Google, the Internet search engine that went public a year ago this week, said Thursday it plans to sell up to 14.8 million shares in an attempt to raise more than $4 billion. The announcement sent shares of the Mountain View, Calif., company tumbling $7, or nearly 3%, to $278 in early trading, as investors grew concerned about the company’s prospects.
Not only will the stock sale dilute the value of the current shares outstanding; it also raises questions about what the company plans to do with the proceeds. In a filing with the Securities and Exchange Commission, the company said it would use some of the cash to make unspecified acquisitions, while the rest would be used for general corporate purposes. But it’s no secret that Google’s success has made it a target of large technology firms such as Yahoo and Microsoft, among others. And now the company is essentially admitting it needs more money to develop new products to fight off competition.
To be sure, Google’s shares have been on a tear over the last 12 months, rocketing nearly 230% since opening at $85 last August 19. But some on Wall Street say the stock is overheated—possibly overvalued by as much as 150%. Google now has a $77 billion market capitalization, roughly the same as blue-chip firms such as Wachovia and SBC Communications.
As of Wednesday’s closing price of $285, its shares were trading at 79 times trailing earnings—more than other Internet stars like Yahoo, which trades at 72 times earnings and eBay which is valued at 57 times earnings. But hardly anyone is sounding the alarm. Virtually all of the analysts who follow the company on Wall Street have a “buy” or “strong buy” on the stock. And Google is one of the largest holdings at top-ranked mutual funds such as Legg Mason Value and Marsico Focus, among others. But take a hard look at the numbers and you’ll wonder why.
That’s not to say that Google is anything like the dot-com bombs of five or six years ago. Unlike those firms, Google is profitable. Last year, the company earned $399 million on $3.2 billion in sales, most of which came from online advertising. And with U.S. spending on online advertising and marketing expected to nearly double to $26 billion over the next five years, Google has plenty of room to grow. That’s even before you factor in all the new services that Google may roll out, like an electronic payment platform and video search capabilities.
Still, the staggering optimism that Wall Street analysts maintain about Google’s prospects seems somewhat misguided. Consider Prudential Equity Group’s Mark Rowen, who currently has the highest price target for Google shares of any analyst following the company. He estimates that Google will boost earnings a heroic 50% over the next several years—nearly twice analysts’ three-to-five year consensus estimate. Assuming the stock maintains roughly the same price-earnings ratio of about 50 times his current-year earnings forecast, Rowen estimates that Google shares should hit $400 at this time next year.
Google does have a history of blowing away earnings forecasts, and as long as it keeps doing that, the stock could go a lot higher. But Rowen’s analysis strikes us as simplistic. For one thing, he uses pro-forma earnings projections, which ignore special charges. And he doesn’t take into account profit margins or the cost of capital, among other items.
For a more sophisticated take, we consulted Aswath Damodaran, a finance professor at New York University and author of Investment Valuation (John Wiley & Sons, 2002). For two decades, Damodaran has been teaching valuation techniques to students at NYU’s Stern School of Business, many of whom have gone on to become securities analysts on Wall Street. He has also made several great calls. When Amazon was trading at $85 per share back in 2000, for example, Damodaran used a valuation model he constructed to calculate the stock was worth no more than $35 per share. Shares collapsed to $6 over the next year and now sell for $44.
To look at Google, Damodaran fired up that same valuation model, which he designed specifically for valuing fast-growing firms. It employs a two-stage growth model that includes a single high-growth period followed by a stable growth period. (After all, no company can grow faster than the economy forever.) And it takes into account everything from operating leases that grant the use of equipment and other assets to future dilution from outstanding stock options. Using numbers from Google’s most recent quarterly financial report, Damodaran made several optimistic assumptions. He assumed revenues would climb 60% annually for the next three years before gradually declining to a stable growth rate of 4% a year after ten years (for a compounded average of 27% per year). He also assumed that pre-tax operating margins would decline gradually to 20% in ten years, from a current 32%, which is even more optimistic since that would yield operating income of almost $10 billion.
In the end, Damodaran’s analysis produced a value that’s far less than the current stock price. He figures Google is currently worth just $110 per share. And this assumes that the company will grow like gangbusters, taking in $49 billion in sales by mid-2015, compared with just $3.2 billion last year—an increase of some 1,400%.
For his part, Damodaran is baffled that anyone would pay close to $300 per share for Google. To justify paying this much, he says, you will need compounded revenue growth of about 40% a year, which would generate revenues of $135 billion and operating income of almost $30 billion in ten years. “If you believe this can happen, the stock is a good buy,” he says. “Is it possible? Sure. Is it likely? I don’t think so.”
The bottom line: Google’s shares may not tumble today or tomorrow, but they are likely significantly overvalued. And they probably won’t stay that way forever.