$GOOG announced stronger than expected third quarter financial results today.  This resulted in a US$13.85 (4.08%) lift in the share price to close at US$353.02 – and more in after-hours trading.  This is still less than half the 52-week high of US$747.24.  This is a good result for $GOOG in volatile market conditions.  We decided to have a look at $GOOG with the Valuecruncher interactive tool to place an estimate on the intrinsic value of the company using a discounted cash flow valuation.

Valuecruncher valuation model of $GOOG with interactive assumptions

Valuecruncher produces a valuation of US$416.73 for $GOOG.  This is a current valuation (an estimate of intrinsic value) not a target price.  This valuation is 18.0% above the current share price of US$353.02.

Assumptions

In 2007 $GOOG had annual revenues of US$16.6 billion and an EBITDA margin (profits) of 40.7%.  Reuters aggregates 26 analysts covering $GOOG and these have mean estimates of 2009 and 2010 revenues of US$22.4 and US$27.9 billion respectively.  For our analysis we have used US$22.0 billion in 2008, US$27.0 billion in 2009 and US$32.5 billion in 2010.  We have forecast EBITDA margins remaining flat at 40% to 2010.  We have estimated capital expenditure in 2008 at US$3.075 billion rising to US$3.75 billion in 2010 and at US$3.25 billion beyond that.  Capital expenditure dropped dramatically in quarter three to US$452 million from US$697 million the previous quarter.  We don’t believe that capital expenditure will remain at the current level (Q3).  All of these assumptions can be amended in the Valuecruncher on-line valuation model to adjust the valuation.

Other Model Assumptions:

Discount Rate: 11.0%.  We believe the discount rate is in the 9-11% range.  We have used the upper end of this range to reflect the uncertain market conditions that $GOOG signalled in the announcement.

Terminal Growth Rate: 6.0%.  The US economy grew at an average of 3.6% over the last five-years.  $GOOG showed that while growth is slowing there is still more to come.

Our analysis incorporates the cash the $GOOG balance sheet – Valuecruncher calculates a net debt number.

Based on our analysis and assumptions the current share price is at a discount to intrinsic value.  Play with our assumptions – what does your analysis say?

Disclosure: None

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

Valuecruncher has recently completed a valuation of $GOOG and previous also completed a multiple scenario valuation for the company. Our recent valuation came out at US$493.88. Henry Blodget in Silicon Alley Insider came out this week with an argument for a fair value of $GOOG being US$300-375 per share. This was based on a multiple (20-25x) of free cash flow and backed by a report that $GOOG is aiming internally for 15% revenue growth next year (2009). We thought that we would revisit our valuation and have a look at Henry’s assumptions in a DCF valuation.

First of all we want to applaud anyone with an audience that talks about valuation with some numbers attached. As we have said previously – in our experience most people don’t run any numbers at all.

Our perspective here is looking at the intrinsic value of $GOOG. Our approach is to start with a DCF and then potentially look at multiples. For that reason we would put aside the 20-25x free cash flow as a starting point and begin with more fundamental analysis. We started with the report of $GOOG internally targeting 15% revenue growth next year (2009). We fleshed that out with some of our own assumptions. Assuming revenues of US$22.5 billion in 2008 we assumed 15% revenue growth in 2009 and 12.5% 2010. We used an EBITDA margin of 37.5% in 2008 rising to 40% in 2010. We used a discount rate of 10% and a terminal growth rate of 5.0%. For CAPEX we assumed US$3.0 billion in 2008 and US$3.5 billion beyond that. We accept that we are adding quite a bit to Henry’s starting point.

Valuation of $GOOG using 15% 2009 revenue growth starting point

This valuation comes out at US$352.67. This is in the middle of the US$300-375 range Henry talks about as fair value using the 20-25x free cash flow metric. Based on these assumptions Henry’s numbers are reasonable. But are these assumptions reasonable?

