The value of Google Inc (NASDAQ:GOOG)‘s stock is soaring, but is the value of the business following suit? A simple discounted cash flow, or DCF, valuation suggests that investor expectations for the stock could be getting a bit too optimistic.
What kind of growth can we expect from Google Inc (NASDAQ:GOOG)? In the trailing 12 months, Google Inc (NASDAQ:GOOG) earned about $12.7 billion in free cash flow, or FCF. This is a very large number to grow. Nevertheless, most analysts hold a buy rating on the stock, expecting meaningful growth over the long haul.
It’s too simplistic to forecast FCF growth in line with revenue growth projections. Over the past five years revenue grew, on average, by 25% per annum. But profitability will inevitably decline as Google Inc (NASDAQ:GOOG)’s revenue mix shifts away from Internet search on desktops to a highly competitive mobile environment.
Mobile search is tough business. There are a greater number of players with a larger share of control: handset manufacturers, wireless carriers, and application stores, to name a few. Google Inc (NASDAQ:GOOG) addressed this problem early in the game with Android, though it failed to carve out the type of dominance Google Inc (NASDAQ:GOOG) has on desktops. The evidence has already surfaced: Distribution traffic acquisition costs are on the rise, up to 7.9% of revenue in the company’s first quarter from 6.4% in the prior year.
How does this all affect FCF growth estimates? FCF growth will probably more closely reflect the company’s year-over-year first-quarter operating income growth (excluding the company’s suffering Motorola Mobility segment) of 11%. Operating income, unlike revenue, is affected by margin contraction, making it a better indicator of Google’s FCF growth trajectory.
Even 11% growth, however, probably isn’t sustainable. Competitors such as Facebook Inc (NASDAQ:FB) could continue to make inroads in the digital advertising market and could even pose a threat to Google’s search business at some point; the launch of Facebook Inc (NASDAQ:FB)’s recent Graph Search, for instance, could very well be the first of many moves by Zuckerberg and Co. Facebook Inc (NASDAQ:FB) is definitely a threat to be reckoned with; 30% of Facebook Inc (NASDAQ:FB)’s first-quarter sales came from mobile advertising — up from virtually nothing in early 2012.
So I’ll assume growth will begin at 11% and then slightly decelerate over the next 10 years.
| Year | Growth Rate |
|---|---|
| 1 | 11% |
| 2 | 10.7% |
| 3 | 10.3% |
| 4 | 10% |
| 5 | 9.7% |
| 6 | 9.4% |
| 7 | 9.2% |
| 8 | 8.9% |
| 9 | 8.6% |
| 10 | 8.4% |
Valuation
Of course, Google probably won’t cease to exist in 10 years. So we’ll need a perpetuity rate to estimate the annualized growth beyond Year 10. To be conservative, we’ll use 3% — equal to the historical rate of inflation.
Finally, we’ll discount these future cash flows by a 10% discount rate. The result? Google shares are worth $927. At this value, Google is trading at a 6% margin of safety — leaving almost no breathing room for error. But if you’re very confident in Google’s economic moat, you may be willing to use a 5% perpetuity rate. In this case, Google’s worth $1,160 per share, trading at a 25% margin of safety. Though a 25% margin of safety isn’t enough to persuade the typical value investor to throw down on a tech stock, it might be enough for investors who are very bullish on Google.
What do you think?
Google definitely isn’t the screaming buy it was, but it isn’t a sell, either — at least not for investors with Foolishly long time horizons. Whether the stock is a buy or not is highly dependent on your view of the company’s competitive advantage.
I’d love to know what you think in the comments below. Is Google a buy? Or is it a hold after its recent run-up?
The article Google Stock: Is It Time to Sell? originally appeared on Fool.com.
Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Facebook and Google.
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