Graham analysis of GOOG

Note: slightly edited from first post.

To try to remember some principles of The Intelligent Investor by Benjamin Graham, I thought I would apply some of the analyses to Google. I own some Google stock (GOOG) because I used to work there. When Graham says "the defensive investor" he is talking about someone who is not willing to spend the equivalent of a full-time job (whether professional or amateur) tracking stocks.

Page 159: "For the defensive investor we suggested an upper limit of purchase price at 25 times average earnings of the past seven years." Google has only been public since 2004, so it does not have seven years of history.

Page 259: Simplified formula for valuation of growth stocks:

value = (current (normal) earnings) * (8.5% + (2 * (expected growth rate)))

or

P = E * (8.5 + 2*G)

or

P/E = 8.5 + 2*G

On the flip side, given the price/earnings ratio, one can calculate what the market is predicting for the expected growth rate by solving backwards:

G = (P/E - 8.5)/2

GOOG has a P/E of 38.25, which corresponds to an annual growth rate of ~14.9% or 401% in ten years. Wow!

Page 290:

Factors affecting capitalization:

1. General long-term prospects.

GOOG does not seem to be taking huge special charges or borrowing lots of money, and it has lots of different customers, although only one real source of revenue (ads make up 99%). The company has a very strong brand, and somewhat of a "moat" (people won't switch search engines quickly, especially if they are tied to other apps). The company has a famously long-term focus, and spends 10% of money on 'crazy' R&D.

2. Management.

I think the management team has been executing pretty well, through boom and bust times for the market.

3. Financial strength and capital structure.

Strong. No debt, few liabilities, a building up of cash.

4. Dividend record. "Continuous dividend payments for the last 20 years or more."

It's never paid a dividend.

5. Current dividend rate.

Again, no dividend. Note in chapter 19 (page 506), they make strong claims that often companies building up cash don't actually know how to make lots of money from it. They cite studies showing earnings growth is actually higher when dividends were higher, and companies that "..raise their dividend not only have better stock returns but that 'dividend increases are associated with [higher] future profitability for at least four years after the dividend change."

Most of the information is in Jason Zweig's commentary in the latest edition of Graham's book.
Jason claims a company keeping cash helps management of a company weather downturns, but not the stockholders because it relieves pressure on management to seek highest-yield returns. Moreover, Jason claims big cash allows management to make dumb bets like the AOL/Time Warner merger. Finally, Jason also claims stock buybacks (as an alternative to dividends) just inflate executive compensation (through options for example).

Page 348: Stock screening criteria.

1. Adequate size. Updated commentary (2003) says total market value of >= $2 billion. GOOG has $171B. Check.

2. Strong financial condition. Current assets at least twice current liabilities. GOOG has $27.6B in assets and $3.3B in liabilities (2008 Q1). Check.

3. Earnings stability. Some earnings for common stock in each of past 10 years. FAIL. GOOG common stock is only 4 years old. It's not obvious where to look to see if GOOG has had earnings each year without digging through all the annual reports. I suspect it has.

4. Dividend record. Uninterrupted payments for at least the past 20 years. FAIL. GOOG common stock is only 4 years old and has never paid a dividend.

5. Earnings growth. A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end. FAIL. Again, GOOG too new.

6. Moderate price/earnings ratio. Current price <= 15 times average earnings of the past three years. FAIL. GOOG price is $540/share, earnings/share (EPS) is $13.52, $9.94, $5.02 over the last three years (see here), or $9.40 average earnings, so P/avgE is 540/9.40 = 57.4. Note Graham does not believe in forward-looking price/earnings ratio (F P/E) at all.

7. Moderate ratio of price to assets. Current price <= 1.5 times book value last reported or (p/e) * (price/book) <= 22.5. FAIL. Book value is total assets minus intangible assets and liabilities such as debt. Total assets $27.6B, intangible assets $1.2B, goodwill assets $4.7B (not sure if I should subtract that but I will), debt 0, total liabilities $2.4B. So, book is $19.3B and 313.7M shares outstanding would lead to book value/share of $61.5. Current price is 8.8 times book. Am I doing this calculation correctly??

Looking at all the above, I believe Graham would never have bought the stock, and clearly would never hold it.

For fun, here is a link to a Google stock screener that embodies as many of the above criteria as I could find: #1, #5, modified #6, #7. There are only 5 companies on it, and I've never heard of any of them.