Putting a Value on Google, Part 2


By Scott Kessler Back in June, we at Standard & Poor's Equity Research Services issued a special report analyzing what we believe to be the most widely anticipated initial public offering of the past few years (see BW Online, 6/11/04, "Putting a Value on Google"). Now it's August, and with the

Dutch auction bidding for Google's shares about to begin (See BW Online, 8/10/04, "The A-B-Cs of Google's Auction"), the question remains: What's a reasonable estimate of Google's valuation? In the second part of our pre-IPO report, we offer our updated assessment.

(Editor's Note: This article is an excerpt from the full report. Full .pdf versions of Part 2 of the Google Pre-IPO report, as well as Part 1 and the Search Engine Survey conducted for S&P, can be purchased directly at http://sandp.ecnext.com/ipo -- Adobe Acrobat is required. Additional information on Standard & Poor's pre-IPO coverage on Google can be found at http://www.standardandpoors.com/pre-ipo)

The Internet search leader anticipates the offering price for its shares will be between $108 and $135. Using the 268.5 million diluted shares outstanding the company expects following its IPO, Google would have a market capitalization of $29 billion to $36 billion. And while some market commentators have remarked that the deal may represent a return to valuations reminiscent of early 2000, we believe this range is reasonable.

In Part 1 of our Pre-IPO Report, we indicated that based on comparisons to Yahoo (YHOO

; recent price, $26; S&P investment rank, 3

STARS, hold), Google's most comparable peer in our opinion, our preliminary estimated market value for Google was from $33 billion to $40 billion. Part 1 was focused on Google's businesses, industry, and competitive position, and included brief valuation analysis. In this report, we more thoroughly consider the company's potential value.

COMPARABLE REVENUES. In our June report, we employed relative analysis involving Yahoo to derive a preliminary valuation for Google. Now, we revisit this analysis, and utilize three additional comparative methodologies as part of our assessment to determine the company's potential value. (Note that our relative analysis was done using prices as of July 27, and Internet stocks have fallen notably since then.)

Updating our previous initial valuation analysis with revised estimates and ratios, we derived the same range for Google's potential market capitalization as we did in June ($33 billion to $40 billion). Following details released in late July, we are also able to derive possible per-share values of $121 of $147. Our updated 2004 forecasts for Google are revenues of $3.0 billion, gross profit of $1.5 billion, and earnings before interest, taxes, depreciation, and amortization (EBITDA) of $1.1 billion.

While our estimates for gross profit and operating cash flow are largely unchanged from our June report, our revenue forecast is different. In late July, Google began reporting gross revenues instead of net revenues. We believe Google made this change so that its financials would be more comparable to those of other Internet companies.

Yahoo recently traded at 12 times sales, 19 times gross profit, and 40 times EBITDA. If Google traded between a 10% discount and a 10% premium to these multiples, its aggregated valuation ranged would be $33 billion to $40 billion. Thus, although Yahoo's valuation has fallen since Part 1 of our report was published, Google's reported and estimated revenues are in effect higher, leading to the comparable valuation assessment.

Updated Yahoo Valuation Analysis ($ in billions, except price per share and ratios)

Financial Projections

Yahoo

Google

2004E Revenues

$3.30

$3.00

2004E Gross profit

$2.20

$1.50

2004E EBITDA

$1.00

$1.10

Valuation Metrics

Market capitalization

$40.40

$32.5-$39.7*

Price per share

$30.00

$121-$148*

Price-to-sales

12X

11X-13X

Price-to-gross profit

19X

17X-21X

Price-to-EBITDA

40X

36X-44X

Note: projections and metrics are as of July 27, 2004

* Estimates

Source: Standard & Poor's Equity Research Services

Taking this analysis further, we compared Yahoo, as well as three other prominent Internet companies, Amazon.com (AMZN

; $38; 3 STARS), IAC/InterActiveCorp (IACI

; $27; 4 STARS, accumulate), and eBay (EBAY

; $77; 5 STARS, buy), to Google. We believe Yahoo is Google's most comparable peer, primarily because both companies derive most of their revenues from online advertising.

