Remember all those $900-$1000 Google (GOOG) price targets analysts were throwing around last year, when Google blasted through $700? Well, those were just typical Wall Street price targets: “Stock going up? Add 20%-30% to current price, fiddle with Excel model to develop required assumptions, publish.” (See “Mary Meeker’s YouTube maths“)
Those kinds of price targets work well as long as nothing changes–as long as the company keeps beating expectations, the market stays strong, the economy keeps rolling, the industry doesn’t change, management doesn’t screw up, etc. If something does change, however… oops.
What changed in Google’s case is that the company stopped blowing away revenue expectations, profit margins began to decline, and mind-boggling capital expenditures compressed the growth of free cash flow. (Also, the stock market crashed). This caused Google’s free cash flow to grow more slowly than expected, and the stock’s multiple–the price that market is willing to pay per dollar of free cash flow–to compress. And here we are at $500 again.
But fear not! One Wall Street fund manager still thinks Google’s fair value is about $1,000. Jeff Coons, Manning & Napier, as quoted in Barron’s, before Google’s Q2 miss:
Google’s (GOOG) stock has come down to around 532, from its 52-week high of nearly 750. Is this a relatively new position?
It was a position that we bought and then took gains in the rally when it went up toward 700. Now that the stock has pulled back, we’ve continued to increase our exposure. We estimate a longer-term growth rate of 30% for the company. Right now, there is a lot of scepticism about Google [whose results disappointed investors last week]. We think that earnings growth is going to be higher than what general expectations are, and that this will be true longer-term. Even with very conservative assumptions, we have Google trading at about a 40%-to-50% discount to its fair value.
What are the key assumptions here?
- 30% long-term revenue growth
- Stock multiple well in excess of today’s 30X-35X.
If Google grows revenue 30% a year over the long-term (at least five years) and maintains its profit margin, Jeff is right, Google is worth at least $1,000. However, given that Google’s US business has already slowed to below 30% (28% in the past quarter), we think this is highly unlikely. We suspect Google will be lucky to grow revenue 15%-20% per year over the next five years, and even that would be spectacular.
Google is already a $20 billion company. There just aren’t that many $20 billion companies that can grow revenue sustainably at 30%, especially when they’re highly dependent on a single product that is nearing the end of its primary growth cycle. At the very least, therefore, we don’t see how 30% long-term revenue growth could be considered a “very conservative assumption.”
Jeff is right that Google is an amazing company with an enormous future opportunity. If and when it drops to a price that we think offers real downside protection, we’ll buy it. Barring major revenue reacceleration, however, we just don’t see the stock’s free cash flow multiple getting back to the 40X-50X that drove the $750 peak last year, let along the 60X that would be necessary to make it worth $1000 today. A 25X-30X multiple seems perfectly reasonable to us, which is about where the stock is now (a bit north of there, after the Q2 miss).
What’s our own price target on Google? We’ll stick with the $2,000 scenario we put out there last year. The caveat is that that’s a 10-year scenario, not a 12-month scenario. And we should note that growth from $500 to $2000 over 10 years would give you a return that’s only a bit better than we would expect from the average stock.
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