The Google Market Cap Game

Well, you would own equity in a massively valuable company that's profitable. And I would hope that by the time they got to $40/share in earnings, they thought about a dividend or something.

If you are just chasing yield you should buy bonds or something.

Yes, but even if Google is earning $40 per share, I'm not earning anything, right? What's my investment doing for me? The whole notion of 'shareholder value' is what we call in dutch 'gebakken lucht' (fried air). I can only bet that someone will buy my shares for more than what I've paid for it. Then what does the buyer have? The same thing I started with: nothing but a speculative value. I find it quite astonishing that this works the way it does.

You have described a stock's earnings yield, the amount of earnings its generating on its total market value. It also happens to be the inverse of a stock's Price/Earnings ratio.

Example: Let's say a stock is priced at $100 and earns $5 per share that year. The stock's P/E is 20. Its earnings yield is 5%.

Google today is about $660. Analysts believe it will earn about $15 per share this year. So the earnings yield on Google is about 2.3%. Mind you, shareholders don't get that money cause they don't pay a dividend. It gets reinvested back into the company.

The bulls will argue that estimates next year bump up to about $20 per share, so based on forward estimates, Google might have an earnings yield closer to 3% next year, based on the current stock price. They call that "discounting the future."

But let's play a game. Let's say Google can double it's earnings per share, to $40. And you could buy it at the same price -- $660. It would then have an earnings yield of 6% and would appear to be a great investment. Would I buy that? Sure!  The problem is that it's not earning $40 yet. When will it earn $40? The question you are asking yourself is, how fast do I get to that 6% earnings yield? How fast can they double their earnings?  If you think that's going to happen quite fast and they will either maintain or accelerate their growth rate, you buy the stock. That's the bet you are making.

Google's earnings history is below. To get to $40 per share in earnings they need to be earning $10 per quarter. Just looking a the trend below, I don't see how that happens for a long, long time! in fact, earnings growth has slowed. There's also recently been a trend down in terms of earnings upside surprises. That's what would worry me the most.

Earnings History	Dec-06	Mar-07	Jun-07	Sep-07
EPS Est	2.92	3.30	3.59	3.78
EPS Actual	3.18	3.68	3.56	3.91
Difference	0.26	0.38	-0.03	0.13
Surprise %	8.9%	11.5%	-0.8%	3.4%

Wouldn't a company's profits as a percentage of market cap be the main figure of merit? I'm guessing Google has a much higher profit margin than companies like Boeing or GE who are vary capital intensive, and have high costs for labor and raw materials,  etc.

How do you determine the value of a company? I'm not that much into accountancy, but I'm a pretty decent pragmatic, so let's do a little exercise: If I'm sitting on $10 million of cash, and I decide to buy a private company, I'd be looking at how much net income that company would generate for me. Anything less than 5% per year wouldn't do, even in a stable market; I'd rather put my money in the bank. If the market is more volatile I'd want at least a 10-20% annual yield, to make sure I get my investment back before the market dries up or the competition takes over, and I'm left with just the value of the fixed assets minus liabilities.

Now the stock market is a different ball game that I haven't quite figured out why it works the way it does. If you own stock in a company you only share in a minor part of the profits through dividends, and for the rest you have to speculate that the value of your shares goes up, driven by... what, actually? The belief of other people some time in the future that the price of the shares will grow even further? Sounds a bit fishy if you ask me, but the fact is that it works and people are taking it for granted. I'd just have a hard time explaining to a visiting extraterrestrial how people can make money by buying something that is really nothing, and then later selling it at a profit. Besides this speculation on gullibility, how can you assign any value to shares in the first place?

Okay, let's play that game then. A price/sales (P/S) ratio of 10 is extravagent. I would submit that you will find high price/sales ratio quite common with young, fast-growing tech companies. But they had better be the leaders in their space and growing REALLY fast.

Facebook is an awful comparison because it's a much more immature company than Google. it's tiny compared with Google. Yes, there's lots of upside. That's why it gets a huge multiple. But it does prove a point -- how quickly things change in the Internet ! How much of a barrier to entry is there? If Facebook came out of nowhere what does that say about Google's potential competition? Orckut didn't do so hot, did it? It hought Google was king of everything? It seems like one minute ago we were talking about MySpace being all the rage and all of the sudden it's Facebook.

I can't wait to see who's all the rage in 2008. It will be interesting (MyBaidubabookboogle.com, anybody?)

I would need to dig up data on this, but you will probably find that it's common for low-cap tech companies to have a P/S ratio of 10:1, but very rare for large tech companies. That's because, the larger the market cap, the harder it is to justify a high P/S. Some quick examples:

Company  P/S ratio  Market Cap

Microsoft      5.76   322B

Google      13.18     206B

Oracle        5.26       105B

Salesforce.com  9.69   6B

Priceline.com  3.05    4.13B

Hmmm...

I suppose at one time, Microsoft had a P/S ratio of 10, but at a much lower valuation. Microsoft's value rose, it's growth rate slowed, the rise in its stock price moderated (and even corrected quite violently. MSFT is still 50% below it's all-time high).

My point is that the larger you get, the harder it is to support a very high P/S ratio, because it implies high rates of sustained long-term growth. Google shares may very well keep going forward, as long as it keeps up with aggressive sales forecats. But one stumble -- or even a moderate rise in costs (mobile phones, anyone?), and the stock price will do a faceplant. I'm just pointing out the risk here.

[Disclosure: I don't own or sell short Google stock. I do, however, own Priceline.com stock.]

Maybe a different way of looking at this would be to look at companies which have a revenue to market cap relationship of about 1:10. 

To do that research would require some effort, far more than quickly typing a response, but it's worth at least keeping an eye out.  One company that immediately comes to mind is Facebook, which isn't publicly traded but is showing annual revenues of about 10 percent of what is perceived to be the value of the company.

Similar kind of company, I guess, and similar value logic, maybe.  Historically, information companies have gained value over asset-based companies.  SABR grew in value that exceeded American Airlines, so a list of flights was worth more than the the company doing the flying.

While the valuation seems to be off, it is impressive that Google and Facebook are so adept at mining that valuation.  I suppose the million-dollar question, or the $200 billion question, is could the bottom fall out of that valuation?  Surely, the answer is yes, but short of an entire market metldown, it seems like someone will have to emerge with metrics that force everyone to look at Google differently before that will happen.

Google could do that to themselves with its mobile phone plans.  Often, Google has bounced into white space industries.  The mobile phone market, and the mobile handset market, and the smartphone software market are all pretty well established.  Pushing against those companies could lead to some recalibration of value.

Or, maybe not--you might be posting a year from now adding 4 of the companies you mention to equal Google's value......