GOOG

Every year, at our annual conference in Las Vegas, we have a session called Hot Stocks. In this session, our analysts present a few companies that are currently exciting in the marketplace, providing analysis and an investment conclusion. This June, one of our “Hot Stocks” was Google (NASDAQ:GOOG). Google is the overall Internet Search market share leader, which has been primarily comprised of PC and desktop computers utilized to access the Web. However, with consumers purchasing more and more mobile devices, causing mobile Internet traffic to increase exponentially, a new search and advertising market has awakened. Therefore, Google is taking a mobile-first approach in almost everything it currently does. Its Android operating system boasted 50,000 apps at the end of April and is growing at an exponential rate. Android is now powering 34 devices, up 70% q-o-q, from 12 different OEMs. Over 120,000 Android devices are sold every day. The use of Google Chrome (web browser) is also growing really well, mostly driven by its technical innovations and perceived superiority over existing browsers.

Today we will take a look at the valuation attractiveness of the S&P 500 and break down the index based on market cap to see how the mega-cap stocks within the index look relative to the smaller players, using The Applied Finance Group’s (AFG’s) valuation framework. Using the AFG Value Score variable (a ranked valuation attractiveness metric, 1 = the least attractively priced stock in the AFG domestic universe of 3,500 stocks, 100 = the most attractively priced stock in the universe) we have broken down the S&P 500 in groups of 50 from largest to smallest market cap to see which quintile group looks the most attractive based on AFG’s systematic approach of valuing securities.

Using the Value Expectations Interface we help to understand the sales growth expectations embedded in Google’s current stock price as well as what they would have to grow sales to justify a $450 price tag and a $650 price tag.

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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Bloomberg provides a score for companies within the S&P 500 based on an average of all analyst ratings from the street. Below is a table highlighting companies with the best analyst ratings, largest increase in rating, highest price targets, and worst analyst ratings and the valuation attractiveness of each of these companies based on The Applied Finance Group’s (AFG) valuation model.

Companies within each of these groups are ranked from most attractive from a valuation perspective to the least attractive. VE.com will actively track the performance of these recommendations and see how they stack up to the analyst recommendations in each group. AFGview.com, AFG’s professional investor website allows you to compare any company using their rating versus the consensus ratings of the sell side. If you are interested in an analysis on a specific company, contact afgsales@afgltd.com.

 

Best/Worst Analyst Rated Companies (Bloomberg)

 

AFG's Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

Faisal Laljee of stocksandblogs.com came out with 2 blogs earlier this year providing companies that he believed were the top stocks to own/watch for 2009 (Part 1, Part 2). Laljee was on the money with his predictions so far through 2009. 13 of the 15 companies he recommended have positive returns and the whole portfolio of 15 companies has an average return of 21.24% compared to the S&P 500 return of 0.10% over the same time period. Valueexpectations.com thought it would be useful to analyze how these firms are positioned as possible investment opportunities going forward from AFG’s valuation standpoint. Valuation Attractiveness is determined by AFG’s proprietary valuation framework, which estimates a stock’s intrinsic value through a DCF model which incorporates a corporation’s Economic Profitability, Growth of Capital Base, Decay, and Cost of Capital. In addition, we also showed sales growth expectations embedded in each company’s latest stock price and its historical 5 year median sales growth. It is interesting but not surprising that all the Attractive stocks have low implied sales growth compared to those companies’ historical performance.

 

Stocksandblogs.com 15 Companies To Own/Watch In 2009 : Perfomance Results

 

*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 the list of companies assuming their EBITDA Margins and Asset Turnovers stay at the 5 year median levels.

Tickersense.com has recently published an article highlighting 15 companies that have been the leaders of the market since the low on November 20, 2008. Made up mostly of Tech stocks (8 of 15), this list of companies has been responsible for about half of the total change of the S&P500 since November 20, and the author believes it is a good place to start if you are “looking for leadership”. Below is a table highlighting the price performance of 12 of the 15 companies (Financials were excluded as well as WYE and SGP due to takeovers).

A second table provides an analysis of the valuation attractiveness of these companies as well as the market expectations for sales growth implied in the stock’s current price using AFG’s Value Expectations interface. Measuring the spread between a company’s VE sales growth expectations and what it has historically delivered should give you a good idea of which companies have the best chance of meeting or exceeding those expectations, and thus are more likely to outperform.

 

 Performance From November 20, 2008 to Yesterday's Close

 

Valuation Attractiveness & Implied Sales Growth Expectations

 

*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 the list of companies assuming their EBITDA Margins and Asset Turnovers stay at the 5 year median levels.

