Optical/IP Networks

Google Is Overvalued

Google (Nasdaq: GOOG) is overvalued.

Yes, Google is a strong company and a growing force in the global market of the Internet and telecommunications.

But Google, the stock and the business, at a recent price of about $430 per share (as of January 19), is currently overvalued. And Google-mania may be peaking. Here’s why:

    1) By the most proven valuation metrics, Google’s current valuation – about $130 billion – assumes hypergrowth of both revenue and profits for many years into the future (52% compound annual growth rate to January, 2011, by my calculations).

    2) The current valuation assumes that Google will see little or no competition and margin pressure.

    3) Google’s move into ancillary projects – and especially telecom – is going to be more expensive, distracting, and less profitable than it believes.
Hopefully, we learned some lessons during the bursting of the bubble. I did. The most important of these lessons is that age-old valuation models do not change. There is no “new economy” for stock valuations. Companies are valued based on a multiple of their future earnings stream, discounted back to the present. They always have been, and they always will be.

That brings us to Google. What’s Google’s valuation? On Thursday it sat at about $130 billion (it's downticked $10 billion or so just as I've been writing this). Now, $130 billion, that’s a big number. That’s about a shade over the valuation of Cisco Systems Inc. (Nasdaq: CSCO), recently worth $120 billion. That’s $55 billion more than pharmaceutical company Merck. It’s about $30 billion more than the value of Coca-Cola. But hey, Google is better than Coke – it’s Internet Coke.

But here’s the real question: What’s its value relative to future earnings?

In terms of a price/earnings ratio, Google trades at a P/E of about a 100, according to data from Capital IQ. Yeah, that’s high, but certainly not as outrageous as some of the valuations achieved by companies over time (bubble stock Corvis, for example, was once valued more than General Motors when it had zero revenues, let alone profits). (See Life After Corvis, Corvis: Time to Come Clean? , and IPO Nostalgia.) In terms of a price/sales ratio, Google sports a 25. This is more troubling. When I used to write about stocks for Red Herring during the bubble, I once swore to never write positively about a stock with a price/sales ratio over 10. I found, through experience, that such valuations are never sustainable. That’s simply too high, even for a growth company in the technology market.

But let’s get more sophisticated. To satisfy the argument of the bulls, let’s use a methodology that would have helped you avert disaster during the bubble. Red Herring publisher and founder Tony Perkins and his brother Michael in 1999 published a book called The Internet Bubble: Inside the Overvalued World of High-Tech Stocks whose title was impeccably timed, with its release in the fall of 1999. In the book, the brothers Perkins debunked nearly all the rationalizations for assigning Internet companies overzealous valuations. (Note: I used to work at Red Herring, and yes, as a former shareholder of now worthless shares of the privately held company, I really wish Mr. Perkins had taken more of his own advice.)

I recently dusted off the book, which is a fascinating read in recapturing the era. It contains lists of forgettable Internet companies (anybody remember EarthWeb? Or how about iMall? iTurf?). But more importantly, the book used an interesting valuation methodology that resulted in an appendix ranking the implied value of most of the Internet companies of the time. The methodology has stood up well over time. It makes certain assumptions about a company’s potential growth rate and comes up with an implied compound annual growth rate (CAGR) for the company, based on its current market valuation.

For example, let’s take one of the Internet success stories. At a market cap of $17 billion on June 11, 1999, Amazon.com had an implied CAGR of 94%, meaning it would need to grow 94% per year for five years to justify its valuation, according to the book. Of course, Amazon stock ran for many more months after the book was published, reaching a valuation as high as $40 billion. Then it fell back to earth, later staging a modest recovery. The bottom line: Today, Amazon’s market cap is roughly where it was in June 1999: $18 billion. There has been virtually no share price growth for five years – and that’s from a company that executed according to plan!

Let’s run in the numbers on Google. According to the book, here’s how it goes: You take today’s market cap and revenue, and project out five years, arriving at a future valuation and revenue run rate. Then you figure out the growth rate needed to yield such revenues.

The calculation assumes that shareholders are looking for a 20% annual return on share-price growth, and that 5% stock dilution will occur over the five-year period (this could in fact be a conservative assumption, considering the rate at which Google issues stock grants and options). We assume that in five years – January 2011 – Google will have matured and carry a more reasonable P/E and profit margin. In this case, we’re being generous – assuming a P/E of 40 and net profit margins of 20%.

Have I lost you? Well here’s the nutshell: Taking in these assumptions, this model would have Google grow into a market capitalization of about $340 billion by 2010.