We also included three smaller companies -- Ask Jeeves (ASKJ), FindWhat (FWHT) and LookSmart (LOOK), none of which is followed analytically by S&P -- focused primarily on online search. We compared Google to these large-cap and search-focused Internet companies, based on a variety of valuation criteria. Our consolidated relative analysis suggests that Google's indication of its stock pricing at $108 to $135 is reasonable, with some of our calculations suggesting potential values as low as $55 and as high as $148. Averaging the ranges derived from our four valuation methodologies yields a possible stock price of $86 to $105 (whose mid-point is $95.50).

We believe that although comparative analysis offers insight as to value, intrinsic considerations are also a critical component in valuation assessment, because they allow for the inclusion of explicit growth assumptions.

GOING DUTCH. Using

discounted cash-flow calculations for a private company requires many assumptions. Because Google's stock has not started trading, we had to estimate its possible

beta -- a widely used measure of a stock's volatility. We estimated it at 25% higher than Yahoo's beta, reflecting uncertainties as to the Dutch auction, Google's current non-public shares, its expected limited float, and likely disparities in analyst expectations (reflecting the company's limited operating history and indications it will not provide financial guidance). This beta (2.0) reflects an expected high degree of relative share volatility, and yielded a relatively high discount rate of 17.4%.

We project annual free cash flow (FCF) will more than double on average over the next three years, trending down to 44% growth from 2007 to 2011, and to under 10% for the seven years thereafter. Our expected perpetuity growth rate for the years to follow is 3%. Based on these assumptions, we derive a possible intrinsic value of $161 per share. Our sensitivity analysis indicates that changes in inputs such as beta, our initial FCF estimate, and rate of perpetuity growth would have a material impact on our intrinsic value calculation.

Discounted Cash Flow Sensitivity Analysis

Change

Intrinsic Value

Relative Change of Intrinsic Value

WACC

Change in beta

+0.1

$150.52

-6.39%

18.02

Change in Debt/Equity

+10

$184.71

14.87%

16.21

-10

$141.06

-12.28%

18.63

Change in 2004 FCF forecast

+10%

$176.89

10.00%

17.42

Change in rate of

+1%

$164.73

2.44%

17.42

perpetuity growth

-1%

$157.38

-2.13%

17.42

Source: Standard & Poor's Equity Research Services

Google's SEC filings include some clues as to what the company has determined as a fair value for its stock. Specifically, for the purposes of financial accounting related to stock-based compensation for employees, the company has engaged in valuation analysis not all that dissimilar to what we have done in this report. Google has utilized relative and intrinsic analyses in valuing the stock options it has granted to its workers.

NO SURPRISES. In the second quarter of 2004, Google incurred deferred compensation expenses associated with stock options of $74.8 million. The company granted 965.5 million stock options during the quarter. Dividing the deferred compensation by the number of options issued yields $77.43 per share in unearned compensation. Adding to this amount the weighted average strike price of the options of $38.43, results in an implied per-share value of $115.86. In the first quarter, the same analysis indicates Google valued its stock at $91.98, suggesting 26% appreciation from the first quarter to the second.

And with our various analyses completed, we set out to arrive at a final valuation for Google's public debut. Taking the average of the possible valuations we calculated using relative analysis, intrinsic analysis, and option analysis results in a potential per-share price for Google of $121 to $127 -- within the indicated price range of $108 to $135 set forth in its July 30 SEC filing.

Required Disclosures

As of June 30, 2004, SPIAS/SPSI and their U.S. research analysts have recommended 35.9% of issuers with buy ratings, 52.7% with hold ratings and 11.4% with sell ratings.

5-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Accumulate): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Avoid): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Note: Scott Kessler has not participated in, and will not participate in, the Google IPO process.

Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com.

Other Disclosures

This research report from which this article was excerpted was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS") and distributed in the U.S. by Standard & Poor's Securities, Inc. ("SPSI"), a registered broker-dealer, and a member of the New York Stock Exchange, Inc. and National Association of Securities Dealers, Inc. The research and analytical services performed by SPIAS are conducted separately from any other analytical activity of Standard & Poor's. No research analyst that prepares a research report on a subject company has a financial interest in or is associated with that subject company.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Analyst Kessler follows Internet software and services stocks for Standard & Poor's Equity Research Services


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