Don’t Believe the Hype on Google
- Feb 04, 2005
- admin
- Entrepreneur, Investing
INVESTORS OFTEN ASK MY OPINION OF GOOGLE (SYM: GOOG).
Not whether the service is good or not (it is), but whether
I believe that the stock is one that should be owned in
their portfolio.
As a strict value investor my standard answer is no.
And that has nothing to do with the amazing growth the
company has shown.
Or the wonderful product the company has.
It has to do with simple economics.
In order to explain why I love the service but not the stock
price, I’m going to use an analogy.
Let us assume that the opportunity has presented itself for you
to buy an Internet search company.
Thatís right.
Remember that college roommate of yours?
Yea, the one who you thought was drinking every night?
Well, instead of drinking he was programming.
And you just got the call to buy his entire search engine outright.
Weíll call it Joeís Search Engine.
You debate the offer.
On the plus side, the search results are always relevant and
the website has a great reputation with advertisers.
In addition it almost seems that the business runs on autopilot.
Now, Joes Search Engine has been in business for over 5 years
and happens to do $1,000,000 in sales each year.
It also happens to be profitable, bringing $100,000.00
per year in earnings.
In a fair value private transaction, it could be argued
that Joe’s could sell for 3-4 times earnings, which would
be between $300,000 – $400,000.
In other words, it would take you 3 – 4 years to get
your money back.
Now letís assume that the Joe, the owner of the search
engine, wakes up one day and reads that Google is selling
with a P/E of 150.
That means that the company is selling for 150 times
its profit.
Joeís shocked.
Stunned may be a better word.
Why?
Because he thinks his search engine is better.
So Joe – in his infinite wisdom – calls you and tells you
the deal is off.
He wonít sell for anything less than 150 times earnings.
Thatís $15 million dollars.
You think about it for a moment.
If you pay $15 million for Joeís Search Engine it would take
you 150 years to earn your money back.
Thatís a long time even for the most patient investor.
Now back to Google.
Google earned close to a whopping $400 million in 2004.
Now lets assume that they grow their profits at an annualized
rate of 30% per year for the next 5 years.
Why only 30%?
Because companies like Time Warnerís AOL (SYM: TWX) will
soon wake up their coma, launch their own pay per click service,
and stop allowing Google to sell their ads.
Microsoft (SYM: MSFT) already started doing it.
Or two other young men from some school will invent
the next new-new thing in search (who even heard of Google
when Yahoo (SYM: YHOO) reigned supreme in the 90ís?).
What Iím trying to say folks is that profits like this bring
big competition.
And big competition reduces prices.
Lower prices = lower profits.
But thatís another story.
Back to Google again.
Anyway, $400 million in profit growing at 30% annually during
the next 5 years means that by 2010 the company will have
$1.5 billion in net income.
And instead of trading at 150 times earnings, the company
now trades with a P/E of 40, which is closer to its internal
growth rate.
If the company is earns $1.5 billion dollars in the year
2010 and trades at 40 times earnings, the company will have a
market capitalization of $60 Billion dollars.
THIS IS ROUGHLY THE SAME MARKET CAP IT HAS TODAY.
Folks, by no means am I saying that the stock of the company
will not trade higher or lower.
What I’m simply pointing out is that there is a disconnect
between Google the business and Google the stock.
A BIG disconnect.
Especially when you consider that over 170 million shares will soon
be free from the IPO lock-up.
Or that Google now has a bigger market value than Ebay (SYM: EBAY).
Or that the same brokerage firms recommending
Google that are part of the multi-billion research
settlement.
In other words ladies and gentlemen, please be patient.
If history is any judge, you’ll have a chance to buy Google
at a much better price.
Remember, you are what you read…
–By Dylan Jovine