Google What Should I Pay for this Stock? The company behind the Net's best search tool is about to go public. The price tag will almost certainly be too high
(MONEY Magazine) – First it was just another way to search the Web. Then it became a verb. Now Google is set to become the hottest initial public offering in years. It's also one of the most intriguing: Google's founders, Larry Page and Sergey Brin, have decided to ditch the traditional IPO process in favor of a so-called Dutch auction, in which anyone, including individual investors, can bid on shares. (Time Warner, MONEY's parent, owns a stake in Google.) This summer, people from Wall Street to Silicon Valley will be scribbling on the backs of envelopes trying to figure out how much this six-year-old company is really worth.
What a great opportunity, we decided, to pull back the curtain and show you how investing pros actually go about valuing a stock. Right now, many analysts are predicting that Google will have a total market value of $20 billion to $30 billion. Some predictions go as high as $50 billion, or roughly the gross domestic product of Guatemala. Let's see if we can make some sense of these lofty numbers.
The value of things not seen
Some classic valuation measures just aren't very helpful with a company like Google. Take book value, or what a company owns--cash, property and patents--minus what it owes. Based on its initial filings, Google's book value is a mere $408 million. But that figures: Google doesn't need to own huge factories, retail outlets or expensive heavy machinery to do business. Its key assets are its technology and its brand name, and you can't put anything but a squishy number on those. A better way to look at Google (and indeed at most companies) is simply to ask, If I owned the whole thing, how much cash would it put in my pocket?
To get a basic feel for this, turn to the consolidated statement of cash flow in Google's filing. (It's at edgar.sec.gov.) The first number to look at is cash flow from operations, which tells you how much money is left over after the company pays regular expenses such as salaries, rent, electric bills and marketing costs. Google's no virtual business: In 2003 it had impressive cash flow of $395 million. But Google also has to shell out for big-ticket items like office furniture and computer servers. Such capital expenditures totaled $177 million last year. So all told, the company generated $218 million--some $100 million more than it did the year before. That kind of growth is why Wall Street thinks Google will dish up billions of dollars to investors down the road.
How the Street looks ahead
But just how many billions? Guessing the long-term cash flow of an established business like, say, Coca-Cola is relatively simple. You just look at how the business has grown in the past and project those growth rates into the future. That won't work for Google. Instead you have to make some broad assumptions about how its growth will slow as it matures. To get an idea of how an analyst might do this, we turned to Aswath Damodaran, a finance professor at New York University who has written a textbook on valuing companies.
Damodaran plugs some pretty bullish numbers into his formula. (He also used a more complex measure of cash flow than the one above, so his starting point is higher.) First, he figures Google's revenue will grow an average of 30% annually over the next decade. That's a steep drop-off from Google's recent triple-digit rate but way ahead of most big companies. Damodaran also reckons that as Google expands, its regular costs and capital expenditures will almost certainly increase. After he crunches all the numbers, Damodaran figures Google will generate a total of nearly $48 billion in cash over its lifetime.
Of course, you wouldn't pay that much today for the promise of all that money in the future. You'd be worried about inflation, as well as the chance that Google won't live up to your expectations. So Damodaran applies a discount rate, starting at 15% in the first year. (That's standard for a growth company.) When he's done, he gets to a value of just under $15 billion.
Is $15 billion too low?
We're willing to bet that the IPO auction will give Google a much higher value than this. Why? Some on Wall Street are using relative valuations to justify their nutty numbers. For example, rival Yahoo trades for 87 times expected earnings. Use that multiple and you might be able to get Google to $50 billion. This ignores the strong possibility that Yahoo's stock is overvalued today. And then there's what you might call the sucker premium. With all the hype surrounding this company, even smart pros will be happy to overpay on the assumption that they'll be able to unload on somebody else at an even higher price.
Our advice: Use Damodaran's number as a kind of benchmark. If you have any doubts at all about Google's sustainability--you may, for example, recall that Netscape browsers used to be just as ubiquitous as Google home pages--you shouldn't touch the stock unless its market capitalization is well under $15 billion. (Market cap is price times shares; you can look the number up at money.com.) And if you buy Google when it's north of that number, remember that you're betting on everything going not just well but almost perfectly. And perfect is hard to do. --STEPHEN GANDEL AND CYBELE WEISSER