Saturday, April 4, 2009 0 comments ++[ CLICK TO COMMENT ]++

Google at $20,000/share? The difference between a stock price and economics/fundamentals

John C. Dvorak, in his typical provocative manner, suggests that Google's share price could hit $20,000 in the distant future (he isn't talking about a hyperinflation scenario so let's rule that out.) Although he writes an investing column on technology stocks, Dvorak shows how he is far more knowledgeable about technology than about investing. He makes what I perceive as one of the a cardinal newbie mistakes of ignoring the economics/fundamentals and simply looking at the stock price. I actually don't dispute the thinking; it's the results that I dispute.

Dvorak's speculation is based on the potential for Google to evolve in a manner similar to what Microsoft went through in the 80's:

That would mean Google shares could hit the equivalent of $20,000, give or take a few thousand dollars. Of course, Google is in a completely different business using a different strategy. But dominance does have a way of rewarding investors.

The point is that Google has given us only glimpses of its potential, and if we were to equate it with Microsoft, it would be like buying Microsoft stock today for 30 cents to 40 cents a share.

I don't actually dispute his comparison. As Dvorak correctly points out in the column, Google has a massive moat. The ability to profit from the moat is debatable but the moat is hard to argue against.

Google Has A Large Moat

As Dvorak points out, Google has essentially mapped the whole World Wide Web and it is debatable if too many other companies will ever be able to reproduce it. Some who are not familiar with technology think that a superior search engine will dethrone Google but I believe they are mistaken. The power of Google is not limited to its superior search technology alone. It also has mastered a lot of the elements that end users don't necessarily think about. For instance, speed. I would argue that it is extremely difficult to duplicate the speed.

Google also keeps strenthening its moat by adding more services, such as e-mail (Gmail), maps (Google Maps), free blogging (Blogger), free picture hosting (Picasa), and so on. This is somewhat similar to how Microsoft kept strengthening its position in the 90's but adding new products, such as office software (MS Office), software development tools (Visual Studio and earlier incarnations), database (Access, FoxPro), and so on. Anyone who started using the Microsoft platform became loyal users because they had almost everything at their fingertips. Similarly, I think Google users will remain loyal for a long time.

Google Is More Like GM or Ford

As crazy as this may sound, Google is actually more like GM or Ford. 'What?', you might say. Well, I'm not talking about the present day near-bankrupt Ford or GM. Rather, Google is like those companies in the 1930's. Similar to the Internet, birth of the auto industry had a lot of car companies initially (I believe there were more than 20 car companies, possibly more than 50.) Yet, by the 1950's, only a few remained, with companies like Ford and GM being dominant. No one was able to dislodge GM or Ford until their demise in the 80's (the 70's oil shock likely did irreparable harm to the American auto companies and shifted the market towards the Japanese.)

So, if Google establishes itself--and it seems to have--I think it will be difficult to dislodge it. Contrary to the thinking of some, I think many internet companies, ranging from Google to Amazon to Ebay to even possibly some company like Expedia or Ticketmaster, will keep strengthening their moat over time. This is not to say that these companies will earn high profits--profits likely depend on industry characteristics e.g. several railroads and airlines were totally dominant from the 50's to 80's but they were poor investments--but they will probably remain in the top 5 for a long time. It will become more and more difficult to dislodge any of them. Seven or eight years ago, someone could have set up a superior online retailer with very little capital outlay and dislodged the top online retailer. Right now, I think it will take hundreads of millions to even put up a fight against someone like Amazon.

So Where's Dvorak Wrong?

If I agree with the core argument of Dvorak, what's my beef? Well, the problem is that, even if Google remains #1 and keeps increasing its revenue and profits, Dvorak's $20,000 price makes no economic sense.

When I look at upside potential of an investment, one of the first things I look at it is the market cap or revenue/sales. In this case, it's market cap that matters.

Dvorak speculates that Google may hit $20,000, while the current price is around $370. That means Google needs to go up 54 times. Microsoft did it so why not Google, after all?

Google's market cap right now is around $117 billion. If it goes up 54x, its market cap will be over $6 trillion! Assuming inflation is not high, it is difficult to see a company with a market cap of $6 trillion within a few decades. Except for that dubious $1 trillion market cap hit by PetroChina, a value I don't think is "real" given how the Chinese market is a gambling den with capital controls and practically no foreigners allowed, no company has reached $1 trillion yet. ExxonMobil had a market cap over $500 billion at the peak of the stock market bubble recently (Cisco similarly had a market cap over $500 billion at the peak of the dot-com bubble.) It is very difficult to pass $500 billion, let alone $1 trillion. Each dollar increase in sales will become more and more difficult.

Hence, even if Google becomes as dominant as Microsoft, the market cap, and hence the stock price, is not plausible.

What Was Missed?

On top of linearly projecting one company's growth onto another, the key flaw has to do with what Microsoft was in the 80's and early 90's versus what Google is right now. Microsoft was small when it went public, whereas Google became, not just a large cap but a megacap within a few years of its IPO. For Google to repeat those numbers, it had to have started with a smaller valuation. I don't remember exactly but I believe Microsoft had a market cap of around $100 million or $200 million (not sure) in the first few years of its IPO. Even if adjust for inflation, Microsoft did not hit a market cap of $100 billion for many years after its IPO.


Even if Google becomes as dominant as Microsoft did, which I think is possible, its share price won't go up as much. Microsoft was worth much less in its early days compared to Google.

The key thing to learn form all this is to always check if some rosy, or even a bearish, projection makes basic sense. If a company ends up being almost equivalent to the present GDP of a large country, as was the case here, or if it ends up with the company taking over the whole planet, it may not be realistic.


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