Much Ado About Google

This article has been updated to put a quote from Scott Devitt in the correct context. The author apologizes to Mr. Devitt for this mistake.

Here we go again
When I read that UBS analyst Benjamin Schachter predicted that Google (NASDAQ:GOOG) would hit $500 per share within the next 12 months, I had mixed emotions.

First, I chuckled. Schachter's forecast reminded me of other seemingly outrageous prophecies during the stock-market bubble. Walter Piecyk thought Qualcomm (NASDAQ:QCOM) would hit $1,000 (pre-split) and Henry Blodget called for Amazon.com (NASDAQ:AMZN) to reach $400. Piecyk's crystal ball seems to have been off that day -- Qualcomm never reached its target. But Amazon.com did move past Blodget's predicted price. However, both stocks saw huge declines after the "irrational exuberance" faded.

Next, I scoffed. Google is hot. Its very name has become a verb; you don't search anymore, you Google. And the stock has risen four-fold since its IPO, prompting more people to climb aboard even as insiders sell billions of dollars worth of shares. So Schachter's call for a $500 price smacks of creating more buzz to keep the momentum going.

Then I became curious. Given how much stronger its business is than Qualcomm and Amazon.com were in their infant stages, maybe Google is different. The powerful dominate, and Google is plenty strong.

Time to invert
So I decided to find out the expectations that go with a $500 stock price by working backward from Schachter's $148 billion valuation. I started by turning my discounted cash flow analysis tool around and using value to calculate the expected free cash flow growth rate and rate of return.

It's all about assessing the odds of the bet. By getting a feel for the expectations built into the valuation, I can estimate the odds for an investment decision. If I don't think the requirements seem plausible, I will pass (or maybe even go short). Otherwise, I would buy.

To keep things simple, I'll assume that Google's free cash flow will grow at some rate for 10 years and then at 5% thereafter. Next, for a given growth rate, I will calculate the rate of return required over that 10-year period to justify a market capitalization of $148 billion. Finally, I'll spot-check free cash flow values along the way to see if they make sense.

The drawbacks
This simple model has a few drawbacks. Google's strategy is based on "punctuated equilibrium," not smooth growth, so there is some modeling error. Given the digital revolution that is currently underway, Google has the ability to monetize anything that could benefit from search. The exact timing and magnitude of the events, however, remains uncertain. So, the model assumes an average.

In addition, the model does not take into account return on invested capital. It only factors in that, somehow, free cash flow is growing. The model does not know if returns are 50% per year, as they have been in 2004 and should be in 2005, or if they are rising or falling. Understanding how returns on invested capital might trend requires a competitive analysis of giants such as Yahoo! (NASDAQ:YHOO), eBay (NASDAQ:EBAY), and Microsoft (NASDAQ:MSFT). Rest assured that none of these guys are going to sit back and let Google reap such huge returns all alone.

Despite the drawbacks, these calculations can still give us a good sense of what Google's future may hold.

The results
Assuming Google generates $1.5 billion in free cash flow by the end of 2005, here are the results:

Look at these results this way. My simple model says that at $500, in order to earn a return of 18.1% per year, Google's free cash flow needs to grow an average of 45% per year for the next 10 years. Frankly, I think the risk that Google will not generate $61.6 billion significantly outweighs the expected return.

Even if Google grows its free cash flow at 30% per year for the next 10 years, you can only expect to average 11.6% returns by paying $500. The last scenario -- 15% growth -- seems to be the most plausible, but it is also the least appealing. Who wants to earn 7.5% by investing in Google?

From these calculations, I see lofty expectations built into a valuation of Google at $500 per share. Scott Devitt, an analyst with Stifel Nicolaus, is also concerned with Google's pricey valuation and cautions potential investors when he states that unfortunately "In [the Internet search advertising] sector, valuation is not a factor as long as there's outperformance in the numbers. But when you have a quarter when you don't outperform, it becomes an issue." Devitt rates Google a "Hold" as of December 1, 2005.

If you don't believe valuation is important, you're being foolish. Valuation is always a concern for investors. In fact, it should be their top concern. If you pay too much for future expectations, your risk of losing money increases. And losing money kills the power of compounding.

It's expected returns that count
Before you make an investment decision, make sure you understand the potential upside as well as the potential downside. It's expected returns that count, not just upside returns. As an investor, resist the temptation to chase returns in the marketplace by paying any price for "outperformance." You'll end up neglecting to consider why prices could go down and take on more risk than you should.

Will Google's market price reach $500 within 12 months? It is certainly possible. In fact, let's say the odds are in favor of Google reaching $500 from its current price of $405, which would be a 23.5% return.

Will Google miss expectations within 12 months? That's also certainly possible. While the chances may be lower, the downside is much greater. High-flying growth companies have seen their prices drop 30% to 40% in one day when missing expectations becomes an "issue."

So let's look a table showing the expected returns based on the information above, with a two-thirds chance of reaching $500 and a one-third chance of Google missing expectations within 12 months.

Given this scenario (and I know others are possible), would you want to make a bet on Google going to $500 within 12 months, especially if $500 seems to have lofty expectations built into the current price? Personally, I'd pass. I think I can find other investment opportunities with risk-adjusted returns above 3.9%.

Believe me -- I've learned the hard way a few times -- there's always an unexpected event looming. And an unexpected event (i.e., missed expectations) coupled with an overly inflated stock price could lead to sharp declines. That's why value investors demand a margin of safety in the form of high expected returns when making an investment purchase.

Would I short Google?
While I think the stock price is very high, I wouldn't short it at these levels either. Market prices can stay disconnected from fundamentals for a long time. And while investing long has the advantages of a finite downside and no time penalties, selling short does not. Plus, there is a reasonable scenario at $500 that can earn 7.5%. More importantly, Google generates huge returns on invested capital and that's hard to bet against. So even if Google's stock price fluctuates as the growth fills in, that doesn't mean it is necessarily a good short.

The Foolish bottom line
Admittedly, I don't like the rhetoric coming out of Wall Street about Google. To me, it smells of those lofty valuations during the Internet bubble, and I for one do not think the bet is in my favor to go long or short. That is why I am perfectly content to use Google to sharpen my thinking skills and move on to find the next big bargain instead of trying to jump on the bandwagon at the wrong time.

Philip Durell is always on the hunt for good bargains as well. To see how his Inside Value newsletter is beating the market, try it risk-free for 30 days.

David Meier prefers to use Yahoo! Search over Google because that's where search started. He does not own shares in any of the companies mentioned. Amazon and eBay are Stock Advisor recommendations; Microsoft is an Inside Value pick. The Motley Fool has a disclosure policy.