Tuesday, January 31, 2006

Google (GOOG) Analysis

Google, the internet darling, reported its 2005 fourth quarter earnings today. We predicted a solid quarter for Google with many analysts upgrading the stock after this quarter. http://finnews.blogspot.com/2006/01/google-and-search-engine-wars-part-iii.html

Turns out the prediction was wrong as Google failed to meet the analyst estimates for earnings. Google did meet the analyst estimates for revenues. Today's announcement does two things. Google will no longer be a momentum stock and it will drive a certain segment of investors out. Secondly, the earnings slow down is now a given as we move into 2006 and 2007. We will await the analysts to follow-up with reduced earnings target in the next few days.

What the stock does tomorrow and the rest of the week will be interesting. The stock will definitely lose some value tomorrow. It has lost 12% tonight in the after hours trading. It depends on the various mutual funds and other investors on how the stock fares in the rest of the week.

Let us analyze Google balance sheet to see at what price point(s) Google is a buy. The year over year revenue growth rate declined this year(2005) to 92% from 118% from 2004. The expectation is for this to decline to 60-70% range in 2006. The operating income from operations is steady at 34% of revenues compared to the previous quarter after the contribution to Google foundation is added to operating earnings. The stock dilution increased year over year by 11% in 2005 compared to 2004. This is higher than the 6% range we saw in the prior years. The dilution could be higher if the drop in Google stock tomorrow leads to further insider selling.

On another worrying note, the diluted earnings per share declined in the fourth quarter compared to the first quarter even though the revenues increased by 52%. In addition to the stock dilution, the contribution to google foundation and increased income taxe payments also played a role in this. It is not clear if these contributions are a one time event or will repeat in the upcoming quarters.

Assuming that cost and other factors remain the same, the earnings per share in the next fiscal year will be 8.0 to 8.5 dollars per share. Accounting for 10% stock dilution in the next year, the earnings per share will be in the 7.2 to 7.7 range. Taking the low end of the earnings spectrum as a conservative measure, the earnings per share would increase by about 35% from where they are today.

Taking the trailing earnings per share of 5.02, the after hours price for Google is 381 dollars. This gives a trailing P/E of 75 for the stock. The forward P/E for the stock is 52 taking into account the lower end of the earnings per share for next year. Given a growth factor of only 35 in earnings, a more reasonable price for the stock would be 7.2x35 which translates to 252 dollars a share. A more reasonable price would be 7.2x30 which translates to 216 taking into consideration other risks. Even if one gives 10% upward momentum, the stock is a buy in the 225-275 range. This price is reasonable as Google faces further competitive pressures from Microsoft and Yahoo! going into 2007. The growth rate is expected to slow down further into 2007 and 2008 causing the P/E to shrink further.

Although several analysts are predicting the stock to go up to 450 and 500, it is more likely that the stock will touch 300 before hitting 500. Google is a momentum stock and the momentum is currently coming out of the stock. As was the case during the dot com bubble, the stock likely wont fare as well moving forward.

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