Google a Strong Earner, but a Weak Buy

Let's start with the PIV ratio, which is today's price divided by our estimate of intrinsic value. The lower the PIV, the greater the margin of safety available to the buyer in case of what Ben Graham termed "miscalculation or bad luck."

Shares of Google recently traded at $374. As for intrinsic value, our forecast starts with base-year earnings of $1.7 billion, which is the sum of GAAP profits for the four quarters ending Mar. 30. Next, I assume for illustration purposes only that base-year earnings grow 66% in year one, 34% in year two, and 20% annually in years three, four and five, per consensus estimates. Further, I will also assume that earnings grow 20% annually for years six through 10, reaching $16.1 billion by 2016. The present value of these cumulative profits is $57 billion, using a 5.3% discount rate, which is the recent yield of the 10-year Treasury.

Since it is reasonable to assume Google will be in business for more than a decade, we also want to estimate the present value of its terminal earnings, that is, profits from 2016 to eternity. To avoid the classic mistake of the growth investor, namely, assuming that most of a company's intrinsic value is due to growth after the forecast period, I say Google sells for 10 times 2016 earnings.

Using a conservative P/E to estimate value in the distant future is just common sense. Although applying such a low P/E may seem harsh based on what we know about Google today, any number of things can happen between now and 2016 to threaten its hegemony in paid search. Isn't it better, then, to be pleasantly surprised than unpleasantly surprised?

Google's firm value, therefore, is $163 billion, which is the sum of $10 billion of cash, $57 billion of operating value, and $96 billion of terminal value. Since Google's only liability is $4 billion of employee stock options, equity value to common stockholders is $159 billion. With 294 million shares outstanding, intrinsic value is $542 a share, so Google's PIV is 69%. (Price-intrinsic value ratio (PIV) equals $374 divided by $542, for 69%.)

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Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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