Why Google Deserves a Premium Valuation

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There's been plenty of talk about whether or not Google could reach $1,000 by the year's end. Deciphering Google's prospects begins with an analysis of the company's market outlook and the durability of its cash flows.

Outlook
One of the first steps in any valuation is to examine the key factors driving the growth of the underlying business. There are two sides to this coin: profitability metrics and market growth potential.

Google's undoubtedly the worldwide leader in online search. But how significant is search to the company's business?


Source: SEC filings.

As shown in the chart above, Google's network sites and its Google.com segments make up 25% and 62% of revenue, respectively. Google's profitability, therefore, is ultimately determined by the performance of its cost-per-click, or CPC, metric. CPC simply refers to the amount an advertiser pays Google when a user clicks on an ad.

Investors have watched Google's CPC metric take quite a rollercoaster ride over the last couple years. As the company becomes increasingly mobile, it's had to adapt its monetization methods. The proliferation of Google's own Android platform has, in fact, been a huge driver in global mobile adoption.

At first, this was a significant challenge for Google as it shifted its advertising to mobile platforms. The company's year-over-year CPC comps began to decline and eventually turned negative. But Q4 2012 showed signs of a potential bottom to this decline, with CPC even trending up 2% sequentially.

Source: SEC filings from the corresponding quarters above.

The company's market outlook reveals considerably favorable growth prospects. Namely, the digital advertising market is growing far more rapidly than other forms of advertising. 

The Pew Research Center's Annual Report on American Journalism describes this transformation:

Digital ads, which outpaced newspaper advertising for the first time in 2011, now make up 23% of overall U.S. advertising, up from 20% in 2011. They are second only to television ads in terms of overall dollars, and are growing three times faster. eMarketer projects digital's share of the U.S. ad market will grow to 29% by 2016.

Google's paid clicks, or the quantity of clicks on its advertisements, confirm that Google is benefiting from the trend of increasingly more digital advertising. Paid clicks were up 24% from the year-ago quarter.

Google's wide economic moat
The next step in valuation is to examine a company's competitive advantage. Is it durable? If not, predicting any growth is pure speculation. So we ask: What core competencies ensure Google can sustain its position as a market leader?

Warren Buffett once said, "In business, I look for economic castles protected by unbreachable 'moats.'" In other words, Buffett looks for businesses with a sustainable competitive advantage.

Examining the durability of Google's core competencies allows us to determine just how wide Google's moat could be.

Three core competencies give Google enormous advantages in the marketplace:

  1. The network effect
  2. Size
  3. Versatility

With every additional click or client, Google's platform becomes increasingly valuable to other clients. The same is true for other social platforms, such as Facebook . This is the power of a network effect; as these digital giants mine enormous amounts of data on users' interests, demographic profiles, and relationships, they can offer increasingly targeted advertising to clients.

Even better, the network effect benefits users, too. The more people using platforms like YouTube, Gmail, Google Plus, and Facebook, the more useful and indispensable they become.

Size does matter -- especially when it comes to companies with network effects. Fortunately for Google, the company has a mind-boggling lead in digital advertising.

Source: eMarketer.

Google has more than five times the market share of runner-up Yahoo! . This places competitors like Yahoo!, Facebook, Microsoft, and AOL at a significant disadvantage in achieving scale in their network and breadth of reach.

Google's size has ensured its dominance and forced competitors Yahoo! and Facebook to think outside the box. Yahoo!'s string of acquisitions since CEO Marissa Mayer came on board about five months ago -- Jybe, Stamped, and now Summly -- all have something to do with personalized content curation. In January, Facebook announced the beta release of Graph Search, a tool giving users a unique way to navigate connections and make them more useful with tailored results.

Source: Facebook press release.

Finally, Google has a valuable and interrelated package of diverse offerings. Each of Google's services adds value to the others. The result is massive brand awareness and familiarity with Google products worldwide. Just to name a few of Google's brands, in no particular order:

  • YouTube
  • Google Earth
  • Android
  • Gmail
  • Google Chrome
  • Google Search
  • Google Analytics
  • Google Maps
  • Google Translate
  • Google Books
  • AdSense
  • AdWords

Even Warren Buffett's business partner, Charlie Munger, praised Google's economic moat in a May 2009 press conference: "Google has a huge new moat," said Munger. "In fact I've probably never seen such a wide moat."

An excellent company
Google is undoubtedly the best in its class and deserving of a premium valuation. But there's more to valuation than examining a company's prospects and its economic moat. Investors need to see if the numbers really make sense -- something many authors tend to avoid. I provide that missing puzzle piece here.

As one of the most dominant Internet companies ever, Google has made a habit of driving strong returns for its shareholders. However, like many other web companies, it's also struggling to adapt to an increasingly mobile world. Despite gaining an enviable lead with its Android operating system, the market isn't sold. That's why it's more important than ever to understand each piece of Google's sprawling empire. In The Motley Fool's new premium research report on Google, we break down the risks and potential rewards for Google investors. Simply click here now to unlock your copy of this invaluable resource.


 

The article Why Google Deserves a Premium Valuation originally appeared on Fool.com.

Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Facebook and Google. The Motley Fool owns shares of Facebook, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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