Tin, while not ranking as high as mercury, is still a weak metal. And many investors continue to exhibit its malleability, over-reacting to a single quarter’s financial results, even for firms which have growing cash flows, have added value during the quarter, and possess strong financial structure and flexibility.
Investors must understand that firms do not operate with the smoothness of a well-crafted tool. They are not machines- yet enterprises that are well managed will continue to build value, even during periods when planning, rather than providing actual results, take place. For example, smart managers acquire during recessions, and aren’t afraid to do so, a time when weak firms are forced to sell assets.
This leads me to Google.
Google disappointed investors during its first quarter due to a perceived lack of financial discipline, as operating expenses rose over twice as fast as its 27% revenue growth; the company hired over 1900 new employees, handed out large salary raises while boosting other discretionary expenses, especially marketing. While GAAP based income disappointed, normalized free cash flow growth clearly exceeded our model’s metrics. Revenues represent a lofty model weighting as discretionary expenses can typically be controlled, while product acceptance reflects the quality of and demand for the product or service. This is not to downplay expense control, as efficiencies including improvements to supply chain and other direct expenditures have the same effect as boosting cash flows and hence, market valuation. Clearly, Google’s products are being very well received in the marketplace with collections from customer receivables growing at a near 24% rate.
With Google selling at 6.1% yield on enterprise value, we view its stock quite appealing, and can point to any number of lower quality companies selling at considerably higher valuations. Although Google shares are currently fair valued at $604 a share, that estimate would jump if managers keep expenses and margins in line and revenues grow as expected.
Obviously, if Google needs to continue to write $500MM checks to settle lawsuits, its fair value will fall and cost of capital will rise. However, its very strong and predictable near-term free cash flows can fight off these legal issues assuming they can indeed be put to an an end. Given the sensitivity analysis below, using our free cash flow model (please refer to Security Valuation and Risk Analysis), current fair value for Google is sufficiently above its current price. The 18.5% tax on repatriation represents the company’s five year average cash tax rate, based on Google’s net cash of $32 billion.
Google Fair Value Sensitivity Using CT Capital Free Cash Flow Model
Disc Rte. Probability FV
7% 10% $732.04
8% 10% $642.04
8.25% 10% $621.91
8.50% 15% $602.64
8.75% 20% $584.18
9.00% 20% $566.49
10.00% 15% $502.76
Fair Value Cash Flow 100% $595.54
Net Cash/Debt* 8.1
Fair Value Per Share $603.64
*includes tax on repatriation and working capital
Note: Google shares are held by clients of CT Capital LLC.