M6.3 Reverse Engineering Google: How Do I Understand the Market s Expectations?

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1 M6.3 Reverse Engineering Google: How Do I Understand the Market s Expectations? After coming to the market at just under $100 per share in a much heralded IPO in August 2004, Google s shares soared to over $700 by the end of The firm, with revenues tied mostly to advertising on its web search engine and web application products, held out the promise of the technological frontier. It certainly delivered sales and earnings growth, increasing sales from $3.2 billion in 2004 to $16.6 billion on 2007, with earnings per share increase over the same years from $2.07 to $ One might be concerned about buying such a hot stock. This case asks you to challenge the market price of $520 in mid-2008, but to do so by challenging the forecasts implicit in the market price. Those forecasts are teased out using the abnormal earnings growth valuation model to understand the earnings forecasts implicit in the market price of $520 in mid A. Working with analysts growth estimates. First, work with analysts two-year earnings forecasts and their five-year growth rate. The pro forma below uses the forecasts for 2008 and 2009 with subsequent EPS growing at the forecasted rate of 28 percent per year 2007A 2008E 2009E 2010E 2011E 2012E DPS EPS DPS reinvested ( x DPS t-1 ) Cum-dividend earnings Normal earnings (1.12 x EPS t-1 ) Abnormal earnings growth (AEG) Discount rate (1.12 t ) Present value of AEG Total PV of AEG Continuing value (CV) PV of CV Total earnings to be capitalized Capitalization rate The continuing value calculation: Accrual Accounting and Valuation: Pricing Earnings Chapter 6 p. 135

2 While analysts forecast a 5-year growth rate, they do not forecast the growth rate for the long term. The valuation applies a 4% long-term growth rate, the average GDP growth rate. With this growth rate, the value per share is $699.58, considerably higher than the market price of $520. The 4% GDP growth rate is typical for the average firm but Google is presumably above average. The 4% rate is applied to an AEG at the end of 2012 that reflects analysts (abnormal) growth expectations up to that point. So it looks as if the analysts are too optimistic in with their 5-year growth rate (or Google is forecasted to have considerably lower growth rate in the longer term). Or, of course, Google may be underpriced. Analysts 5-year growth rates, it should be noted, are notoriously over-optimistic on average, particularly for hot stocks. The rest of the case asks you to infer the market s forecast by anchoring on only two years of analysts forecasts. B. Reverse Engineering the market price of $520 with two years of analysts forecasts The AEG formula for the reverse engineering is: The solution is: P 2007 $ g g = (a 7.2% growth rate) Now apply this growth rate to 2009 AEG to get the market s forecast of AEG for From this AEG forecast, reverse engineer the formula for AEG to get EPS and EPS growth forecasts: Earnings forecast = Normal earnings forecast from prior year + AEG Forecast of earnings from prior year s dividends Google has no dividends, so the earnings forecast is just normal earnings plus AEG for the year: (1) EPS (2) AEG (growing at 7.2%) Accrual Accounting and Valuation: Pricing Earnings Chapter 6 p. 136

3 (3) Normal earning (at 12%) EPS growth rate 22.44% 21.16% 20.11% 19.23% 18.50% 17.88% Line (3) is prior year s earnings growing at 12%. So, in 2010, $ = $ Line (2) is AEG of $2.05 in 2009 growing at 7.2% Line (1) = line (3) + line (2). See equation (6.6) in the text for the modification in the case of dividends. The EPS growth rates decline over time which is what one would expect as a firm matures. These growth forecasts are considerably below the 28% forecasted by analysts. Unless the analysts are seeing a big drop in growth rates after 2012 (unlikely), their forecasts do indeed look optimistic. C. The building block diagram $520 Current market value $ $ $ $ Capitalized forward earnings (1) Value from Forward earnings (2) Value from Short-term forecasts (3) Value from Long-term forecasts Accrual Accounting and Valuation: Pricing Earnings Chapter 6 p. 137

4 Block 1: Forward earnings (for 2008) capitalized = $ Block 2: AEG in 2009 capitalized as a perpetuity (no growth) = $ Total for Blocks 1 and 2 $ Block Market price $ $ $2.05 = = Block 3 is a plug. It is part of the market price not explained by two years of earnings expectations. It is the part of the market price that is due to speculation about further growth in the long term (after the two years). Note that Block 2 capitalizes the $2.05 AEG as a perpetuity (without further growth) by capitalizing it at 12% and then converts this additional flow to a stock of value by capitalizing it at 12%. Here are the EPS growth rates (from the calculations in Part B above). Accrual Accounting and Valuation: Pricing Earnings Chapter 6 p. 138

5 EPS Growth Rate 23.00% 22.00% 22.4% 21.00% 21.2% 20.00% 20.1% 19.00% 18.00% 19.2% 18.5% 17.9% 17.00% D. Challenging the Market Price The market s speculation in Block 3, as distilled into expected earnings growth rates, is the focus of the challenge. One would conduct an analysis of Google to see if the growth rate path in the graph is reasonable. It one could not justify the growth rates, Google would be a SELL. If, on the other hand, one saw growth rates higher than the path, one would BUY. PEG ratio = Forward P/E EPS growth rate two years ahead 22.4%) = = (the two-year-ahead growth rate is $24.01/$ = This is fairly close to 1.0, which is (said to be) the PEG for a fairly priced stock. But note that the 1.0 benchmark is strictly appropriate only if the required return in 10%. For a required return of 12% and thus a normal forward P/E of 8.33, the benchmark PEG is 8.33/12.0 = But the PEG is dangerous. The P/E in the numerator also prices expected growth in later years (after two-years ahead). E. Inverting to the expected return With a growth rate of 6%, one can invert to the expected return, as follows: Accrual Accounting and Valuation: Pricing Earnings Chapter 6 p. 139

6 P 2007 $520 1 X X 1.06 The solution is: X = , or approximately 11.3% So, if you see a 6% growth rate, then the stock yields you an expected return of 11.28%. If your required return is 12%, then you are indifferent to buying this stock. If your required return is less than 12%, then you might BUY. There a bit of a fudge here, however, because the AEG for 2009 is based on a required return of 12%. The formula 6.5 in the text gives the answer without building this in: The answer is 11.42%. You might prefer to reverse engineer to the expected return rather than the growth rate if you feel you have a good handle on the growth rate or if you are using a maximum or minimum growth rate you see possible (as here). Accrual Accounting and Valuation: Pricing Earnings Chapter 6 p. 140