In my opinion, the most important points about Google are as follows:
- Google has an amazing franchise in its Adwords (search advertising) and Adsense (banner/text ads) businesses. These business are likely to continue to grow earnings at very high rates for the foreseeable future.
- At a P/E ratio of roughly 22 and with a high growth rate, Google is somewhat cheap.
- The biggest risk to Google is that of a competitor developing a better search engine. In the history of technology companies, small startups like Google can quickly dethrone the market leader in the span of only a few years. Google did this to the former market leaders such as Yahoo and Altavista. Another company may do the same to Google. I do not see Google as having a moat against a higher quality product. It is not like the soft drink business where Classic Coke has a moat against better tasting products such as New Coke (now defunct) and Pepsi. The technology industry is littered with corpses. Not even network effects protected services such as ICQ and Myspace.
I believe that Google call options are compelling since the options minimize the tail risk and they aren’t expensive.
The biggest risk in Google would be a competitor taking over Google’s search dominance or search being replaced by a better approach. For example, Microsoft’s Encarta encyclopedia product was made obsolete by the Internet and Yahoo’s directory was made obsolete by Google’s search. I do not think that I am smart enough to predict what will happen to Google in the future. One approach to deal with the risk would be to closely monitor Google’s competition. The most dangerous competitor would be one with better search quality than Google. Rising market share could be an indicator of better search quality and may be one method for sizing up Google’s competition. However, rising share could also be due to other reasons. All of the major players in search try to buy users through toolbars, browsers, etc. (Toolbars and browsers increase market share since a small portion of users will stick to the default search engine of the toolbar or browser.) So looking at market share trends does not necessarily indicate which search engines are getting better.
That being said, let’s look at some market share data. StatCounter’s website has information on search engine market share: http://gs.statcounter.com/#search_engine-ww-monthly-201108-201208-bar . Google has around 91% market share while Bing/Yahoo account for almost all of the rest. New upstart search engines such as DuckDuckGo, Blekko, Qyo have so little traffic that they do not have their own category on StatCounter’s main site (they show up if you download the data as a spreadsheet, though their share is effectively 0%). In my opinion, Google’s only serious competition is Baidu, Yandex, Yahoo! Japan, and Bing/Yahoo. Baidu, Yandex, and Yahoo! Japan are dominant in non-English languages and are not competitive for search in English-speaking countries. For English search, Google’s only real competition at the moment is Bing/Yahoo (Yahoo’s search is powered by Bing). Quantitatively, Bing/Yahoo combined have not been gaining market share on Google based on Statcounter’s statistics.
There is another way of looking at Bing versus Google. Bing has a challenge called “Bing it on” where you can compare Bing results to Google results. (*If you perform the search yourself at bing.com and google.com instead of bingiton.com, you may get different results. Also, bingiton.com does not work for me in Canada as it simply redirects to bing.com.) The challenge arguably shows that Google is the better search engine:
- If you simply search for “bingiton” in Bing, bingiton.com is not the #1 result. For me, it ranks #4 (behind bing.com at #3) whereas on google it ranks #1. Here is one tweet by a Google engineer with a screenshot.
- Bing’s Youtube ad referencing the challenge shows a disproportionate level of dislikes versus likes.
- Comments on Bing’s Facebook page suggest that many people found Google to be better.
But, the problem still remains. It is possible for Bing to catch up to and surpass Google one day. While I am generally very negative on Bing, I wouldn’t count them out. As well, there are other companies out there that have access to capital (e.g. from venture capital firms) and may develop disruptive search technology.
The options approach
I think that options are the best way to play Google. The implied volatility on Google options is usually not high. However, one options contract gives roughly $75,000 in exposure to Google. That position size is too big for me.
Google as a very large venture capital fund
You could think of parts of Google as a very large venture capital fund. Google is working on a large number of experimental projects (e.g. self-driving cars) and Google employees are free to spend 20% of their time on anything they think will benefit Google. Aside from the core search business, Google has had successes in developing Adsense (roughly a quarter of its revenues) and Gmail. Its Google Checkout is a good product and competes against other online credit card payment processors such as Paypal and Digital River (NASDAQ:DRIV; market cap $595M). Google does come up with very good products internally.
I’m not entirely sure how to value Google’s “venture capital” side. I definitely do think that there is value here and that this aspect of Google should be valued at more than 0.
Google’s capital allocation
Google may be chasing new opportunities that have low rates of return (Wikipedia has a list of Google acquisitions). Google’s buyout offer of Groupon for $5.75B is suspect. Currently Groupon (GRPN) has a market cap of $3.07B. Short % of float is around 20%. In hindsight it looks like Google offered too much for Groupon.
On the other hand, some of Google’s historic acquisitions may turn out to be reasonable. Youtube and Android came about from acquisitions. These massively popular products can turn out to be worth a lot if Google figures out how to monetize them effectively. Google has a smaller market cap than Apple even though Android has greater market share than Apple’s cell phones and tablets.
Often, Google’s strategy is to create products/services of value and then figure out how to monetize them. There is obvious potential upside in the massively popular products Youtube, Android, and Gmail.
Putting it together
The main factors in valuing Google are:
- Core search and display advertising businesses.
- Competition / tail risk.
- “Venture capital” business.
- Acquisitions – is the expected return of these acquisitions positive? How do these acquisitions compare to share buybacks?
- Youtube, Android, Gmail, and other assets that offer monetization upside.
- Excess cash – One could make the argument that Google has $20-30B+ in excess cash that it does not need and could return to shareholders.
