A fellow Fool recently emailed me to say, "That's it, I'm going to do it. I'm going to buy Google
This particular Fool is not exactly a tech growth investor -- and neither am I for that matter. But you really don't have to be to have an attraction to an industry leader that's grown revenue by 25% over the past 12 months and is trading at less than 15 times forward earnings expectations.
So the obvious question is: Should I be buying Google, too? To answer that, let's take a closer look at the returns we can expect from Google's stock.
As I outlined in a previous article, a good way to get a baseline for growth expectations is to check on what Wall Street analysts expect and how fast the company has grown in the past.
Annual Growth Rate
|Past 12 months||19.9%|
Source: Capital IQ, a division of Standard & Poor's. Historical growth based on operating earnings.
The first thing that might jump out here is the extent to which Google's growth has slowed. This is to be expected to some extent, as it's easier for a company to report a high growth rate when it has $399 million in profit (as Google did in 2004) than when it has more than $8 billion in profit (as Google did over the past 12 months). With Google's towering market cap of nearly $160 billion, it'd be difficult to expect 50%-per-year growth going forward.
But what about the 17% that analysts are projecting -- is that reasonable? If Google were to grow that much per year over the next five years, it would be reporting just over $18 billion in profit in 2016. For sake of comparison, current profit at Apple
For my model, I used 17% as the top end of my expectations and then cut it down to 15% for my mid-case scenario. Finally, I went all the way down to 7% growth for my downside case.
Pinning down valuation
Valuations are a moving target that can be tough to predict, but, as with growth, using a range of values can give us a view of our potential returns without requiring a Miss Cleo-type prescience.
In creating our range, a good place to start is where the stock is trading right now and what its historical trading range has been. Right now, Google's stock changes hands at 18.5 times trailing earnings, after adjusting for one-time charges. That doesn't seem particularly low, but it is on the very low end for Google. Over Google's trading history, it's been a relatively rare occurrence for the stock to trade below 20 times earnings. For the six years ending in 2010, the stock's average annual earnings multiple has been as high as 186 and as low as 24.5.
For broader context, we can also look at how similar companies trade.
Source: Capital IQ, a division of Standard & Poor's.
These companies certainly aren't all exactly the same as Google. Yahoo! may be the closest, while Microsoft has a division that's in direct competition with Google's primary business. But Google has expanded its reach in so many different directions that I think the group can give us a good basis for figuring out how investors think about valuing this kind of business.
What's interesting is that while Google's expected 17% growth rate puts it among the fastest growers, its forward P/E of 14 puts it among the cheaper half of the group. This seems to be a malady affecting the largest of the stocks here -- that is, it seems that investors are eschewing them in favor of the smaller companies such as Yahoo! and AOL. Not that this surprises me, since I've repeated over and over again that large caps look attractively valued versus the rest of the market.
But back to Google. I assumed that investors could get excited about the stock again and boost its multiple as high as 25. If the growth rate slows faster than the market is expecting, I could also see the multiple falling to 15, which is more in line with the market average. My base case is that the multiple will stay around 18.
Dividends and share count
Our final stop is to consider how much we'll get paid through dividends and whether changes in share count will affect our bottom line.
What worries me about a company's share count is that it will issue a boatload of shares and dilute shareholders. Obviously, there was a jump in shares between 2004 and 2005 since Google had its IPO in 2004, but the share count has continued to climb since then. Between March 2005 and this past March, diluted share count has grown 16%, or roughly 2.5% per year.
Despite Google's massive cash hoard, share buybacks haven't been a big part of its world to date, but that could easily change. Looking ahead, investors could reasonably hope that Google starts to chip away at its share count with buybacks if the stock's valuation stays on the lower end. If, on the other hand, share count continues its slow climb, it will provide a drag on earnings-per-share growth.
As for dividends, well, we don't have much work to do here because Google doesn't pay one (and that's a shame).
The verdict, please!
The end result is the returns we can expect under the various scenarios. Here's what my three scenarios would look like.
Annual Earnings-Per-Share Growth
Annual Dividend Growth
Expected Annual Returns
Source: Author's calculations.
Let's now go back to that question that we started with: Could Google's stock double your money?
Under the optimistic case, the answer is most definitely "yes." In fact, it would basically triple your money. Even if it's "just" the mid-case scenario that plays out, a double would still be in the cards. Obviously, that downside case would be a disappointment, but even under those assumptions you're at least still in positive territory.
I have a distinct preference for stocks that pay a dividend, but the potential returns from Google are hard to overlook. I'm a bit uncomfortable with assuming continued high growth and an above-market multiple, but considering Google's growth history and its position in its industry, I think the risk-reward is definitely tipped in favor of buyers today.
Of course, the future is an ever-changing picture, so you need to keep on top of what's going on at Google to see which set of numbers the company and stock are able to live up to. And you can do just that by adding the stock to your Foolish watchlist. Don't have a watch list yet? Start one up.
The Motley Fool owns shares of Microsoft, Apple, Oracle, Google, and Yahoo! Motley Fool newsletter services have recommended buying shares of Microsoft, Google, AT&T, Yahoo!, Apple, and Amazon.com, creating a diagonal call position in Microsoft, and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
Fool contributor Matt Koppenheffer owns shares of Microsoft and AT&T but has no financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.