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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Thursday, May 15, 2008

Comparing Valuations: Yahoo vs Google

Comparing price-earnings multiples and expected growth rates of Yahoo and Google several items become apparent. Yahoo is extremely overvalued as an independent company with its current share price reflecting the likelihood of a buy-out. Google is the better value of the two, but Google alone is fairly valued.

First, let’s run through the numbers I gleaned from Yahoo Finance and Nasdaq.com


Yahoo Valuation:
Yahoo shares currently trade 57.7x FY07 EPS of 47 cents. Looking forward, Yahoo trades 59x FY08 EPS estimate of 46 cents and 48.5x FY09 estimate of 56 cents. These EPS estimates translate into Yr/Yr growth of -2.1% (FY08) and 21.7% (FY09). Yahoo’s annual growth rate has averaged 23.3% the last 5 years.

Taking a slightly different perspective, Yahoo’s combined EPS for the last 4 quarters is 48 cents, and consensus estimates for the next 4 quarters total 52 cents. This represents 7.3% growth. The P/E multiple using EPS for the next 4 quarters is 52.7x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Yahoo has a PEG of 7.23.

Google Valuation:
Google shares currently trade 37x reported FY07 EPS of $15.59. Looking forward, Google trades 28.6x FY08 EPS estimate of $20.14, and 23.3x FY09 estimate of $24.74 . These EPS estimates translate into Yr/Yr growth of 29.2% (FY08) and 22.8% (FY09). Google’s annual growth rate has averaged 75.4% the last 5 years.

Taking a perspective of last 4 quarters versus upcoming 4 quarters, Google’s combined EPS in the trailing 4 quarters is $16.74, and consensus estimates for the next 4 quarters total $21.23. This represents 26.8% growth. The P/E multiple using EPS forecasts in the next 4 quarters is 27.2x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Google has a PEG of 1.01.


The difference in the two’s valuation is stark and quite apparent. Google’s forecasted growth is higher than Yahoo’s, yet it trades at lower multiples. That suggests Yahoo is overvalued relative to Google. But, does that mean Google is undervalued and should be bought? And that Yahoo is overvalued and should be sold?

Yahoo Analysis:
In my opinion, Yahoo is certainly overvalued as the company exists today. Its current valuation hinges on a business combination, most likely with Microsoft. Of course, this is the reason that Yahoo shares are trading at such high levels. It’s not a surprise why Ballmer balked at Yahoo’s $37 asking price since colossal synergies would have to be extracted from a combination to justify that high valuation.

Even at $33, $31, or Yahoo’s current share price, a suitor would really have to leverage Yahoo’s assets to unlock value. Now, common thinking concedes the value in Yahoo’s assets already exists, yet management and its strategy have been poor- leading to weak performance. Hence, strategic synergies and proper management may quickly boost Yahoo’s cash flow to a level that would justify such valuations.

The fact that Yahoo shareholders are irate that the board was holding out for $37 shows that they believe that valuation to be unreasonable. $31-33 is better than $27. If it weren’t for the possibility of a deal, the share price would be much lower, perhaps a teenager. However, Carl Icahn reportedly will launch a proxy battle to replace Yahoo’s current board. Such attempts are generally difficult to execute since ownership is fragmented and diffuse, however shareholders are angered and Icahn has established a track record.

In summary, under Yahoo’s current strategies, analysts don’t foresee much growth. Yahoo’s lackluster performance the past several years is not expected to change going forward, pursing the same course. Yet, shareholders and Carl Icahn believe Yahoo’s potential value is much greater than what historical performance and earnings projections would suggest- value contingent on business combination or management change.

If no deal (of some sort) ever comes to fruition, then YHOO shares would likely be cut in half. Ostensibly, there is inherent value not recognized in Yahoo’s performance, but if Icahn is not successful in removing a stubborn board, then it’s unlikely anyone else would be either.

Independent Yahoo- nearly all of Yahoo’s revenue comes from search and display advertising. Yahoo has been losing share in search; Google’s superior algorithms boosted its share into the mid sixties. In the English lexicon, Google has become a verb “Google xyz,” meaning to perform an internet search. Yahoo is still the second most popular search engine, but I believe most yahoo searches are secondary events. Yahoo’s content attracts users, who in the course of their visit, become compelled to search for a particular item and do so on yahoo, instead of navigating to Google. Conversely, users not on Yahoo’s portal choose to navigate to Google opposed to Yahoo to perform a search query. Hence, some of Yahoo’s search traffic is a matter of circumstance, and not necessarily one’s usually first search engine choice. Hence, the content from the portal aids in generating search traffic, but without a superior search engine, search depends heavily on traffic the portal attracts.

53% of Yahoo’s revenues come from advertising on its own properties, and segment revenues increases 18% in Q1. Yahoo attracts traffic through its news, finance, sports, and mail content/services. There isn’t anything proprietary about the content Yahoo provides, thus can be duplicated. In addition, Yahoo is buggy. Yahoo Mail doesn’t work right (search & spam filter), sometimes pages don’t render correctly and tables fail to populate. Groups and message boards are filled with spammers.

In my opinion, there are many things that have gone down hill on Yahoo’s site. Social networking sites and blogs are gaining traffic, traffic that could be going to Yahoo. Much of what Yahoo has now, could be duplicated, perhaps by Google. Google provides similar content and services, such as mail, messenger, maps, etc. and in my opinion, is better. In sum, Yahoo is dependent creating content and services that will attract visitors to its website.

Yahoo also provides advertising to third parties or affiliate sites, but segment revenue (33%) and margins have been declining. In Q1, segment sales fell 7%, after accounting for the drop in margin (shares more with partner), net revenues declined 13%. Yahoo’s total net revenue increased 9% for Q1. Google’s revenue growth was 42%.

Google Analysis:
At $576 / share, Google is fair-valued. In mid-March, I was bullish on Google when it was trading around $440. In my Google valuation analysis, I pegged Google’s fair value at $540 / share. I think, given the take-over turmoil engulfing Yahoo, and the ensuing distraction and departures, has boosted Google’s lead further. Thus, a $600 share price for Google is reasonable, but not attractive.

I am reluctant to place a valuation higher than $600 on Google due to its spending. GOOG has very high profit margins, but absent from the income statement is capital spending. Capex as a percentage of total revenue has been in the mid-teens for the past several years. R&D as percentage of sales has increased as well, from 10% (FY05) to 13% (FY07). Headcount has also significantly expanding leading to declining sales/employee & income/employee ratios. The significance- On the margin, each incremental dollar of revenue growth is accompanied by higher costs and investment. Hence, Google’s prospective growth generates less incremental corporate value compared to its past growth. Nothing new here, just the law of diminishing returns taking hold.

Conclusion:
Owning Yahoo at these levels is purely a bet on an acquisition. There is some upside to $31 or perhaps $33, but there is some downside risk as well. Owning shares of the acquirer (whoever that may be) is a bet that synergies will enhance value and that the purchase price was not excessive. Owning Google is a pretty safe bet with the upside potential balanced with downside risk.

2 comments:

Jeff Annello said...

Great post.

I came to the same conclusion that the principals of Yahoo! were nuts to think that they were worth north of $38/share. Absolute madness. Here's what I wrote:
http://circleofcompetence.blogspot.com/2008/05/of-toads-and-princes-yahoo-deal-falls.html

My Personal Finance Blog said...

i am satisfied with both yahoo and google..

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