Even if the efficient market hypothesis has severe drawbacks and deficiencies, it's still hard to imagine that the stock of a company as large and well-followed as Google (Nasdaq:GOOG) could be meaningfully undervalued. And yet, a long-term discounted cash flow analysis suggests that it's at least possible. While Motorola's operations will pressure margins and there's ample competition in search, mobile and online ads, Google still looks like a stock to consider in the tech space.

SEE: A Primer On Investing In The Tech Industry

Fourth Quarter Results Offer Plenty of Noise, but Growth too
Google's fourth-quarter results are not necessarily all that messy on a straight GAAP basis, but hardly any investors or analysts evaluate Google on its GAAP performance. Consequently, a lot of moving parts and adjustments muddy the waters a bit. That said, Google's results were largely good.

Gross revenue rose 36% from last year and 2% from the prior quarter. On a stand-alone basis, Google's "core" net revenue rose 21% (or 24% in constant currency), while Motorola revenue fell 56% and missed sell-side estimates by about 25%. Paid clicks increased 24%, while cost per click declined 6% (better than recent trends of high-single-digit to mid-teen declines).

Margins were considerably murkier, but it does look like the mixed shift in revenue is pushing margins lower. There are seemingly as many ways to adjust Google's reported earnings as there are analysts doing the adjustments. With my adjustments, operating income increased by about 6%, with a greater than six-point decline in operating margin. A larger contribution from lower-margin businesses such as YouTube, Motorola and Google Play are largely responsible for the shift.

SEE: How Does Google Make Its Money?

Mobile Still a Big Unknown
It doesn't seem to matter whether you talk about Google, Facebook (Nasdaq:FB), Pandora Media (NYSE:P), Groupon (Nasdaq:GRPN), Microsoft (Nasdaq:MSFT) or even Amazon.com (Nasdaq:AMZN) - mobile is the reigning obsession with analysts and investors today.

To that end, Google appears to be doing well in terms of clicks, search share and so on, but the quarter-to-quarter financial results are volatile and likely to remain so for the near future. Some of this volatility comes from the traffic acquisition costs. In mobile, Google often finds itself in the position of having to pay Apple (Nasdaq:AAPL) or other Android partners for distribution. At the same time, companies such as Apple and Facebook are trying hard to keep/control more and more of their own users and keep Google on the sidelines.

Management Still Has Some Work to Do
I would argue that Google still needs to work on presenting a unified vision of how its parts fit together and build long-term value for shareholders. Granted, Google seems to have a leg up on Facebook. At least Google doesn't seem to make decisions by over-reaching for revenue and then backtracking when users howl in outrage. But many investors are still skeptical about the move to acquire a smartphone business and are uncertain how much margin erosion Google will accept to establish these ancillary businesses.

The issue of the share classes also continues to fester. Launching a third class of shares (C shares) doesn't add any value in my mind. Investors have good reason to begrudge a management team that makes debatable strategic moves (like spending billions on Motorola Mobility) and then shields itself with special voting classes of shares. That said, it's not as though management doesn't have a sizable economic stake in the future of this business. So while they're in a different class of cabins, they are at least on the same boat as common shareholders.

SEE: 5 Surprising Companies Google Owns

The Bottom Line
Google is one of those companies/stocks where the potential value adds up at such a rate that it seems prudent to take a second, third and fourth look at the underlying assumptions. For instance, if Google grows revenue at a long-term rate of 9% - a rate that seems pretty reasonable given the ongoing growth in paid search, online advertising and smartphone adoption - and improves free cash flow margins by about 16% (leading to long-term free cash flow growth of 11%), the fair value seems to be well ahead of today's price.

Even if Google can't improve its free cash flow margins at all, the valuation does not seem demanding - holding free cash flow margins steady and assuming that same 9% or so of growth points to a fair value into the $900s. Clearly, then, it would seem that the market expects ventures such as Motorola Mobility and/or competition in mobile to be seriously bad news for ongoing free cash flow generation. I won't dismiss this threat out of hand, but if you believe Google can continue to grow at a rate of at least the mid-to-high single digits, these shares are still worth considering today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Investing

    The Rise of Corporate Venture Capital

    After the success of Google Ventures, corporate venture capital is an increasingly popular diversification and hedging tool for many large corporations.
  2. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  3. Investing

    What’s Plaguing Twitter and Yelp?

    Yelp and Twitter have recently become grounded in reality and unable to justify their sky-high stock valuations.
  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  8. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  9. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  5. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  6. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
RELATED FAQS
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  4. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  5. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
  6. What happens to the shares of stock purchased in a tender offer?

    The shares of stock purchased in a tender offer become the property of the purchaser. From that point forward, the purchaser, ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!