RealMoney Silver - Is GOOG a Value Stock?

Is GOOG a Value Stock?
By Bill Trent
RealMoney.com Contributor
2/5/2008 2:29 PM EST

In the wake of Google's (GOOG) disappointing earnings results and Microsoft's (MSFT) premium bid for Yahoo! (YHOO) , I started wondering whether Google might finally be cheap enough to consider buying on a contrarian/value basis.

Google generated $3.37 billion in free cash flow (cash from operations less capital expenditures) in 2007, sufficient for a 2.5% free cash flow yield based on the latest enterprise value estimate. That isn't much less than the 2.8% yield on five-year Treasuries, and the Treasury yield, unlike Google's free cash flow, is not doubling annually.

It is also significantly higher than the 2.1% free cash flow yield Microsoft will capture if it succeeds in its $44.6 billion acquisition of Yahoo! On the other hand, if Microsoft truly manages to wring $1 billion in annual synergies from the deal and those synergies flow through to cash rather than just accounting earnings, the yield for Microsoft would double. Since that is a lot of "ifs," I'll stick to the 2.1% number.

At a 2.1% free cash flow yield, Google would trade for $553. And that is assuming the company were truly similar to Yahoo!. In fact, Google is growing its revenue at more than 50% a year as opposed to Yahoo!'s 8.3%, and is estimated to grow its earnings per share nearly 33% annually over the next five years as compared to 23% for Yahoo!. If anything, Google should capture a much higher valuation than Yahoo! will.

For example, assuming both companies were to grow at the expected rate for five years and then at the same rate as the S&P 500 thereafter, they might both decline to a 15 times P/E multiple over the five-year horizon. In such a situation, the five-year price target for Yahoo! would be $19.50, while the five-year price target for Google would be $886. If anything, that scenario seems a bit conservative for Google and a bit aggressive for Yahoo!.

The Downside

While there is no doubt that contextual search ads are a more desirable advertising venue (because customers can monitor the results), I don't buy the notion that Google can see increased ad spending during a recession. If ad budgets are cut, I think advertisers will be willing to pay less for each click. I accept that the search ads might be less hurt than other outlets, but just don't believe that budgets formerly reserved for TV, for example, will be shifted to search.

I also think that Yahoo! offers some insight as to the worst-case scenario for Google in a recession environment, based on what happened to Yahoo! in 2001. Revenues declined 35% in 2001, operating expenses continued to creep up, and free cash flow got hammered.

The comparison to Yahoo! during the tech bust is probably too conservative. Yahoo!'s display ads in 2001 did not offer nearly the advertiser measurability that Google's search ads provide. Further, Yahoo! stock was unfairly tainted by all of the other Internet stocks that didn't deserve to trade at all, let alone at lofty multiples of sales. Still, I think there are useful comparisons to draw from such recent history.

I could see Google's revenue declining as much as 20% year over year, which I don't think many analysts believe could happen. Its earnings would plummet in such a situation because Google continues to add operating expense. I don't see $5 in EPS as being out of the question. But in 2001, Yahoo! ended up with a 100 times P/E multiple against its 2002 earnings per share (the trailing earnings had gone negative.)

At 100 times my recession-trough EPS estimate of $5, Google is fairly valued today.

Sure, history never repeats exactly. And sure, momentum could take Google significantly lower regardless of the logic (or lack thereof) in my analysis.

But to me, Google is starting to look like a value stock.