VALUATION PERSPECTIVE

8/4/2004

Valuing Google
Valuation Perspective
The report analyzes the
markets expectations for
the future financial
performance of the
company. It also compares
historical financial
performance to different
future performance
scenarios.

Are Investors Getting a Fair Price?

With an expected IPO value in the $29-36 billion range,
Google offers investors an expensive and risky
investment.

Relative to peers, such as Yahoo and Ebay, Googles

valuation seems reasonable.

Figure 1 shows the future financial performance

requirements reflected by these potential market values:

(1) $25 Billion, (2) $35 Billion and (3) $45 Billion.

We do not predict the future value of Google. Instead,

we provide investors with critical information needed to

assess the accuracy of the markets valuation.

Googles reported profits overstate its economic profits.

Accounting-based metrics underestimate the aggressive
Contributors
David Trainer
david.trainer@newconstructs.com
615-599-4462

Kiran Akkineni
kiran.akkineni@newconstructs.com
615-599-4462

Note
This document is available to clients
in the Research area of our site
www.newconstructs.com.

market expectations imbedded in Googles valuation.

Figure 1: Performance Required To Justify Potential Market Values

Future Performance to Justify Market Values

Performance Hurdles

Historical Performance

Scenario #1

Scenario #2

Scenario #3

2002

2003

$25 Billion

$35 Billion

$45 Billion

1. Revenue Growth

n/a

176.5%

30%

30%

30%

2. Economic Profit Margin (Avg)

28%

-23%

25%

32%

40%

3. GAP (Growth Appreciation Period)

n/a

n/a

15

15

15

* This is the average margin level required over the next 15 years.

Sources: New Constructs MaxVal Valuation model

This report offers a more comprehensive perspective on Googles

profitability and valuation. Based on Price to Sale and Price to Earnings
multiples, Googles valuation relative to peers such as Yahoo and EBAY
appears in line. We see a different story when we use a more
comprehensive data set to analyze the profitability of Google and assess
the future cash flows required to justify its potential market value.

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Economic versus Reported Profits

New Constructs rectifies

accounting distortions in
GAAP financial statements.

Google's economic profits, as measured by New Constructs, are

significantly lower than its reported GAAP profits. See Figure 3 for a list of
the adjustments we make to a company's reported GAAP profits in order
to arrive at a better measure of a firm's economic earnings.
Figure 2: Accounting Issues that Distort GAAP Profit Reports

Employee Stock Options

Pension Over/Under Funding
Excess Cash
Restructuring charges
Pooling Goodwill
Minority Interests

Off-Balance-Sheet Financing
LIFO Reserve
Unrealized Gains/Losses
Goodwill amortization
Unconsolidated Subsidiaries
Capitalized Expenses

Sources: New Constructs, LLC

Cash is king. When

reported earnings and
economic cash flow
diverge, the market
follows cash.

In the case of Google, the largest adjustment relates to a deduction made

for Employee Stock Options (ESO) issued by the company, as shown in
Figure 3. The stock option expense that Google reports is too conservative
because it defers much of the cost related to option grants in any given
year over the next 5 years. We replace Googles reported stock option
expenses with our own numbers that reflect the cost of all of the options
granted in a given year. Our approach gives investors are more realistic
perspective on the annual costs Google incurs to retain and compensate
its employees. Under Googles reporting method, future reported option
expenses will be boosted by the recognition of the cost of options granted
in prior years. Rather than defer the cost of compensation incurred in the
present, our methodology captures the full cost of options in the year they
are granted.
Figure 3: Insight Into All the Costs To Run the Business

Sources: New Constructs LLC and Company filings

Note: In 2003, the impact of the ESO Expense on Economic Profits is mitigated by our exclusion of
non-operating expenses reported by Google, which depressed GAAP Profits but not our calculation of
Economic Profits.

