Google Inc.’s (NASDAQ:GOOG) Risk/Return Analysis

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Is Google Inc. (NASDAQ:GOOG) a Buy, Hold or Sell?  Not knowing what kind of performance you’re paying for makes it challenging to answer.  It would be just like asking, do I take the over/under in the Super Bowl without knowing the over/under line.

One of the benefits we deliver to our clients, in our suite of tools, is understanding companies’ value expectations. This helps clients gage the Risk/Return characteristics of a company using our Economic Margin Framework. The Value Expectations interface allows clients to perform a sensitivity analysis using value drivers that are accessible to most investors. The engine of Value Expectations uses our Economic Margin framework which encompasses a valuation system that explicitly takes into account profitability, competition, growth, and the cost of capital. Unlike traditional valuation approaches that utilize highly sensitive perpetuity assumptions, our approach incorporates the widely accepted economic principle that competition will erode excess returns over time. 

To help us better understand Risk/Return characteristics of Google Inc. (NASDAQ:GOOG), we performed three distinct scenarios to provide insight into Google’s intrinsic value based on implied performance levels.

Google had a very nice run in 2009, with its stock up over 100%. However, so far in 2010, its shares have lost steam, down just over 12% and underperforming the tech sector. For the first scenario, we used the  Value Expectations Interface to understand the sales growth expectations currently embedded in Google’s stock price. The chart below illustrates that if you assume EBITDA margins and asset turns remain at 3 year median levels, Google must deliver 14% sales growth over the next four years to justify its current trading price of $542. Analysts currently expect the company to grow sales by 18.5% in 2010 and 15.3% in 2011, on average.

VE Source: The Applied Finance Group

*2009 Value drivers are based on Google’s preliminary FY09 results.

For a sensitivity analysis, we also used the Value Expectations Interface to understand the sales growth expectations needed to justify a $450 price (GOOG last traded here in the middle of summer), and a $650 price (it almost reached this point at the end of the year). To justify trading at $650 Google would need to grow sales by 19% over the next four years. To justify a $450 price tag,Google Inc. (NASDAQ:GOOG) would need to grow sales by 9% over the next four years.

 
VE Source: The Applied Finance Group

*2009 Value drivers are based on Google’s preliminary FY09 results.

 
VE Source: The Applied Finance Group

*2009 Value drivers are based on Google’s preliminary FY09 results.

So is Google a buy, Hold or sell? The answer for any investor should be driven on what kind of reasonable performance the investor believes Google can achieve.

The Value Expectations interface is a great tool for understanding what a company must deliver in sales growth to justify its current price, as well as understanding what expectations are necessary to justify previous trading prices or future price targets. 

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