One could make the simplifying assumption that #3 to #6 simply extend the growth of Google’s core business. Looking at all of Google’s businesses as a whole, you make the assumption that the collection will grow at a rate somewhat similar to the past. This should be reasonable unless you believe that Google’s management has been really terrible allocators of capital in its acquisitions and that Google should be penalized for poor management.
Competition / tail risk is, by far, the most difficult to evaluate. If Google is succeeded by another company, it is very possible that its successor is barely on anybody’s radar today. It may not even exist yet. You could arbitrarily discount Google’s value by 0-50% to take into account this tail risk. I am not smart enough to figure out the right number.
Another way of looking at things is to compare Google to other companies and industries. Google is arguably less risky than the following companies:
- Gamestop. It will eventually be killed by online distribution of games unless it reinvents itself like Radio Shack.
- Qualcomm, Marvell, Broadcom, and other smartphone chip designers. They might be killed by Intel.
- Antivirus software vendors (e.g. Symantec). May be killed by Microsoft, which is shipping free antivirus and antispyware with Windows 8. This could play out like Internet Explorer versus Netscape and MSN Messenger versus ICQ/AOL messenger. It may be difficult for these companies to compete against a free solution that is good enough.
Keep in mind that Google is probably safer than most tech stocks out there. Microsoft and Intel are probably the safest tech stocks, though not as safe as Coca-Cola or a railroad. Software companies with the best software in their niche are probably the next safest (these companies usually have 90%+ market share). And then there is everybody else.
Valuing Google’s core search business is just as difficult as it involves projecting future growth. However, considering Google’s rapid growth, its current valuation at a P/E of 22 seems slightly cheap to me. According to Gurufocus, Google’s revenue growth has been an astounding 52.3%/yr over 10 years. Suppose that Google doubles its earnings every 4 years (this has roughly been the rate of growth for the past five years). In 4 years its P/E ratio will be 11, which is lower than the average stock (around 15). If Google’s growth continues for an even longer period of time, then there is more upside. Google can potentially have earnings that are several times what they are today… maybe even more. The growth of online commerce is far from done and I believe that Google will grow alongside that industry (see my previous post on online advertising).
Quick and dirty options math
The options are easier to figure out than the common stock. Let’s make the assumption that Google is likely to grow at a rate similar to its recent historical rate. Arbitrarily assume that the options have a 30% chance of expiring worthless.
The Jan 2014 options expire in 477 days (1.3 years). If Google grows at 18% / year, then it will grow 24.15% in 477 days. The closing price as of Sept 27, 2012 is $756.50. In Jan 2014, Google stock could be at $939.18. The $760 calls have an ask price of $94.20. That call option could be worth $179.18 on expiration. If you take into account the 30% risk of the option going to 0, then the expected value of the option is $125.42. The options trade at roughly three quarters of their expected value (94.20/125.42 = 75.1%). Of course this is an oversimplification of things. Changes in the underlying assumptions can make a big difference. The chance of the options expiring worthless may be greater than 30% and the upside may be understated since markets tend to be pretty random in the short run.
Overall, I think that the options are slightly cheap but this is not a trade where you should take a large position. Perhaps it would be prudent to wait for random market fluctuations to drive the price down and create a trade with better risk/reward. The S&P 500 is up 15% this year… if a market correction occurs, then a better trade may materialize. And if a market correction doesn’t occur, it is ok too as you do not need to switch at every pitch in investing.
Factors that probably do not matter
Market share statistics
Be careful with statistics since many statistics suffer from sampling problems. StatCounter’s sampling is non-random as it involves websites which choose to install StatCounter. A commonly cited source of market share data is Comscore (http://www.marketwatch.com/story/comscore-google-keeps-lead-in-us-search-in-aug-2012-09-12), which claims that Google’s share is only 66%. To me, Comscore’s data seems completely off as I do not know many people who use Yahoo/Bing or other non-Google search engines. As well, my web logs for my various websites are in line with StatCounter’s statistics. If Comscore is right, 1 in 3 people do not use Google. This seems unlikely.
I currently see very few Google Adsense ads since I use Firefox with the NoScript plug-in. It is theoretically possible that future browsers incorporate aggressive ad blocking features. I personally do not believe that this will happen. Usage of the NoScript plug-in may remain low as it introduces annoyances in the browsing experience.
As far as Adwords (search advertising) goes, some of the ads add value. Personally, I want to know where I can buy New Balance shoes online in Canada. For me, the #1 ad (an online store) is more relevant than the #1 search result (New Balance Canada’s website, which has no online store). I think that pervasive ad blocking will be unlikely.
Competition from Facebook, social media
I do not believe that this is a threat to Google’s business model. These sites do different things and do not compete with each other directly.
One VIC writeup (http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/3676) argues that Google will make more money as ad coverage goes up. I do not believe that this will happen as Google plays around with its ad policies to improve the user experience. One thing it has done is to suppress ads that do not pay well and/or have low click-through rates, thereby lowering ad coverage. Google penalizes advertisers for having landing pages irrelevant to the search query so that ads are more relevant. It also filters out ads that point to landing pages similar to other ads’ landing pages. In general, I do not see # of clicks or cost per click to be useful metrics. Useful metrics would measure how well Google is monetizing its products and the quality of the user experience. Sometimes Google sacrifices the former for the latter.
How bad is Bing?
Looking at the logs for this site, I see that many people use Google to find particular pages on this blog instead of using WordPress’ search function. The problem with Bing is that it does not index all the pages on this blog. A search for “KBH short thesis glennchan” will not work with Bing.
*Disclosure: I have no position of any type in Google.