Time to Sell Google
by Wynn Quon
January 18, 2006
The reason why so many get bruised investing in technology stocks is this: Not enough selling. Investors are too optimistic. It's as if there's a Pied Piper who seductively convinces us that there is safety in crowds, that risk decreases as stock prices rise and that anything singing a good tune is worth following. The results of unbridled optimism are clear. Think back to those who bought Cisco or Yahoo! in 2000 and then suffered eighty percent losses within a year. What's mystifying is despite dismal experience, the Pied Piper has no shortage of new recruits. Today he's busy at work once again and this time the infatuation is with Google.
Like Cisco and Yahoo! before it, there's no denying that Google is a great company. Google came out of nowhere to dominate the lucrative world of online advertising while tweaking the nose of everyone's favorite villain, Microsoft. Profit margins are over thirty percent. Yearly revenues are up by one hundred percent and are now US$5.25 billion. Phenomenal for a company that IPO'ed a little over a year ago. On its first day of trading, Google's stock price was US$100. Now it has more than quadrupled, hitting an all-time high of US$446 in December. Analysts (remember the George Gilder, Mary Meeker and Henry Blodget go-go gaga era?) are now calling for it to hit US$600.
This is a perfect Pied Piper story. Investors are piling on the bandwagon without a second thought. Therein lies the fatal attraction. A good story lies at the heart of every investment misadventure. The antidote is a solid dose of boring math.
Start with a question. How much would you pay for a dollar of Google's sales? Assume that all the profits from that dollar of revenue go straight into your pocket. You know from its profit margin that for each dollar you would get thirty cents of profit. If you paid a dollar for each dollar of sales, you would get your money back in a little over three years. But Google's sales are increasing so you probably don't mind paying more for growth. How about paying five dollars for each dollar of sales? To get your money back in three years, Google's sales would have to grow by 100% per annum, everything after that would be gravy. That doesn't sound like a bad bet. But here's the bad news for investors holding Google stock. Paying five dollars for every dollar of sales means an implied value of US$89 per share (US$5.00 times US$5.25 billion of revenue divided by Google's float of 295 million shares).
That's a long way from its current price of US$440.
What are Google investors currently paying for each dollar of sales? They're not paying five dollars, nor are they paying ten. Nope, they're paying close to US$25 dollars. For Google investors to get their money back, Google needs six years of 100% growth in revenues. Think about what that means. At the end of six years Google would need to be a behemoth cranking out US$168 billion of sales each year. By comparison, Microsoft currently pulls in a measly US$40 billion. If Microsoft is a 800-pound gorilla, the new uber-Google would be a 3200-pound gorilla. Imagine the bananas. Incidentally, Cisco investors made the same mistake of paying US$25 per dollar of sales. When was this? You guessed it. Just a couple of months before the stock hit its all-time high in March of 2000. Large companies and high valuation ratios don't mix.
Part of the lure of Google is the recent IPO. We've all heard about those lucky enough to invest in Microsoft in 1986 when it first went public. Adjusting for splits, Microsoft stock at IPO was priced at a mere US$0.09 per share. It then rose 290-fold over the next twenty years. There aren't many things certain about stock prices, but I can definitely say this: Google will never deliver the same performance. Why? Because Google went public with a market capitalization of US$25 billion. Matching Microsoft's record would mean multiplying that by 290: Google would have to be absurdly valued at US$7.25 trillion (Note that U.S. GNP for 2004 is about $US11.7 trillion).
To take a more recent example, eBay's split-adjusted IPO price was US$0.75 per share and it has delivered a 58-fold return over eight years. Beating eBay's performance would mean that Google has to tip the scales at a market capitalization of US$1.45 trillion. At that level, Google would be deemed more valuable than GE, Exxon, Microsoft, Citigroup and Wal-Mart combined.
At US$130 billion, Google's current market capitalization is already half of Microsoft's. The Google investor looking for upside faces the same problem as basketball superstar Yao Ming trying to get inside a Volkswagen: not enough headroom.
On top of the pricey valuation, Google's growth trajectory is far from secure. First of all, its advertising revenues are cyclically sensitive. If the housing slowdown in the U.S. turns into a recession, belts will tighten everywhere. For businesses, advertising budgets are usually the first to get the chop. A decline in Google's revenues will not be a pleasant stockholder experience. Second, Google's search engine is vulnerable to competitive attack. Anyone who's had the disappointment of wading through hundreds of irrelevant Google search results knows there's still a lot of room for improvement. And this leads us to Google's greatest weakness which is that none of its products have lock-in. Microsoft's Windows' customers have other alternatives but they can't switch because the practical cost of doing so is too high. Google's customers on the other hand are free agents, waiting for alternatives to arrive. If that day comes the impact on profit margins will be immediate and negative.
If you're in the stock market, one can't help but hear the voice of the Pied Piper. But there's another voice worth listening to, the poet Robert Frost. He once said: "Take care to sell your horse before he dies. The art of life is passing losses on".
Wynn Quon is chief investment analyst at Legado Associates (e-mail)
