www.hussmanfunds.com/wmc/wmc040823.htm
August 23, 2004 Google is Probably Worth About $24 a Share John P Hussman, PhD All rights reserved and actively enforced. After a decade of seeing IPOs preferentially allocated to affluent customers, a more democratic auction had some appeal. And with the pop in Google's stock when it opened for trading, there was no apparent winners curse for investors who ended up receiving shares. There was also little doubt the stock would enjoy about 72 hours of fun. The simple fact is that a security is nothing more than a claim on a future stream of cash flows that will be delivered to investors over time. It's unfortunate that investors regularly don't seem to grasp this, because it creates inefficiency in the market. I can't complain too much, because that inefficiency is one of our sources of alpha. It's just that I'd always rather see speculative losses limited to speculators who can afford them. In recent years, too many of the losses have been in the portfolios of average investors who were depending on their investments for financial security. To that extent, it's preferable to have a more efficient market, even if it means somewhat lower returns for investors who know what they're doing. From the looks of it, investors really don't know what they're doing in Google. Before reviewing valuations, I should note that Jack Ciesielski of the excellent Accounting Analyst's Observer backed out an implicit price of about $91 for Google, based on data in its financial reports on stock-based compensation. But you've got to understand that Jack is making no assessment of the value of the company when he does that he's doing forensic accounting, not securities analysis. He's saying that's about the per-share value that the company was assuming for accounting purposes when it granted stock-based compensation. What follows here is a back-of-the-envelope calculation, rather than a detailed exposition of our own valuation approach. Enough to provide some insights that I hope will be useful, but certainly not enough to compromise anything proprietary. For 2001 to 2003, Google's revenues were $846 million, $4395 million, and $14659 million, respectively. Heck, for the six-month period ended June 30, 2004, the company's revenues were $13518 million. That's clearly explosive growth, but anybody who projects past rapid growth rates from a low base into the future, once a high market share has already been attained, is endearingly naive. In order to get a handle on future growth, you've got to look at the industry itself. According to Juniper Research, the search industry had total revenues of about $16 billion in 2003, and is projected to grow to over $43 billion by 2008. Those figures seem plausible, representing about 20% compound annual growth over 5 years. Still, one has to remember Warren Buffet's warning that for a major company to predict that its per-share earnings will grow over the long-term at, say, 15% annually is to court trouble. Very few companies, much less entire industries, can pull off growth rates like that over extended periods. Given that Google already holds a large market share, only a very charitable valuation would assume a 20% growth rate for Google's revenues over a decade or more. Our own approach wouldn't let Google off so easily, but let's go ahead and do it anyway. Now comes more trouble, which is translating revenues to profit, and translating profit to free-cash flow the money that can actually be delivered to investors over time. Despite Google's extraordinary growth in recent years, a closer look demonstrates that those revenues have come at rapidly increasing cost. In short, as Google has penetrated the search market, its cost of doing so has increased rapidly as a percentage of revenues. Google's prospectus puts this plainly: We anticipate that the growth rate of our costs and expenses may exceed the growth rate of our revenues We may not be able to manage this growth effectively. Assuming (and these are kind assumptions) that aggressive competition and maintenance of future revenue growth don't eat much further into this margin, we'll assume a sustainable profit margin of about 10% of revenues. Again, our own approach would take more into account here, but I'm being nice because Stanford holds a chunk of this thing. Next, we have to ask how much of this profit can actually be claimed by shareholders as free cash flow. The company's capital expenditures for 2002, 2003, and the past six months were $372 million, $1768 million, and $1823 million, respectively. Its depreciation for these periods was $290 million, $550 million, and $547 million. So as the company has grown, capital expenditures required to sustain revenues have stabilized at about 12% of revenues, while depreciation has stabilized at about 4% of revenues. The depreciation is netted out as part of costs, but the new capex over-and-above depreciation is not. In other words, the company spends about 12% - 4% = 8% of revenues as new investment. These funds come out of profits, leaving just 10% - 8% = 2% of revenues available to shareholders. Leaving aside a lot of other important deductions, we can conclude that shareholders actually have a claim to about 2% of revenues as free cash flow. As the growth phase of the company slows in the coming decades, we can assume that extra capex over-and-above depreciation will fall substantially. Depending on the amount of time it takes for that transition, you have a situation where the amount of free cash flow available to shareholders gradually grows as a percentage of revenue, even though the growth rate of revenues declines. Given that we're already assuming at least a decade of growth at 20% annually without further deterioration of profit margins from competition and revenue acquisition costs, it turns out that transitional assumptions don't do much to our valuation figure (as long as we avoid the implicit assumption that the company will gobble up the entire US economy over time). Finally, we go ahead and discount the future free cash flows to present value. There are a lot of considerations in our own approach that I'm going to skip, and simply make the assumption that no sane investor would take long-term risk on the stock if it were priced to deliver a long-term return of less than 10%. Using that (again very charitable) discount rate, the expected future cash flows have a present value of about $65 billion. This compares with a current capitalization of $294 billion at a stock price of 108. So on charitable growth assumptions, Google's stock price would be roughly $24 a share if it were priced to deliver long-term returns of even 10% to investors. This isn't necessarily a forecast about the future direction of the stock price. Rather, it's a statement that in my view, the stock is probably priced to deliver unsatisfactory long-term returns at current levels. Market valuation and long-term returns Looking at the stock market as a whole, the S&P 500 currently trades at about 21 times peak earnings (we use peak earnings the highest level of earnings previously achieved on the S&P 500 because they remove the uninformative swings in the P/E due to earnings volatility during recessions). Keep in mind that the historical median price/peak earnings ratio is just 11 (last seen at the unremarkable 1990 bear market low), and that the historical average is about 14. Again, this is not a statement about future direction, but it does say a lot about the long-term returns that investors can expect. It is axiomatic that the lower the price you pay for a given stream of cash flows, the higher your long-term rate of return as those cash flows are delivered. The higher the price you pay for a given stream of cash flows, the lower your long-term rate of return. Without going over the algebra that I usually use to explain this in these weekly remarks, a quick look at history will suffice. Suffice it to say that stocks don't always earn 10% annually. Below-average valuations are associated with above-average long-term returns, and vice versa. Now, even the two-year returns quoted here should not be taken as sufficient evidence that h...
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