The revenue target is the easiest starting point. $GOOG did US$16.6 billion in revenues in 2007 – assuming analyst estimates are correct and $GOOG makes the US$22.5 billion 2008 revenue consensus. A 15% increase in 2009 takes revenue to US$25.9 billion in 2009 and a 12.5% increase in 2010 is revenues of US$29.1 billion. This compares to consensus estimates for 2009 of US$28.4 billion. The analyst projections may be off – but that far off? We don’t believe a drop off in on-line advertising spend will impact $GOOG anywhere near as deeply as that - but that is the big question.

Our view is that 15% revenue growth in 2009 looks way too low for $GOOG. Current consensus estimates are 26% revenue growth. The 20-25x free cash flow metric also seems arbitrary. We struggled to find a comparable to make that relevant. We are sticking to the DCF approach. We are also sticking with our earlier valuation numbers for $GOOG. We don’t agree with Henry - we think $GOOG looks cheap. But everyone is entitled to their own assumptions.

Valuecruncher valuation model of GOOG with interactive assumptions

All of this analysis incorporates the cash on the GOOG balance sheet – Valuecruncher calculates a net debt number. All of the assumptions can be amended in the Valuecruncher on-line models to adjust the valuations.

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

Disclosure: None

Valuecruncher has previously completed a valuation of GOOG using a scenario approach. We started with a base case before looking at growth, disruption, and black swan scenarios. GOOG was trading at US$542.30 when we completed that valuation. Our base case was US$481.94 with our low-end disruption scenario at US$363.22. With GOOG trading at US$430.14 we thought it was time to update our base case valuation.

Valuecruncher valuation model of GOOG with interactive assumptions

Valuecruncher produces a valuation of US$493.88 for GOOG. This is a current valuation not a target price. This valuation is 15% above the current share price of US$430.14 (note our model picks up an earlier price of US$449.15 because we completed the valuation earlier). This isn’t materially different to our earlier base case valuation of US$481.94.

Assumptions

Our assumptions are revenues of US$22.25 billion in 2008 growing to US$33.75 billion in 2010. We have used a flat EBITDA margin of 40% to 2010. We used a terminal growth rate of 6.0%. We used a terminal capital expenditure number of US$4.0 billion. We have used a WACC (discount rate) of 10.0%. All of these assumptions can be amended in the Valuecruncher on-line model to adjust the valuation.

Our analysis incorporates the cash on the GOOG balance sheet – Valuecruncher calculates a net debt number.

Based on our analysis the current share price looks cheap. It appears a great opportunity to be buying GOOG. Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

In our experience, most private investors don’t complete fundamental financial analysis on prospective investments.  They often recognise this and say they would like to do more – but “it is hard work”.  They are right – but running financial analysis on prospective investments, even at a high-level, is a vital step in making quality decisions.  The professionals don’t pull the trigger without running the numbers.

One of the aims of our Valuecruncher interactive tool is to make it easier for people to complete fundamental valuation analysis using a discounted cash flow valuation methodology.  Here is our quick guide to completing a high-level discounted cash flow valuation analysis in five-minutes.  We have chosen Microsoft (MSFT) as the example company.

The default Valuecruncher interactive tool is a starting point for the valuation of companies in our database.  Instead of having to build a discounted cash flow model and source the various company projections – Valuecruncher gives you the valuation model and starting inputs.  We start on the MSFT company page.

Valuecruncher MSFT Company Page

To get started – hit the “Create Your Valuation” button.  This takes you to the default Valuecruncher valuation for MSFT.  This default valuation isn’t a recommendation it is a starting point to create your own valuation.

Profitability

The profitability tab covers the company’s anticipated revenues and profitability (at the EBITDA level).  The starting numbers in the default valuation are based on estimates of the company’s prospects moving forward.  To complete a high-level valuation of MSFT we round the revenues to three significant figures – US$67.5 billion in 2009, US$74.5 billion in 2010 and US$79.4 billion in 2011.  We have used a flat EBITDA margin of 40% to 2011.

