Google - Our Insights Before Earnings

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Last week, Google announced that they will be releasing a new operating system set to debut in the second half of 2010. The Google Chrome OS will be a web-based operating system that would allow users to store and access their files online from any computer. The operating systems that are currently in use were designed for a time when the World Wide Web was non-existent.  By creating a web-based OS, Google hopes to debut a much faster and much simpler alternative to Microsoft’s dominant OS.  Google will run the new OS on its Chrome internet browser, released for public access in December 2008.  In addition to speed and simplicity, another main focus of the Chrome OS will be security. Google plans on creating an entirely new security structure that will help protect users from viruses and malware. The Chrome OS is Google's next big product and will certainly be a focus point on how its stock trades over the next few years, as Microsoft and Google battle for dominance.

In the last two years Google has traded as high as $741, as low as $332, and currently trades at $414. Embedded in every stock's trading prices are a set of expectations that the company must deliver to be considered fairly valued. By taking a closer look, we can see exactly how Google must perform to justify their trading price.

On 11-6-07, Google was trading at a stock high of $741. At that time, to be fairly valued Google would have had to grow sales by 25.6% over the next five years assuming it could maintain its 3 year median EBITDA of 38%. (See Below)

 
Chart Source:(www.EconomicMargin.com)

On 10-10-08, Google's stock fell to a low of around $332 which in-turn lowered expectations. To justify that trading price Google only had to grow sales by 7% over the next five years assuming it could maintain its 3 year median Ebitda of 38%, to justify the $332 price.

Chart Source:(www.EconomicMargin.com)

Today, Google is currently trading at $414 a share, and by using AFG's Value Expectations Framework, we can see that based on the chart above that Google would have to grow sales by approximately 8.6% over the next five years to be fairly valued assuming it can maintain its 3 year median Ebitda. This means that by 2013 Google would have to have $33 billion in annual sales over the next 5 years.

Chart Source:(www.EconomicMargin.com)

As investors contemplate whether or not they believe Google could meet these requirements, they should also make note of the company's enterprise value. By looking at the chart below we can see that a considerable amount of Google's value comes from future investments (over 61%.)

Chart Source:(www.EconomicMargin.com)

Although Google meets AFG's default buy criteria (explained below) you should also make note of any positive or negative signals which may help you determine whether or not you believe Google will meet or exceed the implied sales growth rate of 8.6%, EBITDA margin of 37.31% and asset turns of  0.65% over the next 5 years. If you feel confident that they will meet or exeed those Value Expectations, then you may want to consider Google as a potential investment since a mispriced equity will eventually be corrected by the wisdom of crowds.

Google will be reporting their earnings on Thursday, July 16th. 

AFG’s Value Expectations allows us to understand the Sales Growth, EBITDA Margin, and Asset Turnover a company has to deliver in the future to justify its current trading price. In theory, and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future Sales Growth of Apple assuming its EBITDA Margins and Asset Turnover stays at the 3 year median levels.<!--EndFragment-->    

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