BUSINESS BLOGS
BUSINESS BLOGS
category: business
23 Oct 2006

So I got your attention, now let’s see if I can keep it.

At the time of this writing, Google had far surpassed Yahoo! in terms of market value ($130 billion to $30 billion) but still trailed Microsoft ($284 billion).  A tale of the tape suggests that MSFT merits the higher market cap: in 2005, MSFT generated net income of $12 billion off $39 billion in revenues; in 2006, it’s on pace to generate another $12 billion on increased revenues of $44 billion.  As the numbers suggest, Microsoft is so large that it finds growth harder to come by.  It is by no means a mature company in the utilities sense of the word, but indeed, some would say that MSFT has lost its way (click here for O Microsoft , Microsoft ! wherefore art thou Microsoft).

Google, on the other hand, is a much younger company and has been growing at a torrid pace:

Looking at its recent finances on the Google Investor page, you can see that revenue growth has fallen but remains impressive:

- 2002 revenues grew 409%
- 2003 revenues grew 234%
- 2004 revenues grew 118%
- 2005 revenues grew 92%
- 2006 look like they will be growing at least by 70%.

While Google is anything but mature, one can tell that its revenues are growing, but at a slower rate.  We can estimate that its 2007 revenues can grow by 50%, 2008 revenues can grow by 40%, and thereafter, the company’s revenues will grow at some 30% annual clip. 

Of course, YouTube’s notwithstanding, companies are judged by profits or income, not revenues.

Google is an interesting case in that it model is so systematic and automated, that its degree of financial and operating leverage are very high, you can note for example that this most recent quarter, its revenues grew 70% while its profits grew an astounding 92%. 

Google has historically seen net income weigh in at 25% of revenues.  As such, to estimate future profits, we will estimate that Google will maintain 25% profit margin.  This assumes that the company will be reinvesting its mushrooming revenues in the company.

Projecting these growth rates onto the company’s historical performance and 2006’s pace, one can see that Google’s revenues will spiral to $34 billion in 2010.  That is a very daunting task.  What’s the first thing you’re taught in finance class?  Historical performance does not guarantee future performance.  So there is no guarantee that Google can maintain growth rates of 70%, 50%, 40% and 25% in 2007, 2008, 2009 and 2010.

What’s more, Google currently makes 99.9% of its revenues from paid search.  So this all assumes that paid search continues to grow.  Of course, paid search is growing, as are other areas of online advertising.  Just this past month, Morgan Stanley’s Mary Meeker came out and boasted that the US online ad market would be a $32 billion one by 2010, upping eMarketer’s $25 billion estimate.  Mind you, both eMarketer and Mary Meeker have a lot to gain by pumping these numbers, that’s how the system works.  And admittedly, I am certainly not drinking the Google koolaid and implying that Google will be making $32 billion in revenues by 2010 or that it will be worth more than Microsoft in 2010, I am trying to show that numbers can be played with.  When I’m not writing on this site, I’m busy building a company where interested parties ask me to define the market we’re going after, formulate a valuation for our company and what not, I do it as a fun exercise but am the first one to show how laughable such models are… just as crazy as RBC’s Jordan Rohan to come out and say that MySpace could be worth $15 billion in a few years.  The problem is that he’s paid to come up with such models, I’m not.  Point is: if Myspace and its social sexual predators can be worth $15 billion, heck, why can’t Google be worth more than MSFT?  I’ve argued that Google is well on its way to become the Standard Oil or MSFT-esque monopoly of the 21st Century.

Anyway, enough social commentary.  Where were we?  Right, Google is set to take over MSFT in terms of market cap by 2010. 

Right now: Google is at $130 billion while MSFT is at $280 billion.  That’s less than 4 years to increase by $150 billion.  And yes, that assumes MSFT does not increase in value.  Is that realistic.

