How Is The Market Valuing Google?

As a technology firm growing in excess of 15 percent annually, Google Inc GOOG GOOGL's valuation predictably implies sustained high growth rates. Speculation is generally a necessary element of investing in promising tech stocks. A powerful brand, market dominance, investment in future growth avenues, and a history of successful expansion into adjacent categories are all reasons for optimism around Google's story, and these are reflected in bullish analyst recommendations.

Prudena's models show that speculation is relatively modest in Google's valuation and that shares could be 14-18 percent undervalued under strong yet unexceptional growth conditions.

Assuming a required rate of return of 7.8 percent, the long term residual earnings growth rate implied by the market price of $549.53 is 4.96 percent. This likely requires long term EPS growth of just under 9 percent. Book value plus short term forecasts amount to slightly more than $300 per share, meaning that some speculation is clearly required to achieve the current valuation. However the level of speculation is relatively modest in comparison to other internet information providers, especially considering Google's strong history of revenue and earnings growth in addition to stable outlook.

Prudena's residual earnings model estimates value per share of $649, 18.1 percent above the current market price of $549.53. A Monte Carlo simulation which takes adds uncertainty to the residual earnings model returns a most likely value per share of $629.18, 14.5 percent higher than current market price. These models both take analyst estimates as inputs, and the Monte Carlo simulation assumes long term residual earnings growth of 4.5 percent to 5.4 percent. These estimates are achievable if Google can match analyst forecasts of 15 percent annual EPS growth over the next five years, even with that figure falling into the mid single digits in the 20 year horizon.

The Bull Case

Google has had a profound impact on the way people use the internet. Two of its websites, google.com and youtube.com, are ranked among the top five websites of the world, according to Alexa.

Internet penetration in developing markets will serve as a primary growth factor for Google in coming years, and the propagation of e-commerce and digital advertising in those markets will help drive the top line. India and China are expected to witness 24 percent and 16 percent rise in their respective digital advertising markets during 2016, according to eMarketer. Analysts at Warc.com expect global internet ad spending to grow 16 percent during 2015. Multi-device culture is increasing average user-time on the internet, another positive for Google because higher internet usage attracts advertisers. As a leader in mobile operating systems, Google will benefit from a shift toward mobile device use.

Google's investments in disruptive tech for the future such as wearables and autonomous cars could put the company at the front of revolutionary emerging industries. Gartner reports forecast that autonomous vehicles will represent 25 percent of the passenger vehicle population by 2030.

The Bear Case

Social media has become a major platform for digital marketing. Ninety three percent of the marketers use social media and 70 percent of them used Facebook Inc FB successfully to gain new customers. Facebook is emerging as a serious threat for Google, and Google's attempt at the social media space has been uninspiring.

As mobile devices become more popular, an increasing proportion of traffic will go through applications at the expense of browsers. Google's search services are used more often in a browser, so a shift toward app-based communication may harm search revenues. Competitor Facebook engages users with its mobile app, messenger, Instagram and WhatsApp, and has been more successful at attracting mobile traffic than Google to date.

Emerging markets, which are expected to be a major growth driver for ad revenue, will likely coincide with lower margins. Spending in emerging and developing markets is low relative to the existing user base, so future growth opportunities in Google's traditional business is unlikely to be as lucrative per dollar as prior growth.

Google has also been the subject antitrust investigation, with the EU officially opening an investigation in April 2015. This could harm top line growth or result in fines in the future.

Conclusions

Google has so strongly impacted global internet use that the company's name has become a generic trademark synonymous with internet search. The company became a major player in the rise of mobile technology, having the largest number of operating system users and the most expansive app selection. Google has a history of a high, sustained growth, and analysts forecast continued double digit growth for the medium term.

The company has collected a vast amount of user-submitted data over the years, which is an extremely valuable asset with a broad set of applications. Google has also invested in a number of potentially disruptive technologies such as wearables and autonomous cars.

Prudena's models show that a significant amount of speculation is required to arrive at Google's current valuation.

However, this should be expected for an internet company exhibiting such growth rates, and GOOGL valuation still entails substantially less speculation than some competitors such as FB.

Prudena's models indicate that Google may be 14-18 percent undervalued.

About Prudena

Contributors: Soid Ahmad, Ryan Downie

NOTE: The Morning Monte is high-level, and any investment requires a deeper analysis than is presented here. The comments in the Morning Monte are intended to help guide your research and ground you in the fundamentals of the company. In no way should the comments in The Morning Monte be taken as advice to buy or sell a particular equity. Some of the statements are forward looking. As such, these statements are speculation--so beware! The comments represent the views of the author and are not necessarily the views of PRUDENA™.

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