Something interesting to note. WDC has continually grown their book value every year. It has never dipped. Its median annual growth is 47%. If they continue the trend and their book value grows by 35% for 5 years, their 2015 book value would be $86.86. Every stock trades for a price of at least their book value and only that low when the company is going bankrupt. A stock price of $86.86 in 5 years represents a yearly gain of 16%.

This idea has stuck with me. I believe it to be valid. I made a note to re-evaluate if WDC went below $35. It has.

The big question here would be if WDC can continue to increase their book value for 5-years at an average annual growth rate of 35%. They have done better than this for each of the past 10 years. The book value has never declined, even when earnings have. If book value climbs to $86 over the next five years, the stock price will rise a minimum of 20% annually.

Under $35, WDC looks like a great deal. I have no available cash to make a purchase but I definitely would if I could.

Western Digital is another company I purchased last year but sold soon after for fear of a market downturn. Again, it was the wrong decision. I wrote in July about expecting annual growth in book value of 35%. The stock was priced at $32 in July 2010, today it’s at $41, a 28% increase. My 2010 expectations were:

Book: $17.79 per share
Earnings: $2.81 per share

Actual 2010 results were:

Book: $19.37 per share
Earnings: $5.93 per share

The earnings growth was over the top at 185% and isn’t expected to continue. In fact, Standard and Poor’s expects 2011 earnings of $3.01. That number isn’t great but it would still be a 21% annual growth rate from 2009 to 2011. It would also represent very close to a 12% return on book value. It will be a year to watch closely. If return on book value goes below 12%, that is a red flag.

I’m sticking with my expectations of 35% growth in book value. For 2011, I’m looking for:

Book: $26.15 per share
Earnings: $3.14 per share or better (12% of book or better)
Price: Who knows!

With their earnings swinging, it’s difficult to price the stock using a P/E ratio. Their current P/E of 11.5 would result in a price of $36. In 2010, their price to book ranged from 1.8 to 3.6 times book. If that range sticks and a book value of $26.15 is achieved, the price range would be $47 to $94. Those numbers are opposed to Standard and Poor’s 12-month outlook of $36, based on price to sales and price to earnings estimates (S&P is expecting a tough year due to a possible market shift to solid-state drives.)

All-in-all, Western Digital still seems like a good company to own if already owned, but not something I would jump in and buy today. The year ahead could be bumpy and might indicate future difficulty. I’m not going to re-purchase WDC but I’m definitely going to keep them on the radar. If the price dips below $35, I will re-evaluate. Such an event could be a good buying opportunity or could signify deteriorating business conditions.

Something interesting to note. WDC has continually grown their book value every year. It has never dipped. Its median annual growth is 47%. If they continue the trend and their book value grows by 35% for 5 years, their 2015 book value would be $86.86. Every stock trades for a price of at least their book value and only that low when the company is going bankrupt. A stock price of $86.86 in 5 years represents a yearly gain of 16%.

I started writing this review in January, when Google was priced above $600. I then got busy with life and put this review on hold. Here’s how I started:

Once again I failed to follow my own advice and lost out on some nice gains posted by Google. I purchased Google twice in 2010, with an average price of $530. After my first purchase at $580, it dropped $100 and I purchased again. If I would have held until today, I would have been looking at a 15% gain. Instead, I sold at break-even because I was worried about a market down turn.

I need to take Warren Buffet’s advice to heart. The market cannot be predicted. Just because the market *should* go up or down doesn’t mean that it will. Instead of trying to predict, I should just find good companies, wait for them to be priced well, and buy to hold. The reason to sell should be that the stock price is significantly higher than what the fundamentals of the company warrant. This situation signifies a bubble and would be a good time to go to cash.

I’ve since re-purchased Google and intend to hold it for Buffet’s favorite holding period — forever (or once the price is much higher than is warranted by its fundamentals.)

