Berkshire Ruminations

Tuesday, October 23, 2007

Google: Reality Check

I would like to start by making the following disclaimer so all the rabid Google bulls won’t start threatening my family:

Google is one of the greatest growth stories in corporate history. There is absolutely no doubt about that. It’s a great company and has effected tremendous change in its industry.

With that settled let's talk about valuation. Google now trades at $665 a share (up another $15 this morning). That puts its market cap at $207 billion. Now what other companies have comparable market cap? Here is a short list: Citigroup, Wal-Mart, Johnson & Johnson, Microsoft, and AT&T. That is some pretty impressive company – consider how long it took each of those companies to reach a market cap of that level. It took Google only nine years.

In the last four quarters, Google has earned $3.9 billion, putting its trailing PE somewhere around 53. That multiple sure seems high, particularly considering that the aforementioned companies typically earn that much in a single quarter. But Google is a growth company, right?

Well its growth certainly has been impressive, but it is important to consider the limits of such growth. Google earned a mere $7 million in 2001, and had only earned $400 million around the time of its IPO in 2004. Although this exponentially growing income is really unprecedented it is a huge mistake to assume it can continue. Here is a fun calculation that demonstrates my point. If we derive the implicit rate of growth since 2001 from the ratio of $3.4billion to $7million, then compound our $3.4 billion at that rate for ten years we have:

$3.4billion*{1+[($3.4billion / $7million)^(1/6)]}^10 = more wealth than exists on earth or even will for several centuries

Since evidently investors are not crazy enough to price the company at a level that implies it will take over the universe, I believe we can assume they agree the growth must slow. This begs the question, though, how much money will Google be earning ten years from now and how much will the company’s growth slow between now and then?

It is not necessarily my contention that Google is overvalued, but only that investors in the stock at these levels, if they think it is not overvalued, must realize what they are conjecturing as to the company’s growth. That is, for $665 per share and a PE of 53 to be a reasonable price, I figure Google must continue to grow its free cash flow somewhere between 35% and 40% for at least the next seven years. This is a tall task, but given their history maybe it is possible. The problem, though, is that companies already this large have a hard time achieving that kind of growth. In fact I am fairly certain no company this size ever has grown that fast. But I will leave this open for anyone to prove me wrong.

Let us think about what the current implicit future growth rate suggests about the dominance of this company in our economy. Within ten years, Google will be earning as much or more than over half of the Dow 30 components. Google will indeed be the biggest and most dominant American company. That may happen. It may not. But if it doesn’t, then Google is too expensive at this level. Said differently, there is simply no margin of safety.

Also consider the company’s rate of investment. This company has total assets of over $23 billion, a good chunk of which is cash. Further, it was revealed last week that Google just hired 2100 new employees – an investment that, although not appearing on the balance sheet, is indeed real. The company’s returns on capital have been remarkable in the past – it maintains a ROE of over 20% - but with so much more of this capital to work with it will take tremendous returns on that capital (at a level consistent with the earnings growth mentioned previously) to create value. Where such capital can be deployed in the virtual world in which Google operates is not readily apparent to me.

Look, I use Google everyday just like everyone else. The services are amazing and far superior to the existing alternatives. But I do remember a time not long ago when we said the same thing about Yahoo. Or Amazon. Can we really even bet that Google will maintain its current dominance of internet services, let alone the dominance of commerce in general? I guess the short answer is yes. But it’s a long shot, IMHO.

FD: No position in GOOG.

Tuesday, October 02, 2007

Kent Brockman, reporting live...

I have to admit this is not the best market for a long-term value investor like me. This is a trader’s market. Nevermind the enormous volatility the market has experienced in the last six months or so, there seems to be a good deal of outright craziness in investor behavior. I pay attention most closely to Berkshire Hathaway news of course, so perhaps my perception is biased. But can anyone tell me why stock prices are reacting to pure media speculation?

Who are these people that started the rumor last month that Berkshire was going to buy Countrywide? More importantly, who were the people that took the reports of it seriously? There is absolutely no factual basis whatsoever, yet Countrywide stock shot up in reaction. Given the necessary access to the talking heads everyone seems to so blindly believe, I suppose I could have thrown that idea out there and potentially profited nicely myself.

Then, a few weeks later, they said the same thing about Bear Stearns. Again, not a shred of evidence, yet the stock shoots up. Did we not learn our lesson the first time? The rumor du jour is now Capital One for anyone interested, this one spurred by Jim Cramer. Again, folks, please give me some hard facts before manipulating stock prices like this.

Perhaps it’s the market wishfully looking for some direction in the uncertain (in fact, confused) credit markets. What better sign that things won’t get so bad after all than Warren Buffett taking a large stake in an institution heavily affected? That is what investors would like to see. Unfortunately it probably won’t happen. The lending industry is facing some very serious problems and nobody knows how it will all play out.

I certainly am not qualified to predict the direction of the economy. But I can say there is a nonzero probability that we will end up in some sort of recession. In the meantime, all this uncertainty creates an environment in which the sanguine rumor can flourish. A friend of mine and outstanding blogger, Chad Brand of the Peridot Capitalist, recently commented very poignantly on the credence given to the financial media and the problems it creates.

I think it is important to remember that those publishing or reporting in the financial media are journalists first, and economists or businessmen second. Just as we crave sensational stories in the popular media like OJ, Paris Hilton etc, we crave feel-good stories in the financial media. And those media, wanting to feed our craving, oblige.

Come to think of it, I once read somewhere that you can’t believe everything you read…

FD: Long Berkshire, no other position