What is the value of Google? Google is a great company that is beating competition through getting higher market share in search ads, and still delivering sales growth despite a recession. Google traded at a low of $247 back on November 21, 2008 and at that time had -1% sales growth priced in assuming 5 year median margins and asset turns. Now, Google is priced at $348, which implies 5.6% sales growth, is that reasonable, or does Google still appear to be trading at a discount? Last year, Google lowest in terms of sales growth, was still 31.35% and that was during a recession. The economic crisis is expected to continue at least through this year, but even with that expectation, analysts on average are predicting that Google will grow sales 9% in 2009 and 15% in 2010. You do the math.

 

Google's Implied Sales Growth Expectations

 

In our blog dated Jan 26, GOOG was trading at $323.87 and we identified that there were very low sales growth expectations priced into their stock. Again on March 6th ValueExpectations.com issued a buy rating for GOOG when it was trading at $308.57 and it has since grown its share price to just over $348. If you think GOOG can do better than 6% revenue growth and maintain better than a 36% EBITDA Margin, google still has some gas left in the tank. At the 52 Week low of $247.30 and the most attractive valuation point, GOOG had less than –1% sales growth priced in!

 

*AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnovers 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 companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

Fortune magazine recently put out an article listing the most admired companies in the world.  We took the top 50 firms (excluding Financials, and companies not traded in the US) on their list and put them through Applied Finance Group's quantitative recommendation framework.  Just because these firms are among the most admired companies in the world does not qualify them as the most attractive investment. Being among the most admired is an honor and means you must be doing something right, but might not necessarily mean the share price is currently attractive. 

The following articles which we have posted in the past on ValueExpectations.com will give you a better understanding of what it takes for management to create wealth, understand Management Quality, and see how EPS alone falls short in estimating a company’s value. There are two main characteristics a company must have in order to be a good investment opportunity: (1) the company needs to be a strong economic performer, (2) the company should be attractively priced.   Many people admired the DeLorean, but it was neither a good performing car nor a good priced car. Below we reveal a few "DeLoreans" after looking under the hood.

 

Top 50 Most Admired Companies According to Fortune

The Russell 1000 Index has lost 44% over the past year and is down 14% year to date. Similarly, the Russell 2000 Index is down 42% for the past 12 months and lost investors 18% since the beginning of this year. With both of these indexes down substantially recently by about the same amount, are large caps more attractive than small caps?

Percent to Target Charts: This graph shows the Percent to Target Current for a universe relative to the overall market. Values greater than 1 indicate the universe is more undervalued than the market, while values less than 1 indicate the opposite. The red line identifies the historical median value to provide a basis to understand valuation levels relative to historic norms.

Small Universe: Companies in the AFG universe that have a market cap less than $300 million and EPS consensus estimates are available.

This chart illustrates that the median Small Cap company is currently overvalued, relative to the market. Over the past 6 years, small Caps have been trading at a premium to their historic valuation.

 

Large Universe: Companies in the AFG universe that have a market cap greater than $2 billion and EPS consensus estimates are available.

This chart illustrates that the median Large Cap company is currently undervalued, relative to the market. Large Caps have been trading at a discount to their historic valuation, indicating a potentially attractive opportunity.

 

 

Following is a list of the biggest 10 companies (determined by market cap) in the Russell 1000 and Russell 2000. AFG’s Value Expectations interface, which solves for implied sales growth embedded in a stock price (VE Sales Growth), allows us to understand the embedded Sales Growth, EBITDA Margins, and Asset Turnovers 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. An undervalued company is more likely to outperform those companies with high expectations relative to what they have delivered historically. The tables below display the implied future sales growth of these companies assuming their EBITDA margins and Asset turnovers stay at their 5-year median levels.

 

 

Conclusion:
Both the percent to target charts and VE analysis show that large caps look more attractive than small cap stocks. The large cap stocks on the list have lower expectations for implied sales growth and the overall universe is currently undervalued. 

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The tech sector has been taking a pretty bad beating the past few months but according to Bill Luby of SeekingAlpha.com, The 4 Horsemen of Tech (RIMM, AAPL, GOOG, AMZN) will be the most likely companies in the sector to make the strongest comeback when the tech sector makes a comeback. Here is a list of many of the big names in tech and the implied sales growth expectations priced-in to justify their current price. The companies with low sales growth expectations priced-in (VE Sales Growth) compared to what they have been able to deliver in sales growth (5 Year Median Sales Growth) are the companies we believe have the best chance of making a strong comeback with the sector.

