Valuing Google and Yahoo

With advertisers currently paying an average of $1.75 per click-through (according to Fathom Online, March 2005 data), Google's reported gross revenue of $1.257 billion for first quarter 2005 is equivalent to 718 million total click-throughs during the quarter, or 240 million click-throughs per month. Given that the number of active Internet users worldwide far exceeds this 240 million figure, it is easy to understand where Google's revenue comes from: If the typical Internet user clicks through a Google paid search ad just once a month, Google's billion dollar (and rapidly growing) quarterly revenue stream can easily be accounted for.

Obviously, paid search is an amazingly lucrative business. In their enviable position as Internet search leaders, Google (GOOG) and Yahoo (YHOO) are raking in the lion's share of the profits. In this post I take a look at the valuation of both companies, to judge whether or not they make promising investments at current market prices.

First, here are the historical top-line and bottom-line growth numbers:

ANNUAL
In $ Million (YOY % Growth) for 2001, 2002, 2003, 2004

For Google:
Revenue: 86 (353%), 440 (412%), 1466 (233%), 3189 (118%)
Net Income: 7 (---), 100 (1329%), 106 (6%), 399 (276%)
Profit Margin: 8%, 23%, 7%, 13%
Diluted EPS: $0.04, $0.45, $0.41, $1.46

For Yahoo:
Revenue: 717 (-35%), 953 (33%), 1625 (71%), 3575 (120%)
Net Income: -93 (---), 43 (---), 238 (453%), 840 (253%)
Profit Margin: -13%, 5%, 15%, 23%
Diluted EPS: -$0.08, $0.04, $0.19, $0.58

QUARTERLY
In $ Million (QOQ % Growth) for 2004Q1, Q2, Q3, Q4; 2005Q1

For Google:
Revenue: 652 (27%), 700 (7%), 806 (15%), 1032 (28%); 1257 (22%)
Net Income: 64 (137%), 79 (23%), 52 (-34%), 204 (292%); 369 (81%)
Profit Margin: 10%, 11%, 6%, 20%; 29%
Diluted EPS: $0.24, $0.30, $0.19, $0.71; $1.29

For Yahoo:
Revenue: 758 (14%), 832 (10%), 907 (9%), 1078 (19%); 1174 (9%)
Net Income: 101 (35%), 113 (11%), 253 (125%), 373 (47%); 205 (-45%)
Profit Margin: 13%, 14%, 28%, 35%; 17%
Diluted EPS: $0.07, $0.08, $0.17, $0.25; $0.14

Year-on-year revenue growth at both Google and Yahoo were a phenomenal 120% in 2004. Over the most recent five quarters, sequential quarterly revenue growth has averaged 20% at Google and 12% at Yahoo. 2004Q4 and 2005Q1 show that revenues have accelerated recently (especially at Google which depends almost exclusively on paid search). Expanding profit margins, now in the 20% to 30% range, are an indication of how efficiently the paid search business "scales" on high revenue growth and controlled fixed costs.

With the above historical growth trends as a guide, I now take a look at current market valuation using the following five-year pro forma assumptions:

Company: Remainder of 2005; 2006-2009

Revenue Growth:
Google: 15% QOQ in 2005; 30% YOY thereafter
Yahoo: 10% QOQ in 2005; 30% YOY thereafter

Profit Margin:
Google: 25% in 2005; 25% thereafter
Yahoo: 20% in 2005; 25% thereafter

Additionally, assuming 5% share dilution per year (largely from exercise of employee stock options) and five-year take-out pricing at the beginning of 2010 at a PEG of 1.5 (corresponding to a P/E of 36), I find:

Company: Current Price (as of 22-Apr-2005), 5-Year IRR
Google: $216, IRR = 18%
Yahoo: $35, IRR = 19%

In arriving at these pro forma returns, I have assumed that: a) the current momentum in Google's business allows its revenue and profit margins to run ahead of Yahoo's for the remainder of 2005; and b) beginning in 2006, the businesses "converge" on the same 30% YOY revenue growth and 25% profit margins.

The high double-digit pro forma IRRs indicate that, at their current stock prices, Google and Yahoo afford very attractive returns under moderate growth assumptions. With the Internet still in its early days (Google's founders compare their company to a first or second grader "born" in 1998), plenty of growth catalysts still lie ahead:

* Growing international user base;
* More time spent per Internet user as PC, TV and radio merge (broadband, RSS syndication);
* Higher relevance of information (assisted by search);
* More personalized content (think blogs);
* Greater community (I have high expectations for Yahoo!360, now in beta).

Given the "network effect" with the "societal value" of Google and Yahoo's offerings growing as the square of the number of users, I find it very difficult to imagine a future scenario under which the intrinsic value (hence, market value) of these companies would not grow by leaps and bounds.

With Google and Yahoo playing increasingly indispensible roles in how we retrieve, organize, process and share information in our daily lives, I believe it very likely that my 30% revenue growth and 25% profit margin assumptions will turn out to be overly conservative, implying that significantly higher than 20% annual returns should be available to investors holding these stocks over the next five years.

(Disclosure: I am long YHOO and am giving serious consideration to buying GOOG following the one-year anniversary of its IPO.)