Arithmetic and Google's IPO
By Arnold Kling
Allan Sloan warns investors away from Google’s IPO.
A price of $135 a share would give Google a stock market value in the neighborhood of $36 billion…Google’s profit and revenue have been exploding — from $7 million on $86 million of revenue in 2001, its first profitable year, to $191 million on revenue of $2.26 billion in the 12 months ended June 30. (All year-ended-June-30 numbers are mine, derived from Google filings.) But Google’s not a small start-up anymore. Limiting factors are already setting in.
In Arithmetic in a Bubble, I pointed out why the price-to-revenue ratio on a stock might be close to one. If the price-earnings ratio is 25, and the profit margin is .04 (meaning earnings are 4 percent of sales), then multiplying those two numbers together gives a value of one.
Using a price-to-sales ratio of one, then Google should be valued at $2.26 billion, not $36 billion. At $36 billion, Google’s price-revenue ratio will be over 15. When I wrote my essay, Yahoo! had a price-revenue ratio of 150. So the Google IPO would not start out as ridiculously overpriced as Yahoo! was in the latter stages of the dotcom bubble.
UPDATE: Kevin Murphy and Michael Jensen, in a long paper on executive compensation, argue that overvalued stocks cause problems.
Managers in overvalued firms eventually realize they cannot generate the performance necessary to support their sky-high stock price. So, they use the firm’s overvalued equity as currency to make acquisitions to satisfy growth expectations. They use access to cheap capital to engage in excessive internal spending. They make increasingly aggressive accounting and operating decisions that shift future revenues to the present and current expenses to the future. Eventually when these fail to resolve the issues, managers — under incredible pressure to preserve high stock prices —turn to further manipulation and even fraud. The result of all these actions is to destroy part of the core value of the firm.
For Discussion. In 1999, few people thought that Yahoo! would lose its place as the top search engine. How secure is Google’s position today?