Finding the Real Value of Google's Shares

 | Dec 21, 2011 | 4:50 PM EST
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After yesterday's column in which I used a discounted cash flow analysis to illustrate that the shares in IBM (IBM) may be undervalued by as much as 50%, readers suggested that I look at the other big-name, tech companies and value them under the same lens. Google (GOOG), as the dominant Internet search engine and given the fact that it is rapidly becoming a major player in the smartphone market via its Android operating system, possesses attributes that make it truly a fantastic business.

Google essentially operates an Internet toll road that virtually everyone on the Internet must use. In turn, Google uses that toll road to generate billions upon billions of dollars in free cash flow each year that the company then uses to create things like Android, which in a very short period has been able to go toe to toe with Apple's (AAPL) iPhone, and produce even more cash flow. Google's role in the future lives of consumers is assured; if anyone can own a piece of this business at a quality price, it will likely pay off very well in the future.

A discounted cash flow analysis can be used to determine the intrinsic value of Google. Because Google can tailor its capital expenditures depending on what new ideas it wants to pursue, net income, as in the case of IBM and many of the large-cap tech businesses, is a good proxy for free cash flow.

Over the four year period from 2007 to 2010, net income has grown from $4 billion to over $8.5 billion. For the first nine months of 2011, Google has earned $7 billion in net income. Analysts expect Google to earn $11 billion in 2011 and over $13 billion in 2012. Starting with the 2012 figure, its quite reasonable to assume that Google can grow its profits by 15% to 20% a year over the next five years. For simplicity, an average growth rate of 17% will be used discounted at 10%. Further, a company of Google's quality could easily be sold for 15x to 20x 2016 free cash flow; I'll use 15x to err on the safe side.

Thus, the intrinsic value of Google, based on the above assumptions, is thus:

Google's intrinsic value based on a free cash flow analysis is $273 billion. Yet, in addition to that figure, the company has about $30 billion in excess cash on the balance sheet that it does not need in operating its business. That cash balance should be added to the intrinsic value calculation, for a total value of about $303 billion. Shares outstanding currently approximate 323 million and have been steadily rising over time. If S/O increase by 10% over the next five years to 355 million, Google's intrinsic value per share comes to $853 a share vs. $625 today.

To account for imprecision's in the DCF model, I prefer a 50% margin of safety implying that Google shares need to trade around $425 to qualify as an attractive investment. Interestingly enough, Google shares touched a low of $473 over the past 52 weeks before rallying to current levels.

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