Is Google Cheap?

I usually don't invest in or look at technology companies as the rate of change in that industry is way too fast for me to figure out what anything is worth.  One day, Yahoo! is king, and the next, it's Google and Yahoo is an old has-been.  One day the Motorola Razor is the must-have item and now it's the iPhone and iPad.

In the PC business, this is also very true.  When I was a kid, the PC's of the day were the Commodore Pet, Tandy's TRS-80 and the Apple II (but we only had two of those units in the school computer room; most of them were TRS-80s).  Those (except Apple) are long gone.

It seemed at one point that everyone was on Myspace, and now many don't even know what that is.  Today, it's Facebook.  If you don't have a Facebook page, you don't exist.

The other thing that turns value investors off of technology is the usually high valuations.  Not only is it bad that you can't see the industry five or ten years ahead, but you have to pay a very high price for this uncertainty.

But today, whether it's Apple, Microsoft or Google, many technology companies seem to be trading very cheaply.  Maybe they are cheap for a reason.  Or maybe it's that people are really not interested in stocks these days so they are neglected.  The internet bubble and collapse is still fresh in the minds of many.

In any case, the cheapness of some of these tech companies have really piqued my interest.  I can't say I have done any deep research on any of these names, but just a casual look at them shows that they may be pretty darn cheap.  Here's a quick look at Google:

Many people keep talking about Google's valuation by looking at the p/e multiple as is shown in places like Yahoo Finance, but the right way to look at it is to take into account the huge amount of cash and marketable securities it has on it's balance sheet.

Google has cash and marketable securities of $39 billion as of the end of the second quarter (ended June 30, 2011).  With shares outstanding of 323 million, that comes to $121/share of cash on the balance sheet versus the current stock price of $528/share.

So if you purchase Google stock now, you are actually paying only $407/share for the business.

Yahoo Finance shows EPS estimates for Google of $35.47 for the current year ending December 2011 and $42.06 for the year ended December 2012.

If these analysts are correct, then Google is trading at 11.5x 2011 eps estimates and a stunningly cheap 9.7x eps estimate for 2012.

Is this really that cheap?

It depends.  If Google is at the height of popularity and it is a fad, or a formidable competitor is just around the corner to take away a lot of their business, then this may not be cheap at all.  But is Google a Kodak or a Blockbuster Video?  Sure they have good competition, but I think their dominance is pretty secure for a while.  In tech, you never really know.  But the point is that at 10x p/e or so, you are not really taking a lot of risk in case you are wrong. 

If you pay 40x p/e for something, a little hiccup can take the stock down 50%, for example, if the market decides it's only worth 20x p/e.  Or even worse, if it goes to 10x p/e, that can be pretty awful.

But here, you are not paying a high price for Google.

Let's look at some historical figures:

One important figure is revenues.  A company can't do well without growing revenues and earnings over time.  To see how dominant Google is, look at these five year figures that were posted during the biggest near-depression in a long time.

                                        2006      2007     2008      2009     2010   
Revenues  ($billions)      $10.6     $16.6    $21.8     $23.7    $29.3
Operating income ($bn)  $  3.6     $  5.1    $  6.6     $ 8.3     $10.4
Net income ($bn)            $   3.0    $  4.2    $  4.2     $ 6.5    $  8.5
EPS:                                $ 9.94    $ 13.29 $ 13.31  $20.41 $ 26.31

Notice how they grew revenues right through the worst recession since the great depression.  They also continued to grow earnings throughout the period.  This alone is quite astounding.

Sure, they grew in the past five years. But are they still growing?  In the most recent quarter ended June 2011, GOOG grew revenues a nice +32% and +29.5% for the first six months of this year.  That's not a bad growth rate at all given that 2010 was not really a bad year.  Some growth rates over 2009 might have reflected a rebound from a cyclical low point, but I don't think that's the case now with GOOG as revenues have continued to grow every year.

Some worry that there really is no future for the U.S., that there will be no growth in the U.S. for many years to come.

Here is the revenue breakdown of Google by region (first six months of 2011):
  U.S.:  46%
  U.K.:  11%
  Rest of world:  43%

Sure, international exposure is great, but what if a lot of that exposure is in slow growth Europe and Japan?  That's a fair point.  I wish Google had a more detailed regional breakdown.  We know that they are not doing too well in China, but I would love to see their revenue and growth figures by emerging markets versus developed markets.

The other key point in evaluating companies is the return on capital, or return on equity.  Google shows return on equity of around 20% or so.   But that $39 billion of cash and marketable securities sitting on the balance sheet is not really earning a whole lot in this low interest rate environment.

So a fair way to look at what the business of Google earns on equity is to look at the figure excluding that $39 billion, low return position.

Shareholders' equity of Google at the end of June 2011 was $46.2 billion.  Deducting that $39 billion of cash and marketable securities would leave a shareholders' equity of $7.2 billion for the operating business of Google.

Net income of Google was $8.5 billion, and deducting the interest and other income of $415 million (much of which I assume was earned on those marketable securities) leaves net income of $8.1 billion (actually, this is conservative and understates net income as the net income is an after tax number and I deducted the pretax interest and other income).

So Google earned $8.1 billion on a shareholders' equity base of $7.2 billion.  Therefore, their return on equity on the operating business is 113%.  Not bad!

One more thing, I think the eps estimates for Google are non-GAAP, excluding stock compensation expense.  So adjusting for that may give a lower eps number.

The GAAP eps for 2010 was $26.31  (data vendors show and eps of $29.60 for 2010).  Using the $26.31/share, GOOG trades at a p/e of 15.5x last year's EPS which is very reasonable for a company that is continuing to grow.  15x p/e is sort of where the general market tends to trade, so is a good benchmark for stock valuation. 

And for such a dominant, superior company like GOOG trading at a market multiple is a bit mindblowing.   If we apply the eps growth rates that analysts estimate, say 20% growth in EPS, then GOOG would earn $31.6/share in 2011 and around $38/share in 2012.

That puts GOOG at around 12.9x 2011 eps and 10.7x 2012 eps.

GOOG does look like an interesting opportunity.  Of course, there are risks.  GOOG revenue is still mostly advertising revenues, so a double dip recession can hurt GOOG for sure even though the first dip didn't seem to impact them too much.

Competition and other problems are hard to predict.  People talk about how internet time spent is migrating over to social networks like Facebook and they fear advertising revenues will move with them.

I have no insight into any of that.  My point is quite simply that GOOG price may price in a lot of the things that people seem to worry about.   This is not to say that it is certain that GOOG stock will go up.  I have really no idea about that. 

Oh, and I haven't incorporated the Motorola aquisition in this analysis. I'm not quite sure how to think about that yet.  What GOOG will do with the cash, and the cash that keeps coming in will be an important point to keep an eye on.

This is simply my observation at this point in time which may change.