In 2003, our ESO adjustment is partially offset because our

methodology also excludes non-operating, one-time expenses that
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depressed GAAP Profit. Specifically, we remove a $229 million nonrecurring, expense recorded for the adjustment to options that were
issued with below-market strike prices. Off-balance sheet financing
is the second largest adjustment we make to more accurately
present Googles profitability. This adjustment increases the
reported capital by 20% in 2002 and 2003. (For a complete
reconciliation between Google's reported and economic profit, and
further explanation of the full range of our economic adjustments,
please contact the author).
The cost of capital, in particular, the cost of Equity Capital is an
important cost of doing business that Financial Statements overlook.
This cost captures how much capital management requires to
generate earnings or profits. Naturally, the more profits generated
from a smaller amount of capital the better. Many investors,
including Warren Buffett, consider a measurement of the capital
required to generate profits an integral component any profitability
analysis. This cost capital is generally calculated as a percentage
based on a blended average of the cost of borrowing and the cost of
equity capital. Most corporate finance texts refer to this cost as the
Weighted-Average Cost of Capital (WACC). To calculate the dollar
value of the cost of capital, one multiplies WACC by all the capital
invested in the business.

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Is Googles Valuation Fair?

We do not predict the

future value of stocks.

Recent reports by the media suggest that Googles likely IPO

valuation will be between $29 and $36 billion. This report offers
clients specific measurement of the future performance required to
justify these valuations. Specifically, we focus on assessing the
performance expectations embedded in three potential market
values: (1) $25 Billion, (2) $35 Billion and (3) $45 Billion.
Rather than predicting a warranted or future value for a company or
stock, we measure the markets prediction for the financial
performance of companies as reflected in stock prices. Our
measures of valuation are entirely objective. Our goal is to position
investors to make informed decisions about whether or not they
agree with the markets prediction for the future financial
performance of companies.

Our valuation analysis

focuses on assessing the
feasibility of future
financial performance
requirements embedded in
stock price.

Our MaxVal models value stocks based on the present value of

expected free cash flows, with that free cash flow measured
according to our economic (as distinct from conventional
accounting) methodology. MaxVal clients forecast economic free
cash flow by assigning estimates to three value drivers :
1. Revenue Growth compounded over the indicated time
frame.
2. Economic Profit Margin the Return On Invested Capital
minus the weighted-average cost of capital.
3. Growth Appreciation Period number of years the company
can earn a positive Economic Profit Margin on incremental
investments, i.e. the number of years it can create value.
An alternative way to conceptualize the three value drivers is:
1. How fast will the company grow?
2. How profitable will the company be?
3. For how many years will the company grow economic profits
or create value?
Figure 4 summarizes the future performance required for Google to
justify the range of market values mentioned above. To simplify the
exercise, we kept Revenue Growth constant at 30% and the Growth
Appreciation Period (GAP) constant at 15 years for each scenario.
Holding these drivers constant allows us to focus on what the
valuations imply for future economic profitability. We believe these
assumptions are optimistic and, if anything, tend to overstate
Googles likely future performance. The Economic Profit Margin
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calculation captures both the operating profit margin and capital

expenditures of the business.
To justify a $25 billion market value, Google must grow revenues at
30% and maintain a 25% Economic Profit Margin for 15 years.
Scenario #2 shows that Google must maintain a 32% Economic
Profit Margin with 30% revenue growth for 15 years to justify a $35
billion market value. The required future Economic Profit Margin is
40% for a $45 billion market value.
Figure 4: Economic Profit Margin = ROIC minus WACC
Future Performance to Justify Market Values

Performance Hurdles

Historical Performance

Scenario #1

Scenario #2

Scenario #3

2002

2003

$25 Billion

$35 Billion

$45 Billion

1. Revenue Growth

n/a

176.5%

30%

30%

30%

2. Economic Profit Margin (Avg)

28%

-23%

25%

32%

40%

3. GAP (Growth Appreciation Period)

n/a

n/a

15

15

15

* This is the average margin level required over the next 15 years.

Sources: New Constructs, LLC

These valuations were chosen to provide an illustrative spectrum of

future performance scenarios. We aim to provide investors with a
clear sense of the ramifications that the valuation of Google has on
the future cash flows expected of the company. We do not provide
target or warranted prices because we do not claim to possess the
knowledge of all the competitive dynamics that will affect the future
performance of the company. Rather, this report aims to help
investors assess the feasibility of the future economic performance
implied by these market values for Google.
For an analysis using different assumptions for Revenue Growth,
Economic Profit Margin or Growth Appreciation Period, please
contact the author. New Constructs MaxVal models enable
quick and easy analysis of the valuation impact of different
scenarios for every value driver and market valuation.

