FINC 554 Investment Banking

Names:

Ali Geramian & Dinh Ton

Assignment:
Date :

Google, Inc.
February 11, 2013

Section (circle)

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This assignment exclusively represents our own work. We have not discussed this case or this assignment with anyone and have done no outside research unless specifically authorized to do so. We have not discussed this work with any other students past or current nor have we reviewed any related work product prepared by such students. We have complied with the requirements of the Georgetown Honor System.

Signed__________________________________________________________________

1. Our review of the 4 analyst reports yields the following common themes: A) All reports are bullish on Googles 2009 stock forecast; B) All use P/E ratio as part of their valuation method; and C) All EPS estimates, which exclude stock compensation, are in the range of $18.90 to $22.20. (Please refer to Exhibit 1 for more details). We will explore each report in more detail: Credit Suisse: Of the 4 reports, Credit Suisse achieves the most conservative price target at $400 per share based on a 5-year DCF analysis. Adverse macroeconomic factors are reflected in a comparatively high WACC of 13%. Terminal growth rate is responsibly estimated at 3%. Credit Suisse follows up with comparable P/E ratio analysis, which yields a price target of $339/share based on 17.9x 09 EPS of $18.9 and a 7.7x EV/EBITDA multiple. These estimates place a slight premium the industry averages of 16x P/E and 9x EV/EBITDA. Credit Suisse predicts a cautiously optimistic stock appreciation of 13% over current price of $353. Morgan Stanley: This report employs a 10-year DCF analysis to obtain a price target of $490 per share. Projected FCF growth is based on business-specific metrics such as paid click growth, acquisitions and other performance metrics. Unlike Credit Suisse, Morgan Stanley utilizes an optimistic WACC of 11.5% and an extremely high growth rate of 6%. The current volatile macroeconomic environment is only reflected in the downside case. Using the P/E multiple method, Morgan Stanley valued Google at $488 based on a P/E ratio of 22x (09 EPS is projected at $22.20). Morgan Stanley is extremely bullish on Googles valuation, predicting a 38% appreciation in stock price over the next 12 months. Deutsche Bank: Similar to Morgan Stanley, this report values Google at $480/share primarily based on a 22x P/E ratio and 13x 09 EV/EBITDA multiple. These multiples are justified by Googles 20% profit growth (compared to peers average growth of 10%), though Deutsche

Bank assigns a significant premium of 6-7x above the peer groups 16x. Similar to Morgan Stanley, Deutsche Bank also supports its price target utilizing a discounted cash flow analysis using WACC of 11.7% and EBITDA exit multiple of 14x. Deutsche Bank is also highly bullish. Merrill Lynch applies a P/E ratio of 21x and EV/EBITDA ratio of 9.2x to arrive at a price target of $466. Merrill Lynch, however, does not attempt to value Google utilizing a DCF analysis. Justification for these multiples is based on Googles strong performance in adverse economic conditions and its ability to control expenses. Though not as bullish as Morgan Stanley and Deutsche Bank, Morgan Stanley predicts a 32% appreciation in Google stock price. Based on our analysis, we believe that Credit Suisses DCF analysis is the most appropriate method to value Google. Due to Googles unique position in the industry and its lack of true comparable companies, we prefer a DCF-based valuation approach as opposed to a P/E multiple analysis. Credit Suisses thorough consideration of macroeconomic conditions (higher WACC), microeconomic drivers (industry demand, barriers of entry) and operational metrics (ROIC) results in the most objective valuation. Moreover, Credit Suisses conservative terminal growth rate and multiples are more suited for the current economic conditions. 2. As three of the banks heavily rely on P/E multiple for their valuation, we decided to take a critical look at this method. Since the capital structure of most large-cap high tech companies are similar (most do not carry debt), P/E ratio valuation is an acceptable methodology. However, a common theme throughout these reports is that the analysts seem to ignore Googles stock-compensation expense while estimating EPS. According to Martin Peers, Google's $1.1 billion in stock-compensation expense in 2008 amounts to 5% of revenue;

including it reduces net income 17%.1 We believe that utilizing a GAAP-compliant EPS will give us a more appropriate price forecast. Using Merrill Lynchs estimated 2009 GAAP EPS of $18.77 and the chosen P/E ratio of 21x, we calculate a target price of $394/share (rather than the published $466 estimate). Furthermore, Merrill Lynch does not support its estimated target with a DCF approach or any other complementary methods, which casts doubt on the validity of its valuation. Similarly, Morgan Stanley estimates a 2009 EPS of $22.20. Reducing this number by 17% (utilizing the method laid forth by Martin Peers) to $18.43, we obtain a new price of $405/share (based on a 22x multiple). Additionally, as we are concerned that Morgan Stanleys DCF analysis produces a drastically different result from Credit Suisses analysis, we also take a closer look at its projected cash flow: Unlevered FCF 5,293 5,249 6,086 6,931 7,545 8,142 8,750 9,264 9,593 9,940 FCF Growth (our calculation) -0.8% 15.9% 13.9% 8.9% 7.9% 7.5% 5.9% 3.6% 3.6% From our calculations, we see that the FCF growth slows down to 3.6% in 2017, which is a large discrepancy from Morgan Stanleys overly aggressive terminal growth rate of 6%. Recalculating the terminal value using a more responsible growth rate of 4%, we obtained a new price per share of $404. (See Exhibit 2 for detailed calculation). Adjusting Morgan Stanleys valuation techniques produces results similar to Credit Suisses findings. We believe that the Deutsche Bank report contains glaring inconsistencies. The report values Googles stock at $480/share based on the unadjusted EPS of $21.45 and a 22x multiple. However, when calculating the price based on these same assumptions, we obtain a price
1

