Ah, Google (Nasdaq: GOOG ) . This is the duel I've been waiting for. Not that I relish going up against Foolish colleague Rich Smith. Far from it. He's a lawyer, after all. He argues for a living. But still. Argue in favor of a company already flush with $3 billion in cash that's about to get $4 billion more? A company that has Microsoft (Nasdaq: MSFT ) so scared that it's turned to the courts for protection? A company that set a land speed record in transforming itself from Rule Breaker to Rule Maker? Where do I sign up? (Oh, there? Thanks.)
Cheap is as cheap does
No doubt, Rich is going to tell you that from a classic valuation standpoint, Google is remarkably overpriced. Well, he's right -- sort of. I did my own discounted cash flow (DCF) analysis using the DCF calculator available to subscribers of Motley Fool Inside Value (click here for a risk-free trial) and found that Google's shares could be overvalued by $100 per stub. Whew!
The problem with this approach, of course, is that DCF calculations don't often accurately depict the fortunes of a high-growth company. That's the case here, too. How should you evaluate Google? By comparing it with its rivals. Take a look at how Yahoo! (Nasdaq: YHOO ) and eBay (Nasdaq: EBAY ) stack up according to a few classic valuation ratios:
|Estimated 5-year growth||30%||30%||27.9%|
Does Google still appear expensive? Somewhat. It certainly trades for a premium on sales and book value. But where it counts -- on the bottom line -- Google is actually cheaper than Yahoo! and is roughly equivalent to eBay.
When analysts are wrong, Google is right
But are these numbers even fair? I'd say no. For one, they probably woefully underestimate the real growth potential for Google. After all, analysts have consistently come up short when it comes to forecasting anything related to Google. Over the past four quarters alone, analysts have underestimated the search king's earnings per share by 25%, 19.5%, 40.2%, and 12.4%, respectively (according to data provided by Yahoo! Finance).
Part of the problem is that no analyst wants to be the first who looked silly and overestimated Google's potential. Being among the so-called pundits, I can relate. But investors don't take this into account in their valuations of Google. They should. Think about it: If the Street automatically discounts the growth potential for Google, doesn't that mean that all valuation metrics based on forecasts are, at best, lowballed? And if that's true, isn't it all the more impressive that Google compares favorably with rivals using analyst estimates? Yep. It also suggests that Google's stock may be waaaaay cheaper than any of us has been led to believe.
Accelerating sales, accelerating margins
The story doesn't end there. Google is also accelerating sales and margins, a tremendously bullish sign. Have a look at the numbers:
|Quarter||Sales||Gross Margin||Operating Margin|
|Q4 2004||$1,021.501 million||56.0%||29.4%|
|Q1 2005||$1,256.516 million||56.6%||35.2%|
|Q2 2005||$1,384.495 million||56.9%||34.4%|
Got that? Over the span of four quarters, gross margin has improved by nearly 2 points while operating margins have expanded by more than 8 points. And sales have grown with each succeeding quarter. Yet in the face of such improvements, the stock has declined in recent months. That ought to be great news for the Fool in you.
Anything you can do, Google can do better
Why? Because Google, plain and simple, is a Rule Maker. In everything it touches it sets new standards, surpassing and extending innovations brought forth by others in true Microsoftian fashion. First it was search. Then it was search advertising. And then it was email. Now it's video search, desktop search, and even instant messaging. Google is aiming for it all. But it's not treading lightly. Instead, it's entering markets with hip waders and buckets full of moola.
Indeed, not since Mr. Softy was spanked by the Feds has a company emerged so powerful as to engender a wave of pure, unadulterated envy. A decade has passed since those days. Look what Microsoft has done for those who went along for the ride. Isn't it fair to conclude that Google is capable of the same? You bet it is.
You're not done. This is just one part of a four-part Duel! Don't miss Rich Smith's bearish perspective on Google, followed by Tim's and Rich's rebuttals. When you're done, you're still not done. You canvoteand let us know who you think won this Duel.
Fool contributorTim Beyersshouldn't admit this, but Google is his browser's home page. Yet, ironically, he still didn't own shares of Google or any of the other companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile, which ishere. The Motley Fool has an ironcladdisclosure policy.