Google Stock Looks Cheap, Believe It or Not

When looking for places to invest excess cash in an overbought market it is important to not only look at your upside potential, but also how much downside there is as well. If stocks are overdue for a drop, you want to make sure you aren’t buying something that has a lot of air in it that could be let out quickly in a selling frenzy.

I have been warming up to shares of Google (GOOG) more and more as of late because the stock has been dead money while the company’s impressive growth continues. The result of that dichotomy has been a share price that is getting more reasonable on a valuation basis. On Thursday I began initiating Google positions in some of my accounts that had sizable cash reserves.

Long time readers may know that this will be my second bullish call on Google since the company’s IPO in August 2004. Like most people I sat out the IPO after the company indicated the stock would be sold well north of $100 per share. After the first round of their auction, the actual price was reduced to $85 per share, but those who didn’t bid in round one were locked out of bidding at the lower price.

After the stock began trading it became apparent to me that investors were dramatically underestimating the company’s earnings power and incorrectly associating their misfortunes during the Internet bubble with Google’s future. I was late to the party, but began buying Google at around $180 per share.

The stock’s ascent continued and by early 2006 I had sold my entire position at prices as high as $467 per share. At the time it appeared the Street was aware of the company’s earning power, resulting in a fairly valued stock. Since then I have suggested being long Google as part of a paired trade, but have not jumped back in exclusively from the long side. Let me explain why that changed on Thursday.

There is no doubt that Google has tremendous potential to expand its dominance in coming years. That said, there are no assurances that the company’s foray into international markets and domestic markets outside of online search will be successful. So, in order to be willing to make a long bet on the stock, I needed to feel comfortable that my investment downside was fairly limited despite the risks the company faces. At the current price of $461 per share, I feel that is the case. As you can see from the chart below, GOOG sits at the same price it was 16 months ago.

How do I arrive at that conclusion? Some simple math really, no rocket science or anything. Current estimates for Google’s earnings are $15.12 per share in 2007 (growth of 43%) followed by a 27% increase in 2008 to $19.25 per share. I decided to use what I consider to be conservative assumptions in order to do a risk/reward calculation. Very simply, what is my downside and what is my upside? If the risk-reward trade-off seems intriguing, then Google shares look attractive at $461 each.

First, what is my downside? Let’s assume Google earns $15 this year ($0.12 below current estimates) and only manages 20% growth in 2008, to $18 in earnings per share ($1.25 below current estimates). Let’s further assume that Google trades at a P/E of 25 next year. I think both of these assumptions are extremely conservative. A 25 P/E on $18 in earnings gets us a stock price of $450 per share. In my opinion, that is my downside over the next 12 to 18 months, less than 3 percent!

Let’s compare that to the upside. Again, I’m not going to make overly aggressive assumptions here. I want the numbers to be in reach and doable, but also want to be realistic as well as conservative. For this scenario I am going to take the current consensus earnings estimate of 27% growth in 2008, to $19.25 per share and assume that the company continues to beat estimates by a modest amount. It would not be surprising at all to see 2007 EPS numbers head to toward $16.00 by year-end and 2008 numbers to actually come in closer to $20.00 per share. Further, let’s assume GOOG trades at a P/E of 30.

That multiple may seem high given that the market trades at half that valuation. However, I am fairly confident Google will grow at least 20% per year over the next few years, so assuming that growth investors will be willing to pay 30 times earnings for the stock is fairly reasonable. It would be in-line with valuations given to other leading Internet companies, as well as growth stocks such as Starbucks (SBUX)

Quick math tells us that a 30 P/E on profits of $19.25 to $20.00 in 2008 implies a stock price of $577 to $600 per share. Even if we use a more conservative P/E of 25 instead, we get to $481 to $500 per share. Accordingly, the upside is as much as 30% by the end of 2008. Compare this with downside of less than 3% and you can see why I think Google stock in the low 460’s is a good investment, even in an overbought market such as the one we are seeing right now.

