Google Valuation - Decidely Undecided

In early April when Google stock was trading at the mid-$400s, I started thinking about its market valuation and price per share. Maybe it was a good buying opportunity since coming down from its all-time highs in the $700+ range late last year.

In the spirit of the analysis I’ve done in previous articles with valuations Facebook, Starbucks, Bear Stearns, and Yahoo!, I jumped into Google’s financial statements to see what I could find. Happily, I discovered mystery, love, and intrigue – certainly enough for a good story.

I’m drawn to an elemental approach that looks at intrinsic value, even with dynamic technology companies like Google. In taking this approach, I focused my research on the growth of Google’s assets, and more specifically, on the growth of Google’s shareholders' equity. Because shareholders' equity is what’s left after subtracting a company’s liabilities from its assets, it provides a clear of what is left for shareholders after debts are retired from a company’s assets (thus the term “shareholders' equity”).

Starting with the 2003 year-end reporting through 2007, the growth of Google’s shareholder equity has declined fairly rapidly –

From their financial statements, Google’s Total Shareholder Equity (in 000s) over the past five years –

2003: $602,641
2004: $2,929,056 (an increase of 386% from 2003)
2005: $9,418,957 (an increase of 221% from 2004, but a 42% lower growth rate)
2006: $17,039,840 (an increase of 80% from 2004, but a 63% lower growth rate)
2007: $22,689,679 (an increase of 33% from 2004, but a 58% lower growth rate)

Notice the trend? Of course, maintaining triple-digit shareholder equity growth isn’t realistic, but it does show the effects of Google’s increasing company size and asset base.

There are about 313 million shares outstanding. If we divide the current shareholder equity of $22,689,679,000 equally among each shareholder, that comes to about $72/share. So if Google liquidates today and pays off its liabilities in full, there will be $72/share to distribute.

Google isn’t going out of business today, so looking at this number in comparison to a $450-550 share price probably isn’t the best option in determining the true value per share. Another option is to consider current and future Cash Flow/Share (CFS), with future cash flows discounted back to today using a reasonable required rate of return. Google’s Beta is 2.01 and the US Treasury 10-year bond yield is about 3.75%. Using the CAPM, that calculates to a 12.25% required rate of return. To account for the current economic downturn and innovation risk, let’s call it 15%.

Google’s CFS was $17.66 in 2007. If we assume a 10% growth rate per year for 10 years, how does that shake out in valuing its shares after discounting future cash flows to today? With a 15% required rate of return as the discount rate, the sum of the discounted CFS for the next ten years is $101.91. Again, not quite close to the recent $450-550/share trading range.

Extend this 10% growth rate in Cash Flows into perpetuity with the same 15% required rate of return and we get a value of $353/share. But is a 10% growth into perpetuity realistic? Probably not, but it’s hard to argue against it given their Quarter 1 results for 2008. Their ability to innovate is the wild card.

All in all, I’m still undecided about what to decide… I first contemplated this about two weeks ago when the price/share was in the mid-$400s. Now in the mid-$500s, I don’t have any better answers as to whether or not the valuation feels right. It seems a bit high based on fundamental research and intrinsic valuation.

There's a nice article that looks at Google's valuation in a similar, but different way using a "scenario approach." It's worth a read.

It’s clear that investors are flocking to the stock after selling off in recent months. But is in investing or speculating? That’s the part I can’t figure out…

University of San Francisco International Business Plan Competition

Quick update on a great event upcoming --

April 24 - 26 - Hotel Kabuki (San Francisco's Japan Town)

The University of San Francisco Contest will feature 20 graduate student entrepreneur teams from around the world (MIT, Hong Kong UST, Cambridge, USF, Stanford, etc.) pitching their new venture proposals to panels of venture capitalists, top executives, and venture attorneys.

The USF Contest has become internationally recognized as a serious venue for launching new technology companies and provides an exceptionally enjoyable and exciting learning experience.

