided investing in Google simply because it was trading at a high P/E (myself included) missed out big time.

Valuing Google using discounted cash flow (DCF) analysis wasn't any easier. In an excellent article by Stephen Gandel titled "Man was I wrong about Google's IPO" on Fortune.com, he discusses where he went wrong in his valuation of Google. He used a DCF model to value Google at $20 per share, or 60% below its split-adjusted trading price of $50 per share. In other words, his model told him that Google was worth 60% less than the price at which is started trading. Today Google is trading at about $585 per share.

His valuation turned out to be wrong even though he used what I believe are fairly aggressive inputs (he assumed Google could grow earnings at 30% a year over a 10 year period even though most companies can't keep up that growth rate for even half the time) and received help from Aswath Damodaran, considered to be one of the world's foremost experts on teaching valuation and DCF modeling (I keep two of his books on my desk at all times).

The lesson here is that DCF's and P/E ratios can't be used to reliably value a fast growing company that has the potential to change the world. This obviously begs two questions: How can investors determine which companies are going to change the world (which company will be the next Google, Netflix, Amazon, or Facebook) and how do we value them? My answer to both questions is that it's very hard, but that The Motley Fool has gotten pretty good at it over the years. Tom and David Gardner are experts at finding long-term market winners and thinking about their valuation over a very long period of time.

Remarkably, over the past five years, the top 3 performing investment newsletters out of the 200 tracked by Hulbert Financial Digest are all Motley Fool newsletters, and two of those three are run by Tom or David Gardner. The third is run by a longtime Fool, and my teacher and friend, Joe Magyer. Check it out here.

Most of the Real Big Winners in the Stock Market Have at Least One of the Following Two Qualities:

  • High revenue growth over long periods of time, and/or:

  • Consistently high Returns on Equity (ROE)

Google, as it turns out, has both of these qualities. According to Morningstar's Key Ratios, Google has averaged revenue growth of 45% and generated average returns on equity (ROE) of 20% over the past decade.

To drive home how companies with high returns on equity (or returns on invested capital) outperform the market over long periods of time, I turn to a quote by Charlie Munger in Poor Charlie's Almanack:

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.

Sounds like Munger could have been talking about Google!

Munger is suggesting that over time, investors will make a lot more money buying compounders that have the ability to grow revenues, earnings per share, free cash flow per share, and maintain high returns on owner's capital than they will buying a stock simply because it is cheap (selling at a 50% discount to intrinsic value, for example). A strict value investor would sell after the stock reaches his estimate of value, essentially locking in a 50% gain. That's nice, but an investor that identifies a company with the ability to increase its intrinsic value over time, can possibly make 1000%. That's even nicer!

My Foolish Conclusion
Above average companies deserve to trade at an above average multiple because they have the ability to increase their intrinsic value over time. Paying a dollar for a dollar is still "value" investing if that dollar will be worth five or even ten (in the case of Google) dollars down the road.

Leaked: Apple's next smart device (warning, it may shock you)
Apple recently recruited a secret-development "dream team" to guarantee its newest smart device was kept hidden from the public for as long as possible. But the secret is out, and some early viewers are claiming its everyday impact could trump the iPod, iPhone, and the iPad. In fact, ABI Research predicts 485 million of this type of device will be sold per year. But one small company makes Apple's gadget possible. And its stock price has nearly unlimited room to run for early-in-the-know investors. To be one of them, and see Apple's newest smart gizmo, just click here!

John Rotonti has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Facebook, Google (A and C shares), and Netflix. The Motley Fool owns shares of Amazon.com, Facebook, Google (A and C shares), and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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