A friend wrote: “… and I thought Google was overvalued at $150!” She was implying that it must not have been overvalued, since it’s currently selling for so much more. I decided to whip out my amateur finance knowledge and see if she was right.
Disclaimer: I am not a finance jock. My understanding of valuation models is limited to my experience as an investor in startup companies, my MBA finance courses, and my having read all of Berkshire Hathaway’s annual reports, and whatever other writing I can get my hands on from Warren Buffett. (Especially Buffetology by Mary Buffett and David Clark.)
My friend was likely right. Google probably was overpriced at $150. “Overpriced” means its actual value is less than it’s selling price.
Share price isn’t the same as value. Google’s price may be above $150, but its intrinsic value may be lower or higher. Price says nothing about intrinsic value, though the value investing theory goes that over the long term, price will eventually gravitate to intrinsic value. I told my friend, “you can kick yourself for not having speculated, but don’t assume that your instincts were wrong.”
APPLYING 3 DIFFERENT VALUATION TECHNIQUES TO GOOGLE:
P/E (price-to-earnings) analysis: Google is currently at $377, with a P/E of 63. That means it will take 63 years for Google to earn back the price of the share you buy. A P/E of 18 is more reasonable (Walmart is at 17, for instance, Microsoft at 18). If Google falls to a realistic valuation (as it’s certain to do over 63 years), this would be about $101/share (377 / 63 * 18 = $107), which is less than the $150 my friend mentioned.
Warren Buffet “bond coupon” valuation: Google produced its historic high $5.68 of fully diluted earnings per share this year. So you are buying a share that produces $5.68 each year. A perfectly safe investment (a T-bill) returns 5.12% a year, so to get $5.68 in earnings from a T-bill, you could buy $111 in T-bills and generate a risk-free $5.68/year.
So paying more than $111 for a Share of Google is a poorer choice than buying a T-bill, unless you think Google will do far better than $5.68/year over time. Note that because Google is riskier than a T-bill, you should actually expect it to cost less than the T-bill, to compensate you for the risk.
Will Google do better than $5.68/year over time? With 215,000,000 outstanding shares, they need to add $215MM to the bottom line to increase earnings per share $1. That’s a big number. So I’m not holding my breath. But let’s assume they can do it…
So let’s look at a third valuation, where we do assume Google will increase its EPS every year.
NPV valuation: Google’s earnings grew 13% last year. A discounted cash flow assuming $5.68/year of earnings, growing 13%/year for 15 years produces a valuation of $141 per share, still below $150. (And that’s assuming sustained 13% growth in earnings, a tough feat. Also assumed: 5.12% T-bill discount rate, and rates have been rising recently…)
CONCLUSION: Google probably is overpriced at $150, relative to its intrinsic value. Due to branding, hype, and general investor irrationality around tech stocks, it’s likely to sell at far more than intrinsic vaule for a long time.
INVESTOR IMPLICATION: Buying Google at current price levels is speculation, not investing. (At least, not value investing.)