Here's the schedule:

Trade Show Reception and Elevator Pitch Challenge
April 24 (Thursday) 6pm - 9:30pm
Hotel Kabuki
USF Faculty, Staff or Students, free. Alumni ($20 at the door), Other guests ($40 at the door)

Final Round
April 26 (Saturday) 9am - 1pm
Hotel Kabuki
USF Faculty, Staff or Students, free. Alumni ($10 at the door), Other guests ($20 at the door).

Go Entrepreneurial Dons!

The program is organized by Mark V. Cannice, Ph.D.Executive Director and Founder of the USF Entrepreneurship Program.

Economic Arguments for Abandoning H1B Visas

Supporters of America’s H1B visa system argue that firms such as Microsoft and Google (both opposed to the existing system) should simply send these jobs overseas by expanding their current operations in places like China and India. The problem with this argument is that it does not follow economic logic.

There are several economic factors that influence the ongoing development of technology-based industries in the United States. These factors further support the position that the H1B Visa system should be significantly restructured (or abandoned altogether).

1. Agglomeration Economics – As firms in related industries (“clusters”) work in relative proximity to each other, several positive effects are felt:

--> The overall cost of production is reduced because of the increased competition of suppliers and the greater number of firms consuming production inputs. This includes such items as laboratory equipment, software, hardware and other necessary production inputs to developing new technologies .

--> There is an increase in the number of innovations through implicitly shared knowledge.

--> Positive externalities develop - that is - the number of “knowledge spillovers” occur.

These economies of scale and externalities cannot be artificially manufactured by establishing a research park in a foreign country. Economic clusters are complicated organisms that have evolved over time. The organic systems resulted from years in response to market dynamics and locational factors.

2. Labor is not the only factor of economic production. Capital – meaning machinery and related technical equipment - is also a major factor. (Together, Capital and Labor compose the basis of the Cobb-Douglas Production Function upon which economists such as Robert Solow, Greg Mankiw, and Paul Romer have based parts of their research.)

Collect a labor pool of scientists with PhDs from the best universities in world and put them together in Siberia with no research and testing equipment. Their output of new innovations will fall to negligible levels. This basic fact creates another significant advantage to economies such as the United States, and more specifically places like Silicon Valley, that have an inherent base of both private, public, and education sector research and development facilities.

3. Enforceable property rights legislation and intellectual property protection in the United States support research and development better than other developing nations. Countries such as China have a well-documented global reputation for poor enforcement of patent and copyright laws. The ability to develop a new technology and maintain a monopoly on their innovation and idea provides the necessary for profit-maximizing firms to operate. Economies that do not protect a firm’s ability to maximize its profit are not adequate environments for technology firms to effectively operate.

4. And finally, the proximity to a market where the developing firm will be likely to sell whatever technologies it develops plays a role. Technological innovations are likely to be adopted and integrated into the world’s most developed economies first, then eventually trickle down to lesser developed economies. Because firms seek to minimize costs and maximize profits, it makes good business sense to develop technologies in countries where these technologies will be purchased and utilized.

The United States’ comparative advantage in technology industries requires that it be supported the best and brightest global minds regardless of the individual’s country of origin. Without such support, our economy runs the risk of unintentionally developing other “technology clusters” manned by scientists and researchers in other countries. The end result could be the loss of our comparative advantage and our leadership position as the world’s innovator.

The single best solution to maintain our technological leadership is to leverage the privilege of living and working in the United States to attract foreign workers. This labor competition will also pressure the domestic workforce to increase its knowledge and capabilities, resulting in a more effective, innovative labor force.

H1B Visas & American Innovation

Recently, the H1B visa issue has received significant media coverage. In the Wall Street Journal, Miriam Jordan wrote about this issue on March 31 and Shikha Dalmia wrote an editorial in Saturday’s edition.

As Milton Friedman free-marketeer, I share Bill Gates’ viewpoint (detailed in his testimony last year to the US Congress) that the current system should be scrapped to open the American borders to a more effective labor force populated by the best available human capital (labor) available.