Now we can reverse engineer how much revenues and profits Google would need in January 2011 to support that valuation. At a P/E of 40, that 2011 market cap would imply $8.5 billion in earnings. Let’s assume Google’s profit margin in 2011 slips a little, which is natural for a maturing company and industry. I’ll assign a 20% profit margin, which is pretty normal in the software industry. That means Google would need to generate $42.5 billion in revenues and $8.5 billion in profits by the year ending 2010.

How much growth is that? Google’s currently got trailing twelve months of revenue (TTM) of about $5.25 billion. To get to $42.5 billion in revenue, Google would need to show a CAGR of 52% per year.

Doable? Anything’s possible. But that’s just what Google has to do to maintain its valuation. To actually appreciate from here, a growth stock with a valuation of this magnitude must exceed expectations, not just meet then.

I’ve looked over some models from Wall Street analysts to see what they are expecting. Most of the analysts have even higher growth rates built in to their spreadsheets. Some of the assumptions are extremely aggressive. For example, some folks think that Google can sustain margins of 40% for many years to come. I don’t quite understand how, in a market for keyword advertising, filled with competitors, net margins will be at 40%. More typical in the software industry is 20-25%

A bigger question is whether Google can sustain a 52% CAGR and get to $42.5 billion in revenues by 2011, as dictated by our calculations. I can see them doubling revenues quite easily, but once they’re over $10 billion in annual revenue, the law of large numbers sets in. Doubling from $5 billion to $10 billion is a lot easier than going from $10 billion to $20 billion.

The current valuation assumes most things will go extremely well. Now let’s look at what can go wrong – the risks for which Google investors are not being compensated.

Again, let’s look back to 1999. It’s been six years since then. Even the stocks that executed perfectly – companies like Amazon.com, eBay Inc. (Nasdaq: EBAY), and Yahoo Inc. (Nasdaq: YHOO) – haven’t grown their valuations much from the peak levels of the bubble... five years ago. Yahoo is priced at about half what it was at its peak. EBay is about the only stock that I could find in the Perkins book that actually had grown beyond its peak bubble valuation. At the time, though, eBay was much younger than Google is now – it had only $72 million in revenues and a market cap of only $21 billion.

Google’s valuation assumes near perfection in execution, a great economy, sustained growth, and very little viable competition for the next five years. Can anybody do that? Microsoft Corp. (Nasdaq: MSFT) did it in the 1990s. And as we mentioned, eBay, which is currently bumping up against the limits of sustaining growth, did it. I can’t really think of anybody else.

Before you fire up your Google/Microsoft/eBay comparisons, though, let’s get one thing straight: Microsoft has enjoyed enormous power and 40% net margins because it established a monopoly in an installed base of enterprise software. Google has no such thing. There really is no “installed base” of Google. It sells commodity keyword ads. The eyeballs – the sustenance of Google’s business – are free to leave the search engine at any time. There is very little friction, as they say. A trial lawyer soliciting plaintiffs with keywords can easily buy his keyword ads from somebody else. Where’s the barrier to entry?

I’d argue that on the competitive front, life’s been easy for Google so far. It caught Yahoo and Microsoft on their heels, but those guys – not exactly soft competitors – are gearing up for battle. Google was an innovator with its AdSense product and keyword ad-serving algorithm. But I wouldn't feel too comfortable with Mr. Gates breathing down my neck.

Let’s move onto point No. 3: Google has decided to launch a surfeit of “tackle the world” projects ranging from satellite imagery, maps, video distribution, radio ads, fiber networks, data centers, wireless networks, and who knows what else. I understand why they are doing it: They are trying to leverage their market exposure and business model to sell ads through anything to anyone at anytime. But here’s the rub: As former Interent analyst Henry Blodget recently observed, they’re building lots of fixed costs into their company with more infrastructure and employees.

To make matters worse, it seems to me that Google is migrating from high-margin, low fixed costs businesses (sofware and advertising) to lower-margin services (VOIP, wireless, video transport). Is it possible that Google is moving from the ideal world (leveraging other people’s infrastructure and service provider networks for free), to a less ideal world (building out its own global network which will cost large amounts of money to maintain)?

The move into the telecom world is of special concern. Google is now building large networks. As any telecom veteran will tell you: It’s the operating costs, not the capital costs, that kill you. Do Google investors really know where it’s going here? Do they really think supporting VOIP networks is going to be easy, cheap, fun, and high margin? As far as I can tell, VOIP is a brutal, low-margin business.

I think I’ve outlined the risks that could prevent Google from getting to $42.5 billion in revenue and $8.5 billion in annual profits by January of 2011, which I think is what's built into the current stock valuation, given our calculations. Folks are assuming only the best things will happen. They might want to think about some of the bad things.

— R. Scott Raynovich, Editor in Chief, Light Reading

(In accordance with Light Reading's policy, the author does not trade in stocks that he writes about.)

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