When looking for places to invest excess cash in an overbought market it is important to not only look at your upside potential, but also how much downside there is as well. If stocks are overdue for a drop, you want to make sure you aren't buying something that has a lot of air in it that could be let out quickly in a selling frenzy.
I have been warming up to shares of Google (GOOG) more and more as of late because the stock has been dead money while the company's impressive growth continues. The result of that dichotomy has been a share price that is getting more reasonable on a valuation basis. On Thursday I began initiating Google positions in some of my accounts that had sizable cash reserves.
Long time readers may know that this will be my second bullish call on Google since the company's IPO in August 2004. Like most people I sat out the IPO after the company indicated the stock would be sold well north of $100 per share. After the first round of their auction, the actual price was reduced to $85 per share, but those who didn't bid in round one were locked out of bidding at the lower price.
After the stock began trading it became apparent to me that investors were dramatically underestimating the company's earnings power and incorrectly associating their misfortunes during the Internet bubble with Google's future. I was late to the party, but began buying Google at around $180 per share.
The stock's ascent continued and by early 2006 I had sold my entire position at prices as high as $467 per share. At the time it appeared the Street was aware of the company's earning power, resulting in a fairly valued stock. Since then I have suggested being long Google as part of a paired trade, but have not jumped back in exclusively from the long side. Let me explain why that changed on Thursday.
There is no doubt that Google has tremendous potential to expand its dominance in coming years. That said, there are no assurances that the company's foray into international markets and domestic markets outside of online search will be successful. So, in order to be willing to make a long bet on the stock, I needed to feel comfortable that my investment downside was fairly limited despite the risks the company faces. At the current price of $461 per share, I feel that is the case. As you can see from the chart below, GOOG sits at the same price it was 16 months ago.
How do I arrive at that conclusion? Some simple math really, no rocket science or anything. Current estimates for Google's earnings are $15.12 per share in 2007 (growth of 43%) followed by a 27% increase in 2008 to $19.25 per share. I decided to use what I consider to be conservative assumptions in order to do a risk/reward calculation. Very simply, what is my downside and what is my upside? If the risk-reward trade-off seems intriguing, then Google shares look attractive at $461 each.
First, what is my downside? Let's assume Google earns $15 this year ($0.12 below current estimates) and only manages 20% growth in 2008, to $18 in earnings per share ($1.25 below current estimates). Let's further assume that Google trades at a P/E of 25 next year. I think both of these assumptions are extremely conservative. A 25 P/E on $18 in earnings gets us a stock price of $450 per share. In my opinion, that is my downside over the next 12 to 18 months, less than 3 percent!
Let's compare that to the upside. Again, I'm not going to make overly aggressive assumptions here. I want the numbers to be in reach and doable, but also want to be realistic as well as conservative. For this scenario I am going to take the current consensus earnings estimate of 27% growth in 2008, to $19.25 per share and assume that the company continues to beat estimates by a modest amount. It would not be surprising at all to see 2007 EPS numbers head to toward $16.00 by year-end and 2008 numbers to actually come in closer to $20.00 per share. Further, let's assume GOOG trades at a P/E of 30.
That multiple may seem high given that the market trades at half that valuation. However, I am fairly confident Google will grow at least 20% per year over the next few years, so assuming that growth investors will be willing to pay 30 times earnings for the stock is fairly reasonable. It would be in-line with valuations given to other leading Internet companies, as well as growth stocks such as Starbucks (SBUX).
Quick math tells us that a 30 P/E on profits of $19.25 to $20.00 in 2008 implies a stock price of $577 to $600 per share. Even if we use a more conservative P/E of 25 instead, we get to $481 to $500 per share. Accordingly, the upside is as much as 30% by the end of 2008. Compare this with downside of less than 3% and you can see why I think Google stock in the low 460's is a good investment, even in an overbought market such as the one we are seeing right now.
Full Disclosure: Long shares of Google at the time of writing