Key Valuation Assumptions

Discount Rate – reflects the required rate of return on an investment. The discount rate consists of two key components, the time value of money and risk.  The discount rate used in the Valuecruncher valuation is the nominal post-tax weighted average cost of capital (WACC).  The higher the discount rate the more variable (greater risk) the cash flows generated by the company.  For US companies we would expect to see discount rates in the 8-12% range – 8% being stable utility style businesses and 12+% being riskier technology-based companies.  For MSFT we have used a 10% discount rate.

Terminal Growth Rate – is an approximation of the growth rate beyond the next three years into perpetuity (i.e. forever) of the company’s cash flows. The company’s growth rate will fluctuate with economic and industry cycles with the terminal growth rate representing an average growth rate.  The long-run expectation for economy wide growth is approximately 2-3% (nominal).  We have a blog post with a table showing how to estimate terminal growth.  But the place to start is 2-3% + a factor for near term growth.  We have completed a valuation for Google (GOOG) that used a 6.5% terminal growth estimate – that is pretty high.  You would expect to typically see terminal growth in a 2-4% range.  For MSFT we have used 3%.

Tax – The tax rate entered is used to calculate the tax payable for the first three years. Beyond that the marginal tax rate of the country of domicile is used.  For MSFT we have used 35%.

Capital Expenditure / Depreciation

How much does the company have to spend to generate the revenues and profits for the business?  Capital expenditure is a cost that is not included in the revenue or EBITDA margin assumptions.  This covers: the acquisition or disposal of operating assets, research and development costs not included in the EBITDA margin and changes in net working capital.  The terminal capital expenditure represents an estimate of the ongoing investment required to facilitate the forecast long term growth. The terminal capital expenditure value should be viewed as a simplified estimate of a more complex series of expenses.  For MSFT we have assumed capital expenditure of US$3.25 billion in 2009, US$3.75 billion in 2010 and 2011 then terminal capital expenditure of US$4.0 billion.  We have assumed depreciation of US$2.75 billion in 2009, US$3.0 billion in 2010 and US$3.25 billion in 2011.

That is it – 16 variables with default numbers provided.  Other inputs from the balance sheet that form part of a net debt calculation (long-term borrowings and cash) are calculated automatically by Valuecruncher based on the latest balance sheet numbers.

This gives us a valuation for MSFT of US$30.86 – 25.6% above the current share price of US$24.57.  Based on this high-level analysis MSFT looks cheap.

Valuecruncher valuation model of MSFT with interactive assumptions

With a valuation created it now appears on the company page for others to see.  Other users can create their own valuations or they can then take the assumptions from an existing valuation and change ones they choose to create a separate valuation.  Saving changes to a valuation simply creates a new valuation.

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

A US fund manager Manning & Napier has come out with an amazing call in Barron’s that their current view of the Google (GOOG) share price equates to US$950-1,050. Henry Blodget works through some of the assumptions and is not convinced.

Neither are we.

We took the assumptions from Henry Blodget’s analysis in Silicon Alley Insider and ran these through the Valuecruncher on-line valuation tool to see what sort of numbers are required to justify a US$1,000 a share valuation for GOOG.

Assumptions – for a US$1,000 a share valuation for Google today

We started with a 2008 revenue number of US$22.5 billion – and then grew that at 30% per annum to 2010. We used a 40% EBITDA margin on these revenues. We used a US$4.25 billion terminal capital expenditure figure. For a discount rate (WACC) we used 10%.

These are aggressive projections for the period to the end of 2010. But where things get really wild is in determining the terminal growth rate. This is the rate that reflects the growth potential beyond 2010. To achieve a valuation over US$1,000 a share we have needed an 8% terminal growth rate. This is a big number. How big. To get to an 8% terminal growth rate requires a 30% growth rate from 2010 to 2011 then dropping to 6% in perpetuity from 2015. The growth numbers look like 24% in 2012, 18% in 2013, 12% in 2014 and 6% in 2015 and beyond. 6% is a big perpetuity number – 8% is huge. Play with the assumptions and see the impact. Note: in our model the terminal growth rate must be more than 2% below the discount rate. In this example we come up against this constraint.