Full Disclosure: Long shares of Google at the time of writing

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7 Thoughts on “Google Stock Looks Cheap, Believe It or Not

  1. Anonymous on May 11, 2007 at 8:53 AM said:

    I have a hard time looking into the future but I can tell you that Google is a dominant company in ways other than search. As a programmer, I am constantly reading about the innovations at the company. They put a lot of emphasis into recruitment and retention of employees. Essentially, it seems that it is most young, talented programmers highest motivation (next to starting their own company) to work for Google.

    The company is about as decentralized as possible in order to foster a startup-type culture. Employees are allowed to work 20% of their time on projects of their own choice. Creativity and risk-taking is encouraged.

    All of this bodes well for the company going forward.

  2. Chad Brand on May 11, 2007 at 9:10 AM said:

    I completely agree. Let’s hope they can leverage those resources into new profit avenues outside of search.

  3. googlebear!! on May 12, 2007 at 9:45 AM said:

    Google overpriced I predict a collapse to $250 a share…..the economy is heading for a recession and ad spend ill be cut. So you google bulls watch out I’m gonna short google and grab you cash!!!

  4. Wheels of Ire on May 13, 2007 at 9:13 AM said:

    Even should googlebear be right about an imminent recession,only dumb companies will slash ad budgets. Smart ones will want their ad spend to work harder,which is where Google will come in. Being able to measure results is the winner,as the effects of ad campaigns are famously hard to measure.

  5. Anonymous on May 13, 2007 at 11:35 PM said:

    If googlebear is right, I’ll watch it go lower and grab it at the lower price and hopefully at its bottom, as “wheels of ire” is quite right.

    Shorting the stock is tempting, but the middle east climate is still unstable, as the U.S. and Iran’s sabre rattling grows louder.

  6. Anonymous on May 14, 2007 at 6:38 AM said:

    I think you are gambling with clients’ money. Remember that before Google, Yahoo was king and that before Yahoo, Altavista ruled. Netscape was huge before Microsoft started giving Explorer for free and then dominated the brower market. Things change fast in technology and Internet.

    Let me also mention a trend going on with Internet advertising. Lots of old economy companies (including the one I work for) are rushing to online ads to try things out and not be left behind. Many big companies are experimenting with only 1 search engine (normally Google). Initially senior management is willing to sponsor these new initiatives at a loss, but eventually it has to stop. (Again, I’m seeing this in the company I work for). Advertisers have bid many keywords at Google to prices much higher than in Yahoo and others. This would only make sense if Google’s clickthrough rate was much higher, but it isn’t.
    Finally, the customer acquisition cost via online ad for some industries is getting high versus other media (radio, billboard, etc.). I predict that keyword prices will go way down with a downturn in the economy. Ad rates on newspapers and TV have always gone up and down with the economic cycle, it should be no different with the Internet.

  7. Chad Brand on May 14, 2007 at 6:57 AM said:

    Just because things change in technology doesn’t mean Google will be replaced at some point. Intel, Microsoft, Oracle, Cisco, etc have dominated continuously despite the ever-changing technology landscape.

    I agree that the ad business is cyclical and Google will certainly be affected in a recession. However, we have a medium (online advertising) that is becoming a bigger part of the overall ad market.

    Right now, online ads represent 5% of total ad spending. That is projected to grow to 9% by 2011. We don’t know what the number will be, but increasing online market share (due to more people spending more time online) will likely more than offset companies pulling unprofitable campaigns. I’m sure some firms have already done so, and it hasn’t been noticeable because the whole market is growing so fast.

    Besides, markets are based on supply and demand. As the online market grows, there will be more bidders for keywords, not less. More demand will lead to higher keywords, not lower ones. An economic downturn will hurt, but investors know how to value cyclical companies. The stocks won’t be valued on trough earnings power because recessions are very rare.

    There is no guarantee Google will continue to be the leader in 5 or 10 years, but it’s not like investors are paying a lot for the stock. I don’t think paying 24 times 2008 EPS for a company with this type of growth potential is, as you say, gambling with clients’ money. If I was paying 50x that would be a different story.

    Time will tell.

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