Peers, Martin. "Analysts, Expensing Isnt Optional" Heard On The Street. www.wsj.com. January 31, 2009.

target of $471.90/share. Later in the report, the analysts state that $480 price target is based on a 23x multiple, which according to our calculation equals to a price target of $493.35/share. Additionally, the analysts state that the price objective is supported by a discounted cash flow model utilizing a WACC of 11.7% and EBITDA exit multiple of 14x. The analysts fail to address the assumptions behind these valuation metrics and why a 4 year forecast was deemed appropriate. Finally, we are somewhat critical of Deutsche Banks decision to build in a significant effect of foreign-exchange hedge to EPS ($.50-$.74 per share). Credit Suisses DCF analysis proves to be the most conservative approach of all four banks, which is more desirable given the current macroeconomic conditions. We are however, concerned about the short projection period of 5 years. Unlevered FCF FCF Growth $6,247.80 $8,059.10 29.0% $10,402.80 $11,888.40 $13,262.80 29.1% 14.3% 11.6%

As illustrated above, Credit Suisses terminal growth rate of 3% presents the cliff problem when the growth rate falls from 11.6% in the final year. A longer forecast period that allows g to gradually decrease to 3% should produce a more accurate result. Our attempt at this longer projection yields a slightly higher price of $422 (Exhibit 3). Our other concern is that Credit Suisses P/E multiple analysis yields a price of $339, a significant deviation from its DCF result of $400. This inconsistency may imply that Googles stock is being overvalued. As an effort to mitigate the inconsistencies among the banks valuations, we perform a sensitivity analysis on different reported P/E ratios, using GAAP-adjusted and non-adjusted EPS (Exhibit 4). We arrive at a median price of $391.92, which confirms our earlier suspicion that analysts are overestimating Googles value.

3. Our view of Google as a long-term investment is most influenced by the Credit Suisse report. During this period of extreme volatility and economic contraction, we expect to see objective analysis that takes into account the current macroeconomic conditions while focusing on a companys long-term prospects. As part of its DCF valuation, Credit Suisse accounts for the turbulence in the financial markets by increasing the cost of capital to a conservative 13%. Credit Suisses carefully chosen business-specific metrics such as revenue growth, Web search growth and Googles share of query volume (page 136) gives us confidence in their 5-year FCF projection. Furthermore, Credit Suisses long-term optimistic view of Google is supported by upside opportunities that Google is uniquely positioned to benefit from, particularly its early stage initiatives in display/mobile/video advertising, cloud computing and ad exchanges. Exhibit 236 in the report demonstrates that Googles Y/Y excess return (ROIC-WACC) is consistently above 40%, indicating that Google has room to grow over the coming years. Additionally, Credit Suisses confidence in Googles operational efficiency by projecting a ROIC of 94% in 2013 further shapes our view that Google is an excellent long term investment opportunity.

Exhibit 1. Comparison of Valuation Approaches at a Glance

Credit Suisse Price Objective Estimated Stock Appreciation % Methodology DCF $400 13% Morgan Stanley $490 39% Deutsche Bank $480 36% Merrill Lynch $466 32% Comments Median Price: $473 Stock Price as of 10/08: $353.02

P/E Ratio

5-year projection, g=3%, WACC = 13% 17.9x '09EPS of $18.9

10-year projection, g=6%, WACC = 11.5% 22x of '09 EPS of $22.20

4-year projection, WACC=11.7% 23x of '09 EPS of $21.45

N/A

21x of '09E EPS of $22.20

EV/EBITDA Multiple Key Value Drivers Macroeconomic Environment Paid Click/CPC Growth Revenue/Earning Growth Operational Efficiency

7.7x EV/EBITDA

N/A

13x '09 EBITDA Uncertain 18%/8% 20% Operating margin improved to 49% Uncertain 18%/8% 18%

9.2x '09 EBITDA Uncertain

All EPS estimates exclude stock compensation. Peers' average is 16x Peers' average is 9x

Uncertain (higher WACC) 13% paid click growth 19% ROIC=70% in 2007

18% CapEx control, growing EBITDA margin

Exhibit 2. Recalculation of Morgan Stanleys DCF-Based Equity Value at g=4% Given Forecast Period (Years) WACC G PV of TV NPV of Cash Flows Cash and Equivalents # outstanding shares Recalculation PV of TV at 2017 FCF at 2017 New g TV at g=4% EV at g=4% Implied Equity Value Per Share

10 11.50% 6% 97,631.00 $43,266 $15,514 319

289,959 15,045 4% $70,245 $129,025 $404

Exhibit 3. Recalculation of Credit Suisses DCF at 10-year forecast

WACC Shares Outstanding Unlevered FCF FCF Growth NPV of Cash Flows NPV of TV at 3% Off-Balance Sheet Assets Net Debt Equity Value Equity Value Per Share 62,711 49,027 350 (22,710) 134,798 422 13.2% 319.8 $6,248 Year $8,059 29.0% 10 $10,403 29.1% $11,888 14.3% $13,263 11.6% $14,451 9.0% $15,318 6.0% $15,931 4.0% $16,409 3.0% $16,901 3.0%

Exhibit 4. Sensitivity Analysis on Banks Valuation Using Adjusted/Unadjusted EPS P/E Ratio 21.0x $329.43 $373.87 $386.95 $396.90 $450.45 $466.20

GAAP adjusted '09E EPS

Unadjusted '09 EPS

$15.69 $17.80 $18.43 $18.90 $21.45 $22.20 $391.92 $281-$511

17.9x $280.80 $318.68 $329.83 $338.31 $383.96 $397.38

23.0x $360.80 $409.48 $423.80 $434.70 $493.35 $510.60

Median Price Per Share Range