Valuecruncher valuation model of US$1,000 Google share price with interactive assumptions

Our analysis incorporates the cash on the Google balance sheet – Valuecruncher calculates a net debt number.

Here at Valuecruncher we do not believe that Google is worth over US$1,000 a share. The assumptions required are just too heroic to be realistic. A month ago we completed a scenario valuation for Google. We still stand by that as a way to look at and think about the valuation of Google.

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

Microsoft (MSFT) is in an interesting place at the moment - which is only in part to losing Bill Gates from day-today management. It created one of the dominant global businesses of the late 20^th century but has struggled to move beyond the core products that drove this success. The Client (Windows), Server and Tools (enterprise solutions) and MBD (Office) divisions drive 83% of revenues and over 100% of operating profits (the On-line Services and Entertainment divisions are still operating at a loss). Microsoft has spent a lot of money and resources (especially senior management focus) on the aborted (maybe) attempt to acquire Yahoo (YHOO). We agree with the analysis that the pursuit of Yahoo is an attempt to compete with Google (GOOG) in what has become one of the dominant global businesses of the early 21^st century (on-line advertising driven by search). The Microsoft acquisition of Powerset is a further example of this strategy of aiming to compete directly with Google.

At Valuecruncher we are not convinced by this strategy of competing with Google - we are not alone. We completely respect Microsoft’s previous successes in following into and then dominating markets. But in the on-line advertising and search market we see some of the same network effects that suggest a “winner takes all” competitive situation. At Valuecruncher we can see a situation where Google’s current dominance is eroded – but not because of a head-to-head battle with either Yahoo or Microsoft (or a potential combination). At Valuecruncher we believe that Microsoft should be looking beyond the current competitive situation to the next big profit pool. Hockey great Wayne Gretzky when asked about why he was successful is credited with the quote “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be”. Easily said we recognise, but that is our view of where Microsoft should be directing their strategic efforts – not competing head-to-head with Google in a market their competitor dominates.

Any potential acquisition of all, or part, of the Yahoo business clouds any current valuation discussion of Microsoft. Some influential Microsoft insiders have suggested in a piece of high-level analysis that 1% of the global search market is worth US$1 billion in market capitalisation. Microsoft’s potential acquisition of Yahoo valued their share of the search market at more than that - US$47 billion for approximately 20% market share. What about the core Microsoft business? What if we ignore the potential Yahoo scenarios – what is the core Microsoft (MSFT) business worth?

The core Microsoft business is reasonably easy to value – if you exclude growth options. The business is growing well (if not at the levels of ten years ago) with robust margins. There is capital expenditure required to achieve the revenues and profitability. There is strong competitive positioning around these core products but with credible low-end competitors that have the potential to disrupt (i.e. Google Docs). The current business will change as technology develops – but as the current dominant player, Microsoft is well positioned to respond to competitive threats and to potentially lead innovation. At Valuecruncher we are not sure that Microsoft should be investing heavily in the on-line advertising and search market - they should be aiming beyond it.

MSFT Valuation

Microsoft grew revenues from US$36.8 billion in 2004 to US$51.1 billion in 2007 – an 11.5% compound annual growth rate. Our assumptions of revenues for the next three years are US$60.0 billion in 2008 growing to US$74.0 billion in 2010 – a 13.1% compound annual growth rate. We have projected EBITDA margins to be flat at 40%. We have used a terminal growth rate of 4.5%. We calculated this terminal growth rate based on year three growth of 10.4% dropping to a 4% stable growth rate by year 10. We used a terminal capital expenditure number of US$3.0 billion. We have used a WACC (discount rate) of 10.5%. Both the terminal growth rate and WACC have a material impact on the valuation.

Valuecruncher Valuation MSFT

Our analysis incorporates the cash on the Microsoft balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$33.01 which is 20% above the current share price of US$26.03. The market appears to be placing a negative value on the noise around an acquisition of all or part of Yahoo. Focusing on the harvesting the core business and innovating (by making small bets) beyond that core appears to be the highest value strategy for Microsoft.