Since peaking in 1999 at around US$119 (US$60.928 adjusting for splits), MSFT has gone down and traded within a frustrating range with no light at the end of the tunnel.  Nonetheless, it has steadily increased revenues and profits.  So we are making a simple assumption: we do not doubt that MSFT will increase revenues and or profits, but in light of the fact that the stock has been stuck in a rut for half a decade, we have no reason to suspect it will be higher in three years.  We realize it’s an oversimplified basis for debate, but if you disagree, come up with your own model.  Yes Jordan, that’s a challenge.

So this exercise is trying to assertain what kind of valuation we think Google could have in 2010.  We said that given our projected growth in revenue, Google can make $34 billion by 2010.  We know that the entire US online ad market is set to fetch $25 billion to $32 billion in America alone.  It must be true since eMarketer and Morgan Stanley said so.  Of course, the $34 billion Google revenue figure is for international sales, whereas the figures being brandied by eMarketer and Morgan Stanley are for the US alone.

In Google’s most recent quarter, it generated some 44% of its revenues from abroad, outside of the US.  So assuming Google will in the long run generate some 50% of its revenues from outside of the US, that’s $17 billion from the US and $17 billion from non-US nations. 

Is this realistic?  Today, we see that Google commands a 50% market share of the queries conducted in the search engine industry.  We’ve also seen Google command a whopping 25% of the total online US ad industry in terms of dollars.  Add to these numbers the fact that paid search commands some 40% of the overall online market and the fact that over time, Google will hold higher market share in non search areas of online advertising and it is very plausible that if all of these macro level trends hold up, it is not inconceivable for Google to generate $17 billion in paid search, video, display, classified revenue in the US out of a total market of $32 billion (using Morgan Stanley’s figure). 

Yes, that means that Google will command more than $1 out of every $2 of ad spending in the US in 2010.  I personally think that this is not realistic, but if you simply look at Google’s growth rate, it would not be inconceivable for Google to generate that much.  What is more likely (in the event Google were to maintain revenue growth rates and hit that lofty number) is that Google’s many investments in new markets finally pay off and other departments kick in revenue-wise.

More importantly, every time the eMarketers and company increase total ad estimates, it comes off the heels of Google’s homerun numbers.  Fittingly, Google is the one micro factor that impacts macro trends.

So, if Google can generate some $34 billion by 2010, assuming it can maintain a 25% profit margin (which it has historically) then Google will make some $8.2 billion in profit by 2010.

Today, Google commands a price / earnings ratio of 55.  A P/E is simply how much investors are willing to play for one dollar of earning; a P/E of 55 implies that Google’s growth rate (and everything else) is so impressive that Google are willing to pay $55 for the right to own that $1 of earning.  Legendary investors Ben Graham and Warren Buffett would tell you to buy companies when P/Es hit 15 and sell them when they reach 30.  Of course, neither men would invest in Google, though there has only been one sure-thing investment since Google’s IPO, and it ain’t MSFT.

Alas, today Google commands a P/E of 55, in 2007 we believe it will fetch a P/E greater or equal to 50, in 2008 that might fall to 45, in 2009 it will further fall to 40 and in 2010 the famous P/E might be in the 35 range.  At that time, Google will be 15 years old.  Not that age is everything, but MSFT is 30 today and commands a P/E of about 25 (according to Yahoo! Finance); Yahoo! is 10 years old now and commands a P/E of 27 (again taken from Yahoo! Finance).

So in 2010, Google’s current historical growth rate projects a revenue figure of $34 billion, with 25% profit margin of $8.2 billion, and with a P/E of 35, could technically command an enterprise value of $287 billion.  It currently boasts some $10 billion, so at these levels, it would carry enough cash to push up its market cap northwards of $300 billion.

Today, MSFT has a market cap of $284 billion, and that includes a wallop of cash.

Tale of the tape: Google $287 billion; MSFT $284 billion…

There you have it.  Told you it’s not a bubble, we’re actually talking revenues, profits and P/E.