A Step-by-Step PIE Analysis of GOOG

           

For a screencast of this demo click here. This exercise presents a step-by-step example of how to use  Whitebox Research to calculate the Price Implied Expectations (PIE) for  Google.  We will demonstrate how to estimate  what we believe the financial operating variables are that determine and justify  Google’s stock price today and then demonstrate how to use the model to explore  how different assumptions about those variables can change the PIE relative to  Google’s stock price. Looking at the PIE calculator module we have to enter a  series of variables in order to calculate PIE:   Percentage year-over-year sales growth. The percentage year  over year growth in future sales: Based on analysis we expect GOOG sales  to grow at 18% per year for the foreseeable future.         Starting sales.   Sales for the last four quarters (in millions of dollars).  As of the end of September 2006, GOOG’s  trailing twelve month revenue was $8,207 (in millions, this is $8.2 billion).                Operating profit margin.  This is what you think the future operating profit as a percent of sales will be for GOOG.  Start by looking at what it is today (29% as  of the last quarter) and then think about what it would or could be in the  future.   We’re assuming that this will  be 21% as future offerings for GOOG are not as high margin as search is today  for the company. Incremental fixed capital investment rate is equal to  how much incremental fixed capital the company must invest to generate a dollar  of new sales.  For GOOG we took the average  of the change in capital expenditures less depreciation and amortization  divided by the change in sales for the last four years.  For GOOG we estimate that this is 34%                  Working capital investment rate equals cash tied up by  a company's short term operating assets, netted against short term operating  liabilities. It tells us how much cash the company typically ties up in working  capital to generate a dollar of new sales.   For GOOG this is the average of the change in working capital in each  year for the last 4 years divided by the change in sales over 4 years or 6%.                 The cash tax rate is the percent of pre-tax operating  profits a company would pay in cash taxes assuming it was 100% equity financed.  For GOOG this is their tax rate from the last  quarter, which was 31%.                Since GOOG has no debt, the Weighted Average Cost of  Capital (WACC) for GOOG is calculated using the Capital Asset Pricing Model  which is: Cost of Equity Capital = Risk-Free Rate + (Beta times Market Risk  Premium).  In GOOG’s case we calculated  this formula as 4.88% +(1*3.2%) wich equals 8.08%.           We get the inflation rate from the latest 10 year  treasury which was 3.8%.        Share Price is yesterday’s closing price:  GOOG $429.00. Shares Outstanding is last quarter’s weighted average  number of shares outstanding in millions.   For GOOG it was: 310.4        Debt is the long term debt on the balance sheet at the  end of the last quarter.  For GOOG this  is 0.          The capitalized the value of future Operating Lease (in  millions) is a little tricky as this information is pretty buried in the notes  to the financial statements.  In most  cases, in our experience,  it is not  going to materially change the calculation, however when we calculated it came  out to about $75 million for GOOG. Employee Stock Option liability: The outstanding  granted and expected future option "cost" (in millions). See  www.expectationsinvesting.com for a detailed  explanation.   Again, this  variable is a little tricky, but for a growth oriented company with a lot of  stock options it can potentially have a large impact.  For GOOG  we estimate that this number is about $4,000 ($4 billion). Cash and Marketable Securities for GOOG are found on  the balance sheet as of the last quarter and represented $9,822 (or $9.8 billion). We then click on calculate and the Price Implied Expectation  is calculated at $437.46 which is pretty close to the current price of GOOG  when we did this analysis. The fun can now begin as we test these assumptions and see  where GOOG can go, either up or down, based on how GOOG’s business changes and,  in turn, how these variables may change.   For example let’s say that we believe GOOG operating profit margin will  stay at 29%.  What does this mean for the  implied price?  Well if we go back to the  PIE calculator and use the same variables as we just did but enter 29% instead  of 21% for operating profit margin, the PIE comes out at $668.29.  So if we really believe that there is  opportunity for the operating margin to be that high, and we think the market  doesn’t realized or appreciate that fact, the stock may be undervalued and  could appreciate if the market realizes there is upside in GOOG’s operating  margin resulting from underlying changes in its operations…for example higher  margin service offerings. Remember this model is just that, a model and it is only as  good as the thinking that goes into it.   While some of the financial variables will be “hard”, others will be  left open to your thought process, assumptions and justifications.  The variance that comes from this is  encouraged as it will make the model richer. Click on the link for more information and tutorials on calculating  PIE: www.expectationsinvesting.com. Click to order the book: "Expectations Investing"