Based on our analysis the core business looks undervalued. Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

We are revisiting a prior piece of analysis we completed on Google (GOOG). It has been a popular piece of analysis and we wanted to update the analysis using our on-line valuation tool.

GOOG Valuation

Google grew revenues from US$3.2 billion in 2004 to US$16.6 billion in 2007 – a huge 73% compound annual growth rate. Our assumptions of revenues for the next three years are US$22.5 billion in 2008 growing to US$34.5 billion in 2010 – a 27% compound annual growth rate. Year-on-year revenue increases have slowed from 92.5% in 2005 to 56.5% in 2007. We are projecting revenue growth to continue to slow – 35.6% in 2008, 26.7% in 2009 and 21.0% in 2010.

We have projected EBITDA margins at a flat 40%.

We have used a terminal growth rate of 6.5%. We calculated this terminal growth rate based on year three growth (2009 to 2010) of 21% dropping to 18.5% in 2011 and then to a 5% stable growth rate over the next ten years.

We have used a WACC (discount rate) of 10.5%. The WACC (discount rate) has a material impact on a discounted cash flow valuation (as does the terminal growth rate). We think this WACC of 10.5% is reasonable but recognise that the actual number could be as low as 10% or as high as 12-12.5%.

We used a terminal capital expenditure number of US$4.25 billion.

Our analysis incorporates the cash on the Google balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$481.94 which is 11.1% below the current share price of US$542.30.  Our valuation is based on the current share price - it isn’t a target price for the future.

Valuecruncher Valuation GOOG – Base Case

We then created three separate scenarios:

1. Growth – where Google’s current dominance of on-line search and advertising is enhanced and revenues grow faster than anticipated in the base case. This scenario holds all the inputs from the base case constant except that we have increased the terminal growth to 7.0% – based on 2011 growth of 20% decreasing to 5% over ten years – and lifted EBITDA margins to 42.5%. This scenario has a valuation of US$590.39 per share. This is 8.9% above the current share price and 22.5% above our base case valuation.

Valuecruncher Valuation GOOG – Growth

2. Disruption – where Google’s current market dominance is reduced by changes in the competitive landscape. This scenario holds all the inputs from the base case constant except that we have decreased the terminal growth to 5.5% – based on 2011 growth of 15% decreasing to 4% over ten years – and dropped EBITDA margins to 37.5%. This scenario has a valuation of US$363.22 per share. This is 33.0% below the current share price and 24.6% below our base case valuation.

Valuecruncher Valuation GOOG – Disruption

3. Black Swan – where Google’s internal activities create a new growth business similar in value to Salesforce.com. The new business grows from US$250 million in revenues in 2009 to US$1.5 billion in 2012 and from $250m in losses to 50% EBIT margins in the same period. To reflect this we have increased 2009 revenues by US$250 million and 2010 revenues by US$500 million. We have reduced the 2009 EBITDA to 39%. We have also lifted the terminal growth to 6.65%. This scenario has a valuation of US$507.85 per share. This is 6.4% below the current share price and 5.4% above our base case valuation. Google creating a new business of the value of Salesforce.com adds just under US$26 to our base case share price.

Valuecruncher Valuation GOOG – Black Swan

Valuecruncher greatly respects Google’s current market dominance in search and on-line advertising. However – we can see both a situation where Google maintains this dominance and more advertising spend moves from traditional media to on-line and conversely one where new methods of discovery on-line disrupt Google’s current dominant position. We do not have a perspective on which of those might occur – but it is worth considering the impact of both scenarios from a valuation perspective. These are scenarios 1 and 2.

Our third scenario looks at the valuation impact if one of the internal Google R&D activities produces a material new business unit (say US$1.5 billion of revenues by 2012 at 50% EBIT margins). The value of this new business unit is ~US$8.1 billion in the valuation – comparable to the current enterprise value of a Salesforce.com.

Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

Last week New York-based venture capitalist Fred Wilson wrote a blog post on his decision to buy some Google shares which also linked to his Covester account where you can track actual investment transactions of members.  The blog and Covester posts outline the “back of the envelope” calculations that Fred did in deciding to buy the shares.  Fred’s calculations are pretty basic – which is what most people (including very smart people like Fred) do.  At Valuecruncher we try to take the analysis step a little bit further.

Here is our take on Google:

Valuecruncher places a mid-point valuation on Google of $511 per share.  This is based on annual revenue growth decreasing from 35% in 2008 ($22.4 billion in revenues) to 15% in 2012 ($50.2 billion) then decreasing to a 5% terminal growth in 2018. Valuecruncher projects a 35% EBIT margin being maintained over this period - $7.8 billion in 2008 to $17.6 billion in 2012.  Valuecruncher projects capital expenditure growing to $4.5 billion in 2012 and remaining at that level.  Valuecruncher uses a discount rate of 10.5% and a 30% effective tax rate in the DCF calculation.

Valuecruncher has then created three separate scenarios:

1. Growth - where Google’s current dominance of on-line search and advertising is enhanced and revenues grow faster than anticipated in the base case.  This scenario holds all the inputs from the base case constant except that revenues growth decreases at a slower rate from 35% in 2008 to 25% in 2012.  This scenario has a valuation of $631 per share.  This is 34% above the current share price and 23% above our valuation.

2. Disruption - where Google’s current market dominance is reduced by changes in the competitive landscape.  This scenario holds all the inputs from the base case constant except that revenues growth decreases from 35% in 2008 to 25% in 2009 then to a flat 15% to 2012.  This scenario has a valuation of $426 per share.  This is 10% below the current share price and 17% below our valuation.

3. Black Swan - where Google’s internal activities create a new growth business similar in value to Salesforce.com that is separate to the current business.  The new business grows from $250m in revenues in 2009 to $1.5bn in 2012 and from $250m in losses to 50% EBIT margins in the same period. This scenario has a valuation of $533 per share.  This equates to a 5% increase on the current share price or 4% on our valuation.

Valuecruncher greatly respects Google’s current market dominance in search and on-line advertising.  However – we can see both a situation where Google maintains this dominance and more advertising spend moves from traditional media to on-line and one where new methods of discovery on-line disrupt Google’s current dominant position.  We do not have a perspective on which of those might occur – but it is worth considering the impact of both scenarios from a valuation perspective.  These are scenarios 1 and 2.

Our third scenario looks at the valuation impact if one of the internal Google R&D activities produces a material new company ($1.5 billion of revenues by 2012 at 50% EBIT margins) that is separate to the current Google business.  The value of this new entity is $6.8 billion in the valuation – comparable to the current enterprise value of a Salesforce.com.

Details of the base case valuation and three scenarios are included in the attached valuation report.

Valuecruncher Valuation Report - Google 3 March 2008

Updated: Checkout the Valuecruncher Valuation model used and enter your own assumptions-  Valuecruncher Valuation Model – YouTube

Google has recently announced plans to introduce a new overlay styled advertising model for YouTube. The model involves overlaying a semi-transparent ad across the bottom 20% of the video. The overlay appears after 15 seconds of the video and last for 10 seconds with viewers having the option to click on the ad. The overlay model is the result of trials of various advertising formats that included pre-rolls.

The initial release will involve overlay advertising on videos provided by YouTube’s content partners. The advertising revenue will be shared with content partners using a similar model to the Google Adsense network.

This announcement is significant in that it represents the first attempt by Google to monetize their $1.65 billion acquisition of YouTube beyond traditional text and banner advertising. Google acquired YouTube nearly 12 months ago and it has yet to generate significant revenues:

Revenues realized through the Google Print Ads Program, Google Audio Ads, Google Video, Google TV Ads, Google Checkout and YouTube were not material in any of the periods presented. Google 10-Q, 30 June 2007

In a wider context-how the overlay framework will be received will be significant for online video in general, until now revenue models involving pre-roll advertising have not been well received by viewers.