Paul Romer, developer of “endogenous growth theory” (or “new growth theory”) showed that technological progress is a primary engine for an economy’s economic growth. The notion of “building a better mousetrap” is the key motivation for profit-maximizing firms in a competitive environment. In short, ideas are “nonrivalrous” – meaning that the developer of a new innovation or idea has a natural monopoly on that idea’s implementation and use. This leads to increasing returns to scale and firm profits. In the context of economic growth, creating an environment where new innovations and ideas are abound results in subsequent increases in an economy’s growth. (Romer’s complete academic article – “Endogenous Technological Change” - is available in The Journal of Political Economy, October 1990.)

The H1B visa system handicaps American firms from employing the world’s best and brightest minds where these individuals could be developing new innovations for these firms, providing increasing returns to its research and development investments.

For obvious national security reasons, developing and enforcing stringent background checks should certainly be required for all emigrants to the United States, but limiting the number of foreign workers solely to protect American jobs frankly sounds a bit socialistic to me. The competitive nature of the market, including the labor market, is a key ingredient to the ongoing success of the US economy during increased economic globalization. Why should we deliberlately disadvantage American companies?

What if the United States decided in 1933 that we had reached our quota of foreign workers, disallowing Albert Einstein’s entrance to the country?

Yahoo!'s Valuation - Goodwill leads to Goodwill

Recent word is that Microsoft has no plans to raise its $44.6 billion bid for Yahoo! Inc. $44.6 billion got me wondering how this matched up to Yahoo's value based on its balance sheet. I found one item to be particularly interesting - "goodwill" - which seems to be indicative of Yahoo! Inc.'s problems, and could be leading the company to Goodwill Industries very soon. How about a new logo?

As defined on Investopedia - "goodwill appears on the balance sheet of the acquirer in the amount by which the purchase price exceeds the net tangible assets of the acquired company." In other words, goodwill is the extra that you pay for after accounting for the actual company assets.

Keep in mind that I don't know what the media industry norms are with regard to the goodwill-to-acquisition price ratios, but looking at the Yahoo! Inc.'s 2007 Annual Report, it seems to me that they're pretty good at throwing cash into the goodwill bucket for acquisitions without getting much of a tangible return.

A few examples from Yahoo! Inc.'s 2007 10-K to illustrate (this info is found around page 70-85 of the report...):

1. Purchase of SOFTBANK, a firm with which Yahoo! had a couple of joint ventures (2005)

Total purchase price = $500 million in cash
Amount of purchase price allocated to Goodwill = $388 million

2. Purchase of Right Media (2007):

Price = $526 million ($246 in cash, $237 in equity)
Amount of purchase price allocated to Goodwill = $440 million

3. Purchase of Zimbra (2007):

Price = $302 million ($290 in cash)
Amount of purchase price allocated to Goodwill = $241 million

4. Purchase of Blue Lithium (2007):

Price = $255 million ($245 in cash)
Amount of purchase price allocated to Goodwill = $221 million

5. Alibaba (2005):

Price of 46% of shares = $1 billion in cash
Amount of purchase price allocated to Goodwill in 2007 = $443 million

Like I said, I don't know what the normal allocation to goodwill as a percentage of total purchase prices in the media business, but when I look at these transactions, I see a significant trend -

Yahoo! likes to take cash from its pockets and exchange it for an accounting asset called "goodwill" that you can't touch or see. These investments are not all-inclusive of all of the deals on Yahoo! Inc.'s books, but just up the cash spent on these five examples and you get nearly $2.3 billion.

I'd like to think that the brain trust at Yahoo! Inc. would like to have that $2.3 billion to spend on projects developed internally to produce organic company and product growth. Perhaps these actions are a microcosm of what's happened to the Yahoo! brand. A company that led the Web 1.0 revolution is now becoming a sideline watcher in the Web 2.0 and Web 3.0 evolution.

To put some perspective Microsoft's $44 billion offer - Yahoo! generated $6.9 billion in revenue in 2007, putting Microsoft's offer at a bit more than 6x revenues. Compare that to Microsoft's valuation of Facebook at $15 billion, estimated to be 500x revenues.