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Conclusion
In our opinion, the expected market values for Google imply future
financial performances that are potentially too optimistic. For
example, each scenario assumes profitability (economic profit
margins) at or better than what the company has done in the past.
And each scenario requires 15 years of annual revenue growth of
30% to justify its valuation. Few companies in the history of
business have been able to grow revenues at 30% for fifteen years.
To add another layer of perspective on the performance implications
embedded in each potential market value, Figure 3 presents the
actual (not averaged) Economic Profit Margins that each market
value scenario implies. It is these values that comprise the average
values for Economic Profit Margin presented in Figure 4.
Because each scenarios model assumes a gradual, rather than
immediate, rise in economic profitability, the actual Economic Profit
Margin values in Figure 5 span levels meaningfully lower and higher
than the averages presented in Figure 4. Figure 5 presents the lows
(anchored by historical performance) and the highs for the
Economic Profit Margin for each Scenario. For example, Figure 5
shows that Googles Economic Profit Margin reaches a peak of over
53% in 15 years for Scenario #2 and over 65% in scenario #3.
These levels of performance suggest an even greater improvement
over historical benchmarks than indicated by the average values.
Figure 5: Google: Performance Required to Justify Potential Market Values
Economic Profit Margin Scenarios
75%

Future

55%
35%
15%
-5%
-25%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

$25 bn

$35 bn

$45 bn

Sources: New Constructs, LLC

New Constructs does not purport to have an ability to predict the future.
On the other hand, we empower clients to assess the market predictions
reflected in stock prices with greater accuracy and speed.
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New Constructs Profile

New ConstructsTM is a specialty equity research firm. Our main activity is
delivering to clients an integrated research platform that maximizes the
analytical value of financial data. This platform offers clients a suite of
interactive analytical tools, along with traditional equity research and raw
data services. All of our products are customizable. Our primary goal is to
empower clients to achieve better investment performance.
Our main products are MaxValTM, MaxStrategyTM and MaxDataTM. These
research tools are delivered via www.newconstructs.com. MaxVal is a
DCF-based, equity valuation model that allows clients to define their own
forecasts and forecast drivers. MaxStrategy is a stock screening/ranking
tool that enables clients to analyze stocks based on many metrics, several
unique to our platform. Both MaxVal & MaxStrategy are integrated with
MaxData, our proprietary financial database. Unlike many other research
firms, we do not buy our raw material - corporate financial data - from
commercial vendors. Rather, we source it ourselves to create MaxData.
The key advantage provided by MaxData is that it delivers data drawn
directly from SEC filings, including the Notes to the Financial Statements.
We can cost-effectively deliver any reported data point. We believe our
capabilities in this area are unmatched.
MaxData provides a scalable approach to the time-consuming task of
collecting and modeling data. It enables our research analysts to gather
and analyze corporate filings more efficiently and accurately than any
manual process. MaxData can implement any valuation methodology
requested by clients. For example, our MaxVal models provide both a
high-integrity economic analysis as well as a traditional GAAP accounting
analysis.
The result is a research platform that empowers better investment
performance.
Our clients are professional investors, research firms, consulting firms and
publicly listed corporations. We also partner with colleges and business
schools. Our products may also be of interest to active individual
investors.
For further information, contact:
David Trainer
david.trainer@newconstructs.com

(615) 599-4462

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DISCLAIMER
The information and opinions presented in this report are provided to you for information purposes only and
are not to be used or considered as an offer or solicitation of an offer to buy or sell securities or other financial
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not taken any steps to ensure that the securities referred to in this report are suitable for any particular
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general information that does not take into account your individual circumstance, financial situation or needs,
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that is equal to or greater than 1% of its outstanding stock.
Copyright New Constructs, LLC 2003, 2004. All rights reserved.

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