The announcement of the overlay framework has generated a range of analysis including a number of posts on Silicon Alley Insider (SAI) estimating the potential revenue YouTube could generate from in-video advertising.

SAI Analysis:
Economics of Online Video 1
Economics of Online Video 2
Analyzing YouTube’s Revenue Potential

SAI’s analysis includes estimates of YouTube’s operating expenses.

Valuecruncher has built a high-level valuation model for YouTube incorporating the SAI analysis of the overlay revenue model, Valuecruncher’s analysis of the opportunity and a range of other online sources. The valuation model is designed to value YouTube as an independent entity with revenues coming from both in-video advertising and traditional online advertising (Adsense and banners).

Key Assumptions

Videos Streamed
The total number of videos streamed is important for estimating the costs associated with operating the YouTube. These costs include streaming and storage. Based on ComScore data United States viewers watched 2.4 billion videos at YouTube in July 2007. In August 2006 the United States accounted for approximately 22% of all YouTube’s streaming activity. Valuecruncher has assumed an average of 15 billion videos will be streamed worldwide per month in 2008 increasing to 50 billion per month in 2012. This is an aggressive growth rate that is very subjective. Valuecruncher believes that based on YouTube’s current audience and the projected increase in time spent online this growth is achievable. If YouTube can establish a sustainable revenue model for online video combined with its audience dominance it will become the default online distribution channel for content providers.

Percentage Monetized
YouTube is implementing the overlay ads on videos provided by content partners. The percentage monetized represents the portion of YouTube’s video servings that will contain advertising. Valuecruncher has utilized SAI estimate that 30% of YouTube’s servings will be monetized. Google does not disclose what portion of YouTube’s inventory content partners supply and it is uncertain what percentage of “individual” generated content would be monetized.

Content Royalty ‘
The content royalty represents the percentage of the advertising revenue that is distributed to content providers. This model is similar to the Adsense framework. We have estimated that 60% of the advertising revenue will be passed onto content providers. This is lower than the estimated 85% paid out in the Adsense framework. The lower content royalty reflects the higher costs associated with delivering the video content.

CPM Rate
The CPM rate reflects the price paid by advertisers per 1,000 overlays. Valuecruncher has used an estimated CPM rate of $20.

Storage & Streaming Expenses
Valuecruncher utilizes the SAI’s analysis and assumes storage and streaming expenses of $1.20 per 1,000 videos streamed. These expenses are expected to drop to $0.23 per 1,000 videos streamed by 2012. The assumed decline in delivery costs is based on streaming costs falling at a greater rate than video file sizes increase.

Sales, General and Administration (SG&A) Expenses
SG&A expenses are estimated at 15% of revenues based on Google’s SG&A.

Research and Development (R&D)
YouTube’s R&D is estimated at 10% of revenues and is expensed not capitalized.

Supplementary Revenues
Valuecruncher assumes that YouTube will be able to generate additional revenues via Adsense and banners. Valuecruncher has assumed a CPM rate of $0.75 and for simplicity has applied this to the total number of videos streamed.

Cost of Capital
Valuecruncher uses a cost of capital of 15% for YouTube, this is higher than the 12% used by analysts for Google. Valuecruncher believes the uncertainty surrounding the acceptance of the overlay intrusion and CPM rates advertisers will pay justifies the higher cost of capital.

Long-term Growth
Valuecruncher has used a long-term growth rate of 7%, this growth rate represents the potential of online video beyond the 2012.

