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Apr 18, 2008

NEWS: Resurrected Google: How's That Valuation? (35X FCF)

Ed: I estimate that some $200 million of the $937 million FCF has been earned by holding the average $50 that millions of the Long Tail blog earns, but never receives. Google has a $100 limit before issuing the first check. Even though they pay if you close your AS account, like most gift cards, people forget.

Resurrected Google: How's That Valuation? (35X FCF)
from Silicon Alley Insider by 

googlelogo.gifAfter Google's $75 post-earnings pop, it's time we checked on valuation again.

We value Google (GOOG) using free cash flow (see below). The bad news in the quarter was that Google's capital expenditures soared to $842 million, which depressed free cash flow (only $937 million in quarter, down from more than $1 billion the past two quarters). But we're optimistically going to assume that this massive increase in CAPEX won't continue forever and that Google will generated about $4.5 billion of free cash flow this year.

How's Google trading relative to that? At $530, it's trading at 35X FCF. That's a bit higher than we think it should be given then rapid deceleration of Google's US and UK businesses, but its certainly not insane. Unless free cash flow gets hammered, we continue to think the stock has a valuation floor around 25X (the long-term power of the franchise is just too compelling for investors to completely throw in the towel).

Free Cash Flow vs. EBITDA and P/E

Why do we look at free cash flow instead of EBITDA or Earnings? We find Google's non-GAAP P/E less meaningful than it would otherwise be because of the significant percentage of option cost that the company is still expensing (which most analysts ignore).

EBITDA, meanwhile, is a meaningless metric for companies that have significant capital expenditures, which Google now does. (Wait, do we mean EBITDA is a meaningless metric for the entire media and cable industry, which clings to it like a crutch? Yes, we do! We suspect "EBITDA" was invented by brilliant early cable industry titans who hoodwinked analysts into thinking that cash-flow-before-required-expenses was meaningful. It isn't.)

Will Google's FCF Get Crushed?

If Google's revenue flattens (or, God forbid, drops), will FCF get slammed? It might, especially for a couple of quarters. We believe, however, that Google's huge capital spending in recent years has been the direct result of having operating cash flow coming out its ears. If operating cash flow shrank, therefore, we believe Google would be able to significantly cut back on CAPEX, thus preserving cash flow.

Going forward, moreover, as Google continues to grow (perhaps on the other side of a recession), we think there's room for CAPEX to decline as a percentage of revenue. This would allow FCF to grow far faster than revenue.

Bottom line, we don't think Google's free cash flow margin is a "peak margin." We believe the company has been spending like a drunken sailor. If times get tough, we think the company would be able to cut back, thus boosting its FCF yield.

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