Analyst's Toolkit is a weekly feature that assesses stocks, bonds and funds by using measures that can give different perspectives on valuation. Come back every Wednesday for fresh insights into analyzing securities.
To most people,
can do no wrong. Despite
best attempts and massive cash pile, the software company always seems to lag behind in areas outside operating systems.
But now Microsoft has released its Bing search engine, catching the attention of investors. It's a bold move aimed at Google.
The love affair with Google is easily seen in its stock price. Google has risen 41% this year, almost triple that of Microsoft. Over three years, Google has climbed a total of 12%, compared with Microsoft's gain of 5.9%.
When evaluating those two companies and their merits, investors could consider a method of valuation know as the present value of growth opportunities, or PVGO, to gauge the expected growth priced into their shares. Technology stocks have a history of irrational growth estimates, so this technique can help bring investors down to Earth.
The theory behind the PVGO model is that the price of a stock comprises two components. The first is based on the value of the firm with no earnings growth. The second is the present value of growth opportunities.
The model can be written as follows:
Market price = (projected earnings/required return) + present value of growth opportunities.
Most of the variables are available on TheStreet.com at the stock quote page. Projected earnings can be found under the "Earnings Estimates" tab and the market price, of course, is listed on the main quote page as the current stock price.
The required return is a little more arduous. The number can be estimated by using the capital asset pricing model (CAPM). This calculation sounds far more difficult than it actually is.
The CAPM formula is as follows:
Required return = risk-free rate + stock beta X (return on the market - risk-free rate).
The risk-free rate can be determined by using the 10-year Treasury note yield, while the return on the market is more open to opinion. Typically a rate of 10% to 11% is reasonable. The stock's beta can be found on TheStreet.com quote page under the tab "Ratio Comparison."
The table below summarizes the inputs and results for Microsoft's and Google's required return.
Using the input calculated above and the inputs found on TheStreet.com quote page, the present value of growth opportunities can be calculated as shown in the following table.
That calculation shows that more than half of Google's price is based solely on the potential for future growth -- perhaps an exaggeration. Google's share of Internet search is more than 80%, so it's difficult to tell where this supposed growth will come from.
Microsoft, on the other hand, is launching into Internet search with gusto, aiming to take market share from Google. While Microsoft has started to lose ground in its operating system to
, it still holds over 85% of that market.
Based on growth priced into the shares, Google looks overvalued. Considering that Google is to search what Microsoft is to operating systems, the big difference between those two is fairly irrational.
TheStreet.com Ratings recently upgraded Microsoft to "buy," driven by a strong balance sheet and solid performance for the stock. Google has a similar rating, but be wary of unreasonable growth expectations heavily influencing its stock price.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.