YouTube Valuation
Based on the assumptions above Valuecruncher estimates the enterprise value of YouTube at $4.91 billion (this point estimate is very sensitive to a number of subjective assumptions and Valuecruncher encourages readers to interrogate the valuation by adjusting some of the assumptions – Valuecruncher Valuation Model – YouTube). This represents $15.73 per share for Google shareholders or 3.0% of Google’s value (based on a share price of $522.65). Google is currently trading at an EV/EBITDA multiple of 29.14. The YouTube valuation implies an EV/EBITDA multiple of 52.77 based 2008 EBITDA, this is relatively high multiple reflects the significant growth expected over the next 5 years. Based on analysts forecasts for Google and Valuecruncher’s projections YouTube will represent 9.3 % of Google’s revenues ($3.65 billion of $39 billion) and 3.4% of Googles EBITDA ($645 million of $19 billion) in 2011. Google’s current EBITDA margins are approximately 38% driven by Google Adwords. The delivery costs and revenue sharing of associated with online video content contribute to significantly lower EBITDA margins for YouTube (24% in 2012 in Valuecruncher’s financial projections).

Based on Valuecruncher’s projections YouTube’s ad overlay revenues would represent approximately 4.4 % of online advertising (based of PwC estimates) and approximately 32% of online video advertising in 2011.


This valuation involves a number of very subjective assumptions and considerable uncertainty.
Key issues include:

• Viewer response to the overlay advertising; will they reject the intrusion and exit the videos?
  
• How viewers respond will be crucial to determining what CPM rates advertisers are willing to pay.
  
• What percentage of videos advertisers will be prepared to advertise in?
  
• How will YouTube match advertisers with content and visitors?
  
• Although the overlay model has been trialed it is still unproved with a mass audience. Other revenue models may emerge including a cost per click framework in place of or in conjunction with the CPM framework that could have a significant impact on YouTube’s valuation.
  
• YouTube’s potential margins are dramatically reduced by monetized content subsidizing the cost of delivering “non-commercial” content.
  
• Will YouTube continue to dominate the online video space or will competitors that focus on a purely “premium” content (i.e not have the cost cost of serving non-monetizable content) develop a superior business model?
  

In the online world there are two key metrics; eyeballs and content and these two metrics are very highly correlated. At the moment YouTube dominate both of these categories but it will be interesting to observe how this changes as more “premium content” moves online. Will YouTube become the online broadcaster of choice for content providers?

A key issue that this valuation reiterates is that “content is king”. A significant portion of the projected growth in the online advertising spend will be realized by content providers not the distribution channels. This is the model that businesses such as WatchMojo are looking to capitalize on.

Did YouTube’s founders miss out when they sold for $1.65 billion?
YouTube has grown significantly since the Google acquisition in October 2006. At the time of acquisition YouTube was at best operating at breakeven, facing legal action and had no sustainable business model in place. The Valuecruncher valuation may underestimate the uncertainty surrounding the advertising potential but based on the uncertainty that existed at the time of the acquisition and the costs associated with scaling YouTube to the size it is today the acquisition price of $1.65 billion is still a great result for the YouTube founders.

Valuecruncher has placed a value on Google of US$325.01 per share with a range of US$257.01 and $402.31. Currently Google is trading at US$509. We believe that the stock is over-valued and appears priced for perfection.  The market appears to be valuing the continuation of the current businesses success and placing value on the options the company has generated.

Key Assumptions

Revenue Growth

Although revenue growth has been high for Google over the past three annual periods, with growths of 117.56% and 92.48% in the periods of 03/04 and 04/05, respectively, we forecast the growth of Google to be slowing down. For the current valuation, growth for the 05/06 periods have been estimated at 80%, declining to 60% and 40% for the periods 06/07 and 07/08, which corresponds to a decrease in revenue growth by 20% per year.

EBIT Margins

EBIT margins over the past three years have ranged from 24% in 2003 to 35% in 2005. For 2006, the EBIT margins have been maintained between 35-40%. For the purpose of this valuation we have used EBIT margins of 35%.

Terminal Growth

Terminal growth has been estimated to be 6%.

WACC

WACC has been estimated to be 12%

Google Valuation

Aswath Damodaran - a well know finance academic and author - has a valuation of Google on his site.  His valuation (completed in September 2006) is below our value at US$217 a share.