I built a spreadsheet last year and plugged in Google’s numbers. I crunched and crunched until I came up with what I considered a conservative plan. I determined that Google should have a sustainable growth rate of 24% a year (yes, that’s more than the 18% I wrote in my first article.) I plotted estimates for 2010 that looked as follows.

Book: $118.25 per share
Earnings: $25.29 per share
Price: $605 per share

Amazingly, Google performed very close to my estimates.

Book: $121.20 per share
Earnings: $26.31 per share
Price: $620 per share

If Google’s fundamentals matched so closely to expectations, why has their share price not matched the expected prices I posted? The world is fickle. They missed their recent earnings by $0.02, which sent the share price down. They’ve changed CEO’s, which scares people… maybe something bad is happening. Finally, I used overly optimistic calculations. The world is much different today than it was five years ago. Investor’s are more risk-averse.

I’m satisfied with my expected growth rate of 24%. Because a fair P/E ratio is the same as a company’s expected growth rate, Google’s current price should be $631 based on its earnings. It’s currently 19% below that. If Google continues to grow at 24%, the share price could touch $780 sometime in the next year. Here’s what I’m looking for at 2011 year-end.

Book: $150.56 per share
Earnings: $32.68 per share
Price: $621 per share

This price uses today’s P/E ratio of 19. I believe Google warrants a higher P/E but what I think doesn’t really matter. There are reasons its P/E could go up and reasons it could go down. I’m going to be conservative and use today’s P/E instead of relying on the best-case scenario. Here are prices at various P/E ratios using an estimated 2011 earnings per share of $32.68.

P/E 14 (low from 2009): $458
P/E 16 (low from 2010): $523
P/E 19 (current): $621
P/E 21 (growth rate expected by S&P): $686
P/E 24 (fair P/E based on expected return): $784

I purchased a handful of Western Digital (WDC) shares today. Their fundamentals look strong and the price of the stock appears undervalued. Although I am uncertain of how strong the company’s durable competitive advantage is, they do have an excellent brand name. I use WD drives in my own computers and would use them exclusively if given the option.

Pros

• Consistently positive equity growth for the last 7 years, 47% median. Continued growth at 35% for five years would put the book value per share at $80.08 in 2015. A stock price of only 1x book value would represent an annualized return of 21% from today’s price of $31.40. The stock typically trades from 4x to 8x book value.
• Strong and consistent return on equity, 37% median. I consider ROE to be a company’s sustainable growth rate. WDC is employing their capital to great effect and growing their revenue well.
• Current TTM P/E is 5.5, typical low is 8, and usually hovers around 10 with occasional pushes up to 18. With earnings around $6, pushing back up to a P/E of 8 should lift the stock price to $48, a 52% gain.
• Retained earnings from 2002 to 2009 of $12.95 have produced 2010 earnings that are $6.03(E) higher than 2002, a 46% effectiveness of reinvesting in the company.
• Long term debt has consistently been kept under 1x net income.
• Standard & Poor lists WDC as a 5-star pick with a 12-month target price of $55.

Cons

• While the annual earnings growth has been good (median 42%), it has dipped twice in the past 7 years.
• They sell the same physical hardware as their competitors. What they can’t make up in brand name and service level, they must discount in price. Their product is constantly endangered by innovation. They’re in a price-competitive business without a rock-solid durable competitive advantage.
• I’m not certain that they can raise their prices with inflation. High pricing pressure may incite B2B partners to look for lower prices elsewhere.

Fifteen Things to Despise about Government Regulation

In some ways, then, a worsening system of medical provision is only the beginning of the downside of universal health insurance. The unseen costs include inflation down the line, worsening business cycles, and, quite possibility, the final destruction of the dollar and the wiping out of all private wealth.

Read more: Healthcare Intervention: The Bigger Picture

He dwells only on what he would have the state do for the people. Where, then, are the prohibitions? The program he favors would cost X hundred million dollars annually. From where come these millions? The state has nothing except that which it takes from the people. Therefore, this man favors that we be prohibited from using the fruits of our own labor as we choose in order that these fruits be expended as the state chooses.

