Monday, October 29, 2018

Google Inc. - Risk is High

Would you go out in this?

Overview:

Alphabet, Inc. is a holding company, which engages in the business of acquisition and operation of different companies. It operates through the Google and Other Bets segments. The Google segment includes its main Internet products such as Ads, Android, Chrome, Commerce, Google Cloud, Google Maps, Google Play, Hardware, Search, and YouTube. The Other B)ets segment includes businesses such as Access, Calico, CapitalG, GV, Nest, Verily, Waymo, and X. The company was founded by Lawrence E. Page and Sergey Mikhaylovich Brin on October 2, 2015 and is headquartered in Mountain View, CA.

Founded: 2015
Number of Employees: 80110
Headquarters: Mountain View US
CEO: Lawrence E. Page

Analysis Methodology:

This will be a general analysis reviewing the following areas: earnings quality, growth, value and dividends.  We'll also look at R&D investment as an indicator of potential competitive advantage, sales per employee as an indicator of efficiency and relative earnings growth compared to price growth.

It will be a peer based analysis as it's a good way to give the results context and an opportunity to uncover other opportunities.

We'll use as a peer group the group of stocks popularly known as FAANG, but we'll substitute in MSFT instead of NFLX.  These are the biggest companies in North America, if size was the only qualifying factor, we'd also include Berkshire Hathaway.  We're going to exclude it as this group is technologically focused.

Peer Group:

Stock Name (Symbol)Last Price (Oct 28, 2018)Market Cap
Microsoft Corporation(MSFT:XNAS)$106.96821.4528B
Facebook Inc(FB:XNAS)$145.37420.2647B
Amazon.com, Inc.(AMZN:XNAS)$1642.81800.0485B
Apple Inc.(AAPL:XNAS)$216.301.0475T
Google Inc.(GOOG:XNAS)$1071.47745.6853B

Quality of Earnings

It's a fact that earnings can be manipulated and changed by accounting-driven decisions.  We want earnings that are persistent, can be expected to repeat and aren't the result of one-off events or management tinkering.  I use an nine part quality of earnings framework based off the work of two academics, Lev & Thiagarajan.  You can read their original paper here.  You can read my adaptation here.

The framework looks at nine areas in the financial statements: inventories, receivables, capital expenditures, research & development, gross income, selling-general-administrative expenses, sales per employees, tax rate and audit opinion.  The first two, the fourth, fifth and six are compared to sales levels, capex and/or r&d are compared to industry averages (I use a peer group average as a proxy), the tax rate measures seeks to remove the effect of an earnings bump from a reduction in the tax rate and the a last one looks for a clean audit opinion.  When any of these measures give a favourable signal, it gets a score of one.  All the scores are summed to get a total out of nine, the higher the better.

GOOG at 4/9 isn't good.  We have to be skeptical of their earnings results now.  FB is great, It's actually perfect - 8/8 as they don't carry inventories (everyone else does).  I almost never see perfect scores.

Growth

Year over Year Growth in Earnings

This metric calculates the number of times the company is able to grow its earnings compared to the previous year.  Each time the company increases its earnings relative to the previous year it earns a score of one.   We'll use seven years of data so the maximum score is six.  Here are the results in tabular form:

GOOG5/6
FB5/6 
AMZN4/6
MSFT4/6
AAPL3/5 - missing year seven data

These are all decent results, especially of course GOOG and FB.  As a point of interest, GOOG missed increasing earnings between the most recent year Y and the year previous Y-1 and FB missed between year six and seven.

Remember the quality of earnings, GOOG's aren't as trustworthy as FB's.

Earnings Growth Relative to Price Growth 

This measure is known as the earnings yield and it's the reciprocal of the PE ratio, however I tweak it so that rather than a static number, earning divided by price, I take the change in earnings over a period of time divided by the change in price over a period of time.  I'm looking to see if earnings growth has outpaced the growth in price of vice versa.  If the number is greater than one, I consider that a good sign, if it's between 1 and 0 I consider it less promising.  The period of time used to measure the change is three years.

The change in earnings and the change in price for GOOG is almost equivalent.  On the other two extremes, FB has seen more earnings increase than price and AMZN has seen more price increase than earnings change.

Value

We'll work with four value metrics - P/E ratio, EV/EBITDA, Ohlson Clean Surplus (OCS) and Discounted Cash Flow (DCF).  We're looking for consistency in the value story.

PE Ratio

I debated using this one because it's so similar to earnings yield we already used.  I decided to because it's so ubiquitous and its handy to know what a dollar of earnings cost.

