Irrational Exuberance?

Let me confess two things right off the top: I can only pretend to know something about stock valuations, and I’m troubled by my continual posting on Google.

Now that I’ve confessed both my obsession and ignorance, I want to write one more post about GOOG, its earnings and its valuation. I’ll try to make it my last, on this topic at least.

First off, three clear camps emerging today after the earnings announcement yesterday:

Analysts cheerleaders, who are still pushing GOOG $500
The market, which hasn’t really punished the stock too badly, and is essentially aligned with the analysts
The valley observers (as chronicled best by Om Malik), who are still bullish on Google

Basically, all three of these groups effectively have the same outlook. They all believe the earnings report yesterday was a blip, the miss largely a technical tax and accounting issue, that GOOG still rocks and is still delivering blowout growth. Sure, fine, I agree — but it conveniently ignores the real issue, which is what is a rational price for the stock?

Right now, the stock is hovering at about $400.  That provides it with a forward P/E of about 48, based on the consensus of most analysts for about $8.76 in non-GAAP EPS in 2006. That non-GAAP EPS probably translates into about $2.65B in  non-GAAP net income for FY 2006. By comparison, non-GAAP net income was about $1.6B in 2005. To hit these net income targets, they’ll have to deliver roughly $10B in revenue in ’06, off a $6.1B 2005 base.

To have a rational PEG ratio based on that forward P/E, you would then have to believe that they can deliver between 30-40% growth in the following 4-5 years, FY 2007-2010 roughly, while maintaining GAAP net income at about 25% and non-GAAP net income at about 27-28% of total revenues. That would take GOOG to a $30-35B top line revenue ($8-9B net income) company by 2010. Basically achieving what the best technology company to date — Microsoft — achieved in its first fourteen years as a public company, but in about half the time and without the benefit of a monopoly.

That’s the outcome you have to believe for it to make sense to buy GOOG as a rational person at $400 a share, with a plan or hope to make money.

So, is it possible for Google to do this? The expectations for 2006 seem achievable based on nothing but Google’s trendlines and the scope of the opportunity. Hard — because they’re pretty much relying on continued outstanding growth in their one line of business — but achievable.

What is less clear to me is how Google gets from $10B in top line to $20B, let alone $30B, between now and say 2010. Right now, Google is depending pretty much entirely on the search-driven targeted advertising business. It really has no other business. And it has not demonstrated — at least so far — that it can really deliver a world class, compelling product (other than Google Maps and Google Earth) that is clearly better than what competitors offer beyond the core search product.

It’s interesting to compare their situation with Microsoft at a similar point in the Softie’s history. Microsoft was a $100B market cap company at the beginning of 1997. That was only 9 years ago, about 18 months after the launch of Windows95, when Microsoft was viewed as the behemoth that sat astride the industry, and had a full range of products including not only Windows but Office and a large array of server-side products, was generating about twice Google’s top line, and almost 2.5 times its GOOG’s net income. It had a trailing P/E of 50, and would continue to enjoy 40% net income growth (on average) over the following three years (which then stalled out to low double digit growth — the law of large numbers finally catching up with it — starting in 2000-2001).  To take a trip down memory lane, read this interesting piece on MSFT by James Surowiecki then writing at Fool.com.

So to convince yourself about Google’s chance to outdo Microsoft’s feat, it seems to me you really have to believe in the continued growth prospects for keyword search marketing; that Google will be able to continue growing it’s share of that market, despite incursions by Microsoft and Yahoo! among others; and that there will not be commoditization and thus lower pricing because of increased supply of avails. Or, you have to believe some combination of those things AND that Google will find a way to innovate and build other, new businesses — perhaps with a company like dMarc.

I like and admire Google tremendously — how can you not? — but I guess where I net out is that I’d be a lot more comfortable as a buyer with their shares between $200-250, a trailing P/E in the 40s and a forward P/E somewhere in the 20s. That would seem more appropriate given they are currently a one-trick pony and the unknown unknowns. But don’t listen to me, I’m also one of the idiots who thought it was pricey at $85!


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