According to historical valuations the tech sector appears to be trading at a discount compared to historical valuations such as the Tech Bubble.

Big Tech Companies and Sales Growth Expectations

 

In life, the most attractive people are in shape and have good looks, just look at Hollywood. The same is true the majority of the time in investing. The most attractive stocks have healthy financial statements and look good from a valuation standpoint.

The Altman Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years. The model was developed by Professor Edward I. Altman of the NYU’s Stern School of Business and first published in The Journal of FINANCE in September 1968. A common critique to this metric is that it was developed over 40 years ago and is no longer relevant.

In 2001, Professor Joseph D. Piotroski of The University of Chicago Graduate School of Business, published a paper called, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski showed that value investors were rewarded by looking at a firm’s financial health and he showed that Z-score was a meaningful statistic.
More recently, on December 5, 2008, Dr. Altman was called to testify before a House of Representatives Committee on the condition of U.S. Automakers. In his testimony, he noted that Bloomberg, Inc. reported, “that approximately 1,000 users of their system per day access the Altman Z-Score model.”

The Altman Z-Score breaks down firms into 3 zones:
• >2.99 – Not Likely to Go Bankrupt
• 1.8 - 2.99 – Gray Area
• <1.8 – Likely to Go Bankrupt in the Next 2 Years

Using AFGView.com, we screened for firms that looked relatively attractive from a valuation perspective and had an Altman Z-Score above 2.99. Below is a list of those firms. Later we will look at firms that are expensive and have a Z-Score below 1.8.

Sales Expectations for Companies with an Attractive Valuation and Healthy Balance Sheet

According to MotleyFool.com, InvestorPlace.com, Jubak’s Journal, Cramer, and FortuneMagazine.com these are the most attractive stocks to own in 2009. Compare the sales growth priced-in to justify the current stock price (VE Sales Growth) to what the company has achieved in revenue growth over the last five years (5 Year Median Sales Growth) to see if what’s priced-in is a reasonable number for the company to meet or exceed expectations. Couple the expectation information with AFG’s ranking for a stock’s attractiveness relative to the universe (Value Score AFG) to find companies that we find attractive on a default basis that also have low expectations for growing sales compared to what they have delivered the past 5 years. Companies with High Value Score’s and low sales growth expectations will be the companies on this list that are more likely to out-perform.

 

Recommended Stocks for 2009

Related Article: EPS Increased.....Company Underperformed?

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According to Forbes.com, Cramer and a few other financial blog-sites the following qualities are usually found in stocks that do well in economic downturns of extended time periods.

• Consumer necessities
• Ability to pay a dividend
• Ability to add employees as other firms cut back
• Productivity increases as market goes down
• Healthcare stocks
• Legacy Companies – high quality company with long business history
• Involved in Military
• Oil industry
• Infrastructure
• Companies that sell used goods
• Generic products
• Overseas exposure

The following companies all have one or more of the above qualities to help them survive and perform well in an economic downturn. This table provides the implied 5 year sales growth priced-in to the stock to justify its current price along with the 5 year median achieved sales growth. Compare the revenue growth priced-in to what the company has been able to deliver in the past 5 years to see if the expectations are reasonable enough for the company to meet. Companies with reasonable expectations compared to what they have achieved are the most likely companies on the list to out-perform.

Stocks with Recession Resistant Qualities & Sales Growth Expectations

 

 

According to Bespoke Investment Group, these ten companies have the highest percentage of Buy ratings from the analysts that follow them. This table shows the number of analysts covering each stock and the number of buy and sell ratings as well as the percentage of buy ratings on the top 10 companies from Bespoke. Also in the table is the achieved 5 year median sales growth and the VE Sales growth (Sales Growth expectations priced in to the stock at today’s price). Only the top 4 companies on the list LO, PM, TMO, and AYE have 100% buy ratings from all analysts. Of those four, only AYE has high expectations relative to what they have delivered in sales growth in the past. Six out of the twelve companies on the list LO, PM, TMO, GOOG, COV, and BLL have very realistic expectations for sales growth priced-in compared to what they have been able to achieve. With the high percentage of buy ratings on these stocks they all deserve a more in-depth look, but the six with low expectations look especially worthy of consideration as potential investments.

S&P 500 Stocks with the Highest Percentage of Analyst Buy Ratings.

*denotes company only has 2 years of historical sales growth
**denotes company only has 3 years of historical sales growth
VE Sales Growth was calculated for these companies on 12/12/08.