GOOG trades at 47x earnings.  How do you feel about that?

EV/EBITDA

Similar to a PE ratio, this valuation model looks at what one dollar of earnings costs the investor, but using enterprise value and EBITDA instead of price and earnings strips out the effects of different capital structures and lease versus purchase decisions.  Since we've already got a PE ratio, I thought that looking at this metric over time would give us more information.   This metric is the current EV/EBITDA divided by the EV/EBITDA from three years ago.  A value greater than one means the stock has become relatively more expensive.  Between 0 and 1 and the stock has become less.

Except for FB, they've all become more expensive and GOOG has increased its dearness the most.

OCS

The OCS is an interesting valuation model that calculates a theoretical stock value.  While I don't hold it out to be an exact value, it can give a decent ball park or at least an indication whether the stock is over, under or fairly valued.  For a detailed explanation of the model, please review this article.   Academic testing demonstrates that the model has predictive results two to three years out.

All of these companies look over-priced.  There are tweaks that can be made to the model, but even with adjustments GOOG is still trading at a premium. 
The graph below shows by how much the stock is trading over its theoretical price.

Google is trading at 5x its theoretical price.

DCF

This model can get elaborate with individual rates for each future year.  I'm going to keep it simple.  I'm using the most current free cash flow per share figure, the firm's rate calculated for the OCS (which isn't a WAAC, it's just the risk free rate + the company's beta x the market premium using 7% as the expected rate of return for the market) and I'll do a range of terminal growth rates 0%, 1%, 2% and 3%.

SecurityFCF/ShareFirm's rate0%1%2%3%
FB5.91440.08302771.2380.9993.84111.54
AAPL7.30770.7521697.16112.05132.35161.62
AMZN13.14.084888154.82175.49202.53239.43
MSFT2.51.09155927.4030.7635.0640.75
GOOG33.98.091472371.47417.06475.42552.76
Again, on the surface, these stocks all appear over-valued, however we're used to seeing these companies command a large premium.

Income

GOOG doesn't offer a dividend so this analysis won't delve into income.  Just as information, AAPL and MSFT have dividend yields of 1.56% and 1.7% respectively.

Other Factors

We'll look at a couple of other factors in this analysis: R&D spend as a percentage of sales and sales per employee.  The former can inform us how "relevant" they may be in the future and the later gives us an idea how efficient the company is.

R&D as a Percentage of Sales


GOOG's is the second highest spend of the group and it's spend has been increasing moderately over time, both factors are appealing.

Sales per Employee


GOOG looks good according to this metric.  Although it's middle of the road compared to its peers, it's been trending up over time.

Conclusion


The GOOG's potential investment story is growth, not income, not value.  Growth can be measured in different ways but I think the most pragmatic and important measure is earnings.  Earnings are what turns companies in their stock market firmament.   The question then becomes a) how good are those earnings and b) how expensive is that growth?  Let's start with the first question.

GOOG doesn't have the quality of earnings and it's earnings growth has been good, but I'm bothered by the fact that the one year it didn't grow was its most recent year.   If I'm making an investment decision based on earnings, I want to feel good about them.  I don't.  Not as good as I'd like if I was going to pay 47x earnings.

Which brings us to the second factor.   A aura has developed around these big tech players and it seems that the usual valuation laws don't apply to them.  I will concede that their cultures encourage innovation.  I will concede that they are very well managed.  And I will concede that they've changed the world at least once and may do so again.  Those three factors may allow for some valuation rules to be more flexibly applied.  What one is willing to pay for growth is a bit of a personal question.

Based on the information in this analysis, relative to its peers, GOOG is middle of the road on OCS, Price to Theoretical Price  and DCF.  But relative to three years ago, it's become 38% more expensive using the EV/EBITDA measure.  That's the biggest jump of the group.

This is a difficult conclusion to make so I'm only going to speak of what I would do.  I don't like the cost of those earnings when I question how good they are.  I wouldn't buy.  I would also take profits if I was long. 

This analysis indicates that FB might be a good candidate - it's got the high quality earnings and the stock is less expensive relative to the group.  I do want to point out that AAPL and MSFT may have merit that wasn't fully explored in this analysis because they both have an income component.

Disclaimer

Part of intelligent investing involves taking on risk levels appropriate to one's circumstances.  We don't know what your's are and this analysis should not be construed as investment advice.  INVRS, its parent company, its officers, directors and employees cannot be held responsible for any investment decisions you make.

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