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A Benjamin Graham Value Analysis for Google

Warren Buffett has been exclusively following Graham's value investing framework for 57 years. Google qualifies under blue chips, but is just as justifiable as a defensive Graham stock

April 24, 2018 | About:

Alphabet Inc. (NASDAQ:GOOG) (NASDAQ:GOOGL), the parent company of Google, is an American technology company that specializes in internet-related services and products. Google was founded by Larry Page and Sergey Brin in 1998 while they were students at Stanford University. 

Alphabet was created through a corporate restructuring, becoming the parent company of Google and several subsidiaries. Shares of Google's stock have been converted into Alphabet stock, which now trade under Google's former ticker symbols.

Benjamin Graham is known as the "father of value investing". Warren Buffett (Trades, Portfolio) says he has been exclusively following Graham's value investing framework for 57 years.

Previously, we discussed "How To Build A Complete Benjamin Graham Portfolio."

Graham recommended five investing strategies, depending on the kind of investor one was. Blue-chips were for the most passive investors, while special situations were meant only for the professionals.

In this article, we will determine if Google qualifies for investment under one of these strategies.

Financial condition

Below are Google's sales and balance sheet figures, which are used to verify its financial condition and calculate its net current asset value (NCAV or net-net).

  • Annual sales: $110.8 billion
  • Current assets: $124.3 billion
  • Intangibles: $19.44 billion
  • Goodwill: $16.75 billion
  • Total assets: $197.3 billion
  • Current liabilities: $24.2 billion
  • Long-term debt: $3.97 billion
  • Total liabilities: $44.79 billion
  • Shares outstanding: 703.60 million

Note: Graham analyses are done exclusively with annual data.

Per-share values

Below are Google's book value per share, tangible book value per share and earnings per share values, which are used to verify its earnings stability and calculate its defensive price (Graham number).

  • Book value per share: $219.50
  • Tangible book value per share: $191.52
  • Earnings per share: $18
  • EPS - one year ago: $27.85
  • EPS - two years ago: $22.84
  • EPS - three years ago: $20.57
  • EPS - four years ago: $18.79
  • EPS - five years ago: $16.16
  • EPS - six years ago: $14.89
  • EPS - seven years ago: $13.17
  • EPS - eight years ago: $10.21
  • EPS - nine years ago: $6.66

Defensive Graham investments require 10 years of uninterrupted positive earnings. Enterprising Graham investments require five years of uninterrupted positive earnings. NCAV Graham investments require one year of positive earnings.

Google clears Graham's qualitative criteria for the NCAV (net-net) investment grade. Therefore, one of its possible intrinsic values is its NCAV.

Ncav.png

(124,308 - 44,793)/703.60 = $113.01

But there are more Graham strategies to discuss.

Blue chips

From chapter 14, Stock Selection for the Defensive Investor, of "The Intelligent Investor":

"In setting up this diversified list he has a choice of two approaches, the DJIA-type of portfolio and the quantitatively-tested portfolio. In the first he acquires a true cross-section sample of the leading issues, which will include both some favored growth companies, whose shares sell at especially high multipliers, and also less popular and less expensive enterprises."

The "leading issues" or blue-chip strategy is very specifically not quantitatively tested, as Graham writes above. This strategy is particularly interesting to discuss because it goes against the common perception of Graham.

The idea of "favored growth companies whose shares sell at especially high multipliers" in a Graham portfolio may seem blasphemous. But there it is, in his own words.

Graham actually recommends higher price-earnings multiples for defensive investors than he does for enterprising investors, even for his quantitatively tested portfolios. But the idea that costlier stocks can be more defensive is very counterintuitive.

Google does qualify for investment under Graham's blue-chip category (strategy number one in the portfolio link above), being one of the biggest constituents of major indexes such as the S&P 500 and the S&P 100.

Blue chips also fall within Graham's definition of defensive investment, but the blue chips subcategory does not have a specific intrinsic value calculation.

Defensive investment criteria

Graham's criteria for quantitatively tested defensive investments, as discussed in the "Intelligent Investor," are as follows:

1. No less than $100 million of annual sales.

2-A. Current assets should be at least twice current liabilities.
2-B. Long-term debt should not exceed the net current assets.
3. Some earnings for the common stock in each of the past 10 years.
4. Uninterrupted [dividend] payments for at least the past 20 years.
5. A minimum increase of at least one-third in per-share earnings in the past 10 years using three-year averages at the beginning and end.
6. Current price should not be more than 15 times average earnings of the past three years.
7. Current price should not be more than 1.5 times the book value. As a rule of thumb, we suggest the product of the multiplier times the ratio of price-book value should not exceed 22.5.

The first criterion works out to $500 million today, based on the difference between the consumer price index and inflation from when the book was written in 1971.

The intrinsic value for a defensive stock can be calculated from the quantitative criteria (numbers six and seven) given above, which is popularly known as the Graham number.

GrNm.png

Let's see how Google's numbers stack up against the above requirements.

Final assessment: Defensive

Google actually clears all of Graham's requirements for defensive investment with flying colors, except for one.

Google has:

  • Sales/size: 221 times that required by Graham, even adjusted for inflation.
  • Current ratio: 2.57 times that required by Graham.
  • Net current assets/long-term debt: 25 times that required by Graham.
  • Earnings stability: Full 10 years, as required by Graham.
  • Earnings growth: 3.9 times that required by Graham.

If we are willing to overlook the one missing requirement — the dividends — Google is actually a stellar defensive Graham stock.

Considering Alphabet has an earnings growth rate 3.9 times that required by Graham — indicating it is utilizing its retained earnings very well — this is by no means an unwarranted assumption.

Thus, Alphabet's minimum intrinsic value here would be its defensive price (Graham number): $336.28.

But there's one more adjustment to make.

Graham's intrinsic value formulas actually allow for price-earnings ratios of 30 — or more — based on current bond yields.

We would, therefore, need to multiply the company's Graham number by 1.41 to adjust it to a price-earnings multiple of 30.

eqn9460.png

30÷15 = 2
√2 = 1.41

Intrinsic value = $336.28 x 1.41 = $474.15

Thus, we get a final Graham intrinsic value of $474.15.

But again, one needs to account for the fact Google is one of today's top blue-chip stocks that exceeds all of Graham's requirements for defensive investment by several multiples, especially earnings growth, which is nearly four times that required by Graham.

So Google's current price of $1,067.45 — which is 2.25 times the intrinsic value — is not an overvaluation even by Graham's standards.

Please note that no stock ever qualifies alone under Graham's framework. Every stock is always a constituent of a portfolio of similar stocks. Google would, therefore, qualify for investment as part of a diversified portfolio of defensive and blue-chip stocks.

About the author:

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Value Investing Software True To Benjamin Graham - SerenityStocks.com

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