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.