Google's Valuation Finally Reasonable

Google Inc (nasd:GOOG) $439.16- Google shares have dropped about 40% from its high around $750 due to concerns of slowing growth. Considering the long-term picture, coupled with GOOG shares historically being overvalued, Google’s current valuation is attractive. Google a the dominant player on the internet with a strong competitive position that will provide sustained growth and high margins for many years. In the internet space, Google is a must-own, and finally its valuation is reasonable.

Online Advertising Market Growth:
The internet is still growing in terms of users and usage- More people are spending more time online. Devices such as the iPhone, are contributing to this trend. Online advertising only accounts for 10% of total ad spending. As advertising on the web continues to grow, Google stands to capture a significant amount of expenditures.

TV advertising is facing major battles. Popularity of DVR devices is leading to declines in live viewer-ship as more people are recording content to watch later. It’s very likely that a significant number are skipping through commercials while viewing their recordings. According to an IBM study, 25% of US households own a DVR device, and 53% claim the majority of their TV viewing are recordings.

In addition, the proliferation of available television channels and content has dispersed the audience around the dial. This implies that on any given channel, there are less viewers. Audience dispersion encumbers advertisers seeking a mass audience in a single place (network TV). Declines in TV advertinsing will result in increases in web advertising.

User-generated content, such as videos found on YouTube are boosting web usage. The explosion of blogs, as well as more free content from the media and press are also catalysts. Print readership, newspapers and magazines, is declining, yet readership online is growing. Advertising spending will follow audiences online, and Google is well-positioned to benefit.

Market Share Growth:
Google’s share of online search is more than 65%, while Yahoo, the closest competitor, is only around 20%. Google’s share has been rising, while Yahoo’s has been falling. Google’s search engine is far superior to the alternatives, so much that “Google it” has become part of the English lexicon. As the web continues to expand, search is critical for navigation, thus Google will always be relevant.

Google dominates the paid-search category, which generated high ROI for advertisers. Yahoo has been stumbling for the past few years which has allowed Google to build a sizable lead. The fact that Microsoft is making a bid for Yahoo, is an admission that it can’t compete with Google. I don’t know that buying a company that can’t compete with Google either, will help Microsoft. I believe that the merger discussions are a distraction for both, and are giving Google the opportunity to further increase its lead.

Google’s growth potential is just not limited to paid search. Implementing ads in YouTube videos presents another avenue for growth. The acquisition of DoubleClick will boost display advertising revenues. In addition, Google has been experimenting with online applications for software as a service (SaaS) possibilities.

Valuation:
According to Yahoo Estimates, Google is expected to earn $19.98/share for FY08 and $24.91/share for FY09. Google trades at 22x and 17.6x FY08 and FY09 EPS, respectively. A 22x multiple is attractive considering the growth potential and its duration. Google is highly profitable, with operating margins over 30% and a net margin around 25%.

In comparison, Amazon’s multiple is 46 and Yahoo is trading at a 60 multiple. Google is more profitable, and I believe has better growth prospects than the two.

My discounted cash flow model returns a fair value of $537. Sales are assumed to grow 25% per annum for the next five years, then for years 6-12 growth steadily decreases to 3%. Operating margin assumption is 30% for the next five years then decline to 18% in the next 7 years. I believe these are conservative assumptions and suggest that Google is undervalued by almost $100.

One caveat, is that current earnings estimates may be too high, thus Google’s actual multiples are higher. While this might make Google less attractive, I think the focus should be on Google’s industry position, industry growth and duration.

Risks:
A significant risk is that Google will squander shareholder value by making poor investments. Google is actively exploring multiple new forms of growth, which can be both positive and negative. Firms must take risks to create value; however, taking the wrong types of risks can be detrimental.

Summary:
Google’s strong brand and dominant position in search guarantees strong growth and profitability for many years. Online advertising will continue to increase, and Google is well positioned to capture those ad dollars. Google’s valuation is attractive, 22x this years estimated EPS given 28% growth. Even if Google’s growth turns out to be less than expected, the length of time that growth will be above average, will be longer than expected. This is primary point that the market is missing.