Posted July 24, 2007 10:30 am by with 8 comments

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Mr Impossible Here’s a wake-up call for every investor that was disappointed in Google’s recent financial numbers – you’re expecting the impossible out of the company!

According to Fortune, it’s virtually impossible for Google to live up to the expectations of its current stock price. A quick explanation. When you buy a stock, you shouldn’t buy based on the company’s current valuation or profits. Instead, most investors value a stock based upon the expected future value.

Specifically, a stream of future profits, in particular what’s called economic profit or economic value added (EVA), the dollar amount by which return on capital exceeds the cost of capital.

Ok, still with me? Fortune asked analysts to calculate how much Google would have to grow, in order to match the expectations set by its current stock price.

To live up to the expectations embedded in its current share price, Google would have to increase its EVA, which was $2.4 billion for the past four quarters, by $2 billion annually this year, next year, and every year into the future – forever. So Google’s EVA next year would have to be $4.4 billion; in five years it would have to be $12.4 billion, and so on.

As Google continues to mature, it can’t possible maintain this kind of growth. As Fortune points out, it doesn’t necessarily mean Google’s stock is overpriced – if all companies were valued by EVA we wouldn’t need brokers and analysts – but it does suggest that the company may continue to see a correction in its share price.

  • Very sensible post Andy. I couldn’t agree more, EVA is just a pattern that is taken into account by the brokers, who in fact are the ones who set the real stock value.

  • I agree. I only wish I could not meet expectations the way Google did last quarter.

  • This is interesting stuff – not least because as I understand it (I don’t own any Google stock, so I haven’t looked into it closely) all of the stock is non-voting and so in many ways there isn’t even a pretense of you really ‘owning’ a bit of the company.

    Given that you can’t vote (and they don’t pay dividends – or at least didn’t last time I checked), it’s kinda hard to know how to value them from an expected future value perspective.

    So I think there are potentially bigger problems than whether the implied growth is possible…

    I would like to have owned some Google stock (obviously) with hindsight, but I am still amazed by how well it has been performing – by my reading the valuation pretty much implies that Google will own the universe by next Tuesday.

    Of course, let’s not discount that possibility….

  • G-watch

    Any star Internet company who gets into “Domain Registration” and “Web Hosting” is doomed!

    Common sense tells that Internet companies gets into web hosting when they fear that their main income stream will collapse…..

    See what happened to Yahoo after they got into domain registration and web hosting and now google is following the same path, history repeats itself…..

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  • The old principal was buy low sell high – google is too high for the average person anyway…..
    But I would love it if Google bought Weblo:
    It’s sort of like second life.

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  • Read this article from Fortune in 2004 some quotes:

    “But the doubters–and there are many–point to shadows in the nursery: questions about Google’s geeky, dot-com-era management style and the possibility that it can’t cope with growth; recent sales of stock by insiders and other major stakeholders (including Time Warner, FORTUNE’s parent and owner of AOL, which lately unloaded $188 million worth); and increasing pressure from Microsoft, Yahoo, and other formidable rivals that would like to crush this infant in its crib”

    “Goldman Sach’s Anthony Noto recently assumed that earnings could also rise by a 25% annual rate through at least 2009, which then justified his new “target price” of $215.

    Now let’s check such math and figure out just where it implies Google might be ten years out. Assuming 20% annual returns from that $165-a-share level (a reasonable investor expectation given the risks), its market cap would soar from around $45 billion today to $278 billion by 2014. That is a lofty height where only a handful of blue chips stand today–GE, Exxon Mobil, Wal-Mart, Citigroup, Pfizer, and Microsoft, to be precise. Dazzling? Yes. Doable? Only if everything over the next ten years goes right.”

    Yes Google is priced to perform well (and if they fail to do so the price will go down). It is great if you can buy a good stock cheaply but often you are better paying more for a very well managed company than buying cheap companies (by PE, cash flow or EVA or whatever measure you want to use). I don’t think Google investors are betting on impossible growth but time will tell. And the internet makes it easy to see what people predicted previously so we can all see who was right in 10 years.

    For more see