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nternet business
Feb 16th 2006 | NEW YORK
From The Economist print edition
SERVING fine wines to chief executives and “global leaders” too drunk to appreciate it made Google's party the talk of last month's World Economic Forum in Davos. Its generosity with 1959 clarets and 1990 Krug champagne seemed, at the time, only to confirm the firm's greatness. Yet, three weeks on, Google's pristine reputation has been damaged by its willingness to collaborate with the Chinese government's censorship requirements, its shares have tumbled, and the Davos party is in danger of resembling the Great Gatsby's glorious last hurrah.
Google's share price peaked a couple of weeks before Davos, at $475, on January 11th. After slipping during the rest of the month, the price plunged on February 1st, after the firm reported results that disappointed Wall Street analysts, and then plummeted again this week—for no obvious reason—to $343 on February 14th. In barely a month, some $38 billion has been wiped off the firm's market capitalisation, which now stands at a mere $101 billion. Investors have fallen out of love with Google. Is there a good reason for this?
On the face of it, that Google's results disappointed analysts is no grounds for panic, especially as—for all the right reasons—the company refuses to give analysts advance “guidance” about its likely performance. (Most firms are happy to play the Wall Street earnings game, whereby their guidance ensures that their results typically come in a fraction better than the analysts predict.) In fact, Google's latest results were strong—profits of $814m in the fourth quarter of 2005, net revenue up by 23% quarter-on-quarter—and certainly provided no basis for investors to slash one-quarter off the firm's value. Moreover, shares of the other internet superstars—eBay, Yahoo! and Amazon—have also tumbled this year (see chart), suggesting that this may have more to do with a decline in investor exuberance towards the internet than in the underlying performance and prospects of the firms themselves.
A serious debate about how to value internet shares, and above all those of Google, is long overdue. Since the disappointing months after Google's initial public offering in August 2004, when the shares appeared to have been overpriced at $85, they had risen inexorably, without anyone providing a particularly compelling reason why. An article in last week's Barron's newspaper suggested that—on plausible assumptions—the right price for Google shares could be as little as $188. Yet some bulls think there remains plenty of upside: Mark Stahlman of Caris & Co, a brokerage firm, has $2,000 as a long-term target, on the assumption that Google eventually wins a 1% share of the global digital-services business.
Having survived the 2000 internet bubble—almost alone among Wall Street internet analysts—Mary Meeker of Morgan Stanley is keen to be seen as prudent in her bullishness. Yet like most of her peers, she thinks the shares are worth more than $400. Discounting expected cash flow for the coming ten years, she calculates a fair price of $413. Using other valuation techniques, she gets as high as $597. But these valuations all rely on Google delivering the now expected future performance—which, as is clear from its current high ratio of share price to profits of 68 (compared with an average of 18 for the S&P 500), means spectacular growth. Whether it will achieve this growth, or even come close, is frankly anyone's guess, especially given how rapidly its market is evolving—a risk factor that surely argues for a far larger discount rate to be applied to future cash flow than the 11.5% in the Meeker model.
On the other hand, as Ms Meeker points out, Google has so far consistently beaten her forecasts, both for revenues and for profit margins. Strikingly, just after Google went public, she predicted that it would generate revenues of $7 per user in 2005, up from $2 in 2002. In fact, it generated $10 per user—a number that, she plausibly argues, can be greatly improved on as ever more advertising dollars shift to new media from old (which still account for 95% of total advertising spending).
One reason that Google has been able to exceed earnings expectations in recent years is that the full-frontal attack some analysts predicted from Microsoft has yet to materialise. Ms Meeker had forecast a competitive search product from Microsoft by Christmas 2004, supported by a $100m advertising campaign. The passage of time has allowed Google to deepen its relations with its customers, making it more able to fight off competitors. Yet, ominously, Microsoft's share price has edged higher as Google's has tumbled. Will Google be serving cheap plonk in Davos next year?