Read more: Find the Wrong, and There’s the Right

Democratic representative Dennis Kucinich sponsors a bill called the American Monetary Act. On its face, the act would “strip the banks of their privileges and put the money power back into the hands of the people through their elected representatives; it would break the bankers’ secretive monopoly racket, which enables them to pay out billions in bonuses while ordinary people suffer” (mises.org). Looking deeper, the act may get us out of difficult times for the short run but is just another step down the path of big government, less freedom, and more economic toil. Read the article that takes a deeper look at the American Monetary Act at mises.org.

The coming collapse represents both great danger and great opportunity. We have a chance to fix fundamental flaws with the current system but we’ll have to stay alert to avoid supporting a new system that doesn’t work.

How did I not purchase Google at a price of $262 on 11/21/2008? What an epic failure!

Summary

1-Year Target Price: $945
Expected EPS Growth Rate: 18%
Scheduled Review Dates:
     4/2010 - Next Earnings Release
     1/21/2011 - Postmortem on 1-year target
 
 

Does Google have a durable competitive advantage? Yes.

It could have been argued ten years ago that Internet search was an emerging technology, competition fierce, and investments subject to a great amount of risk. I don’t think that is any longer the case. Google has established itself as the #1 search engine, making Google the phonebook of the world. Many have tried (Yahoo, Microsoft’s Bing, etc) but have not succeeded. When a person needs information, they Google it. The company’s name has become part of our language. That is a significant competitive advantage.

Is Google’s competitive advantage durable? Is it the same service today as it was ten years ago? Will it be the same in another ten years? Yes. To start, look at the user interface. It hasn’t changed since Google started. They haven’t tried to make it fancy. It’s streamlined, the same way it was at the turn of the millennium. Ten years from today, it will look and act the same. There’s no need to change it.

Anyone who watches television can recall a number of very funny Yahoo commercials. More recently, Microsoft is running a huge marketing campaign for its new Bing search engine. Has anyone ever seen a paid Google ad? Nope. Google doesn’t have to pay to advertise. Why should they? They earned $22 billion in 2008 without any fancy ads. Since day one they’ve advertised through three channels: word of mouth, press, and their own “Ads by Google” caption on websites that use their services. That’s it.

How does Google make money, since their search engine is free to use? A few cents at a time. Above and on the side of your search results are targeted ads. When you click one of those ads, the advertiser pays Google a fee they previously agreed upon. The higher the fee they’ve agreed to pay, the higher their ad appears among the other ads. The minimum amount is $0.10 and amounts up to $1.00 per click can be found for highly competitive keywords. If the average click price is $0.20, it takes 300 million ad clicks every day to add up to $22 billion in one year. Google’s service is used by millions of customers every day. Take that Gillette! I only use your razor once a day but I Google fifty times.

Return on Equity / Return on Capital

Google’s return on equity has averaged 23% since 2003, the first year the company had a positive book value. Google’s capital is nearly identical to its equity so the return on capital has averaged 23% as well. This number is above my minimum requirement of 12% and bolsters the claim that Google has a competitive advantage and is not in a price-competitive business.

Earnings Growth

Google’s earnings have steadily increased year after year, including 2008 which proved to be a trying year. Since becoming profitable, Google has achieved an annualized 87% EPS growth rate. Since achieving revenues of $10 billion in 2006, its annualized rate has been 27%. Although growth was flat in 2008, growth from 2008 to 2009 was 53%, and growth from 2007 to 2009 was 24% annualized. Using a conservative growth estimate of 18% would give Google an EPS of $46.69 in 2014. Google’s price to earnings ratio averages between 30 and 62, giving an expected 5-year price target range of $1,400 to $2,895. From Google’s current price of $580, that would be an annualized 19% to 38%.

Effectiveness of Retained Earnings

Since attaining revenues over $1 billion in 2003, Google retained earnings of $43.53 per share from 2003 through 2008. In 2009, Google’s EPS was $20.41. Compared to 2003 earnings of $0.51, that is an increase of $19.90. Dividing the $19.90 gain into the total of $43.53, Google made a 46% return on the earnings it retained for that period. This shows that Google is excellent at putting it’s earnings back to work to make even greater profits.

Long Term Debt

Google has never had any significant long term debt. I like to see a company carry less debt than 4 times annual earnings. Google’s long term debt plus current liabilities has never been greater than one year’s annual earnings. Google is conservatively financed and can be due to their competitive advantage which is a cash machine.

Organized Labor

Companies with a competitive advantage don’t have to deal with labor unions. Google can pay attractive salaries to its employees because of its competitive advantage. Unions aren’t necessary. I don’t like to invest in companies run by labor unions. Google should never have to deal with union negotiations, a definite plus.

Inflation

A company with a competitive advantage can raise prices as inflation demands. For example, if the price to make a Nike shoe goes up 3%, they will raise their sale price by an equal amount. Nike won’t lose customers. People want their product and will pay a higher price as inflation demands.

The genius of Google’s business plan is that they don’t have to raise their prices. They never set their own prices! Google is always paid whatever the customer decides to pay. Using a bidding system, Google’s price structure is true capitalism.

Inflation is an increase in the money supply. More money being available means the money is less valuable. As Google’s customers receive more money of less value, they will be more willing to spend higher amounts on advertising. Google’s revenues will automatically adjust to inflation as their customer’s sales prices adjust.

Stock Buy Back

Google has not undertaken any aggressive stock repurchasing. This is the only drawback I see to their business strategy but it is hard to argue with putting the cash back in to the business for a 46% return. Buying back its own stock would increase investor share but likely not anything near 46% gains.

Book Value

Google’s book value has steadily increased year after year. This is another mark of a well managed company with a durable competitive advantage. Its first year with a positive book value was 2003 at $7.66 a share. In 2008, the book value per share was $71.09, a growth rate of 56% a year. From 2006, Google’s first year of revenues over $10 billion, to 2008, the book value has increased at 20% per year.

Google’s price has ranged from 6 to 13 times book value. With the 2008 book value of $71.09, Google’s stock price should range from $427 to $924. The current TTM book value of $106.40 yields a price range of $638 to $1,383. At the current price of $580, Google is trading at 5.5 times book value, below its average low. At the average book value multiplier of 9.5, Google’s stock should be priced at $1,011, a 74% gain above today’s price.

Growth Stock Valuation

Benjamin Graham, the father of value investing, gave a formula for calculating the value of a growth stock as EPS * (8.5 + (2 * Expected Annual Growth Rate)). Google’s 2008 EPS was $13.31. Using our conservative growth rate of 18% from above, this formula would give a stock value of $13.31 * (8.5 + (2 * 18)) or $592.30, which approximates the current price. The 2009 EPS was $20.41, which gives a stock value of $908.25. It appears that Google is undervalued by 57%.

Graham’s formula can also be applied in reverse to calculate the growth rate at which the market is currently valuing the company. Using the 2008 EPS of $13.31 and the current price of $580, the formula is (($580 / $13.31) - 8.5) / 2. This yields an expected growth rate of 18%. Using the 2009 EPS of $20.41, the expected growth rate is 10%. This rate is significantly under Google’s historical rates and shows that the stock price is undervalued.

Interesting to note here is that Google’s P/E ratio has historically ranged from 30 to 62 for an average of 46, which is eerily close to the P/E multiplier of 44.5 we receive from Graham’s method when using an expected growth rate of 18%.

Recent Events

Google announced 2009 earnings tonight of $20.41. This earnings report caused a bad quarter in 2008 to drop out of the 12-month trailing EPS picture. Before the announcement, Google was trading at a P/E of 38. With the earnings announcement, the P/E ratio has dropped to 28, below Google’s typical low for P/E ratio. To reach back up to its current P/E of 38, which is still below its average of 46, the stock price would need to reach $776, a gain of 34%.