Googling the capital markets

by John Q on April 30, 2004

The Google IPO has now been announced, and there are some more figures to analyze. In addition, I wanted to talk a bit about the option, suggested by one of the commenters on Kevin Drum’s blog of arbitraging by short-selling overpriced dotcoms and buying those with more reasonable valuations. Finally, I wanted to look at what all this means for capital markets and therefore for capitalism.

Looking at this NYT report, that doesn’t seem likely to be an option.

In 2003, Google reported an operating profit of $340 million on sales of $960 million. But the 2003 figure appears to understate the company’s cash profit margin, since it includes very high expenses related to stock options that will probably decline in future years. On a cash basis, Google had an operating profit of $570 million in 2003, and an operating margin of 62 percent.

Given those figures, Google will easily command a market valuation of at least $30 billion, and perhaps much more. EBay, which had an operating profit of $660 million on sales of $2.2 billion last year, is valued at $54 billion; Yahoo, with sales of $1.6 billion and operating cash flow $428 million, is valued at $36 billion.

I’m not an accountant, but I think the “operating profit” referred to here is EBITDA (earnings before interest, tax, depreciation and amortisation): in any case, it’s more than the profit accruing to owners of equity. So it appears that all of these well-established businesses are valued at more than 100 times annual earnings.

As I recall, the ratio for profitable companies during the hyperbubble was around 400, so some progress has been made. But these values still look bubbly to me. To match an investment in 10-year bonds, without allowing for any risk premium or for the inevitable increase in long-term interest rates, all these companies need to more than quadruple their earnings, then maintain those earnings for at least 20 years. Maybe Google can do this, and maybe Yahoo can do it, but it’s most unlikely that both of them can.

At one time, I would have tried hard to think of an explanation consistent with some notion of aggregate market rationality, in which capital markets allocate capital to its most productive us. In the light of the evidence of the last ten years – the dotcom bubble, the US dollar bubble, the (still continuing) bond bubble – I no longer bother. Capital markets are driven by fashion (in this case, the continuing desire to be part of the Internet happening, in the face of mounting evidence that it provides almost exclusively public goods), fear and greed. On average, capital markets do a better job than Soviet central planners, but I think they do less well than the mixed economy that was dominant during the postwar Golden Age.

Eventually, no doubt, reality will prevail. If I knew that was going to happen within the next twelve months, I’d be shorting the remnants of the dotcom sector for all I was worth. But, as Keynes apparently didn’t say, the market can stay irrational longer than you can stay solvent.



Mrs Tilton 04.30.04 at 12:52 pm

I’m not an accountant, but I think the “operating profit” referred to here is EBITDA (earnings before interest, tax, depreciation and amortisation): in any case, it’s more than the profit accruing to owners of equity.

I’m not an accountant either, but from time to time I get to observe them in the wild. I don’t know how the NYT is using the term, but ‘operating profit’ is a somewhat broader concept than EBITDA. OP is calculated from the top line down: it’s simply revenue from operations minus expenses of operation, i.e., the money a firm has from its ordinary business. EBITDA is calculated from the bottom line up, starting with net income (or loss) and adding back certain items. Thus OP can contain items you won’t find in EBITDA.

OP is ‘GAAP information’, i.e. a line item required in the income statement by US generally accepted accounting principles, International Financial Reporting Standards and (presumably) every other GAAP in the world. EBITDA isn’t. And, as it’s not defined by GAAP, different firms define it in different ways. Notorious are some of the ‘adjusted EBITDAs’ used to eliminate costs that, erm, ‘don’t give a true picture of the firms’ finances’ (or so their management). In some cases, significant costs that recurred like clockwork would be eliminated as ‘non-recurring’ or ‘extraordinary’. The SEC has recently cracked down on this, and the effects are filtering through to the European markets.

Operating profit is often a pretty decent measure for shareholders of how good a firm is at what it does. EBITDA can also serve in this role, but I think it’s of more interest to investors in debt instruments as a guide to how much free cash flow the firm will have to service the debt. (Shareholders, by contrast, have a claim on what’s left after the IT, D, A and everything else.)


Steve Carr 04.30.04 at 1:04 pm

John, you’ve made this argument contrasting the new capital-markets-rule world to the Golden Age a number of times. But this post in particular has me completely perplexed about what you’re actually saying. Are you suggesting that before 1973 (or whenever you think the Golden Age ended), the U.S. government would have been deciding which search engine technology or Internet auction service was the best and channeling capital to it accordingly? I have to say, if you look at the U.S. economy between 1946 and 1973, I don’t see any evidence of that sort of guidance or intervention. The major decisions about how to allocate capital in the U.S. have always been in private hands. In the postwar years, those hands were more likely to be the hands of corporate CEOs than stock-market investors, but the truth is that that’s still the case. There’s just a slightly greater check on CEOs by the capital markets today.

In any case, this whole argument seems theoretically dubious. In the first place, where is your control group? How do we know what would have happened if a “capital-markets-rule” regime had been in place in the wake of World War II, with all the advantages — from the perspective of economic growth, employment, wages, etc. — of an educated, industrialized developed world reconstructing itself and facing essentially no competition from the rest of the world? (The fact that the Golden Age maps so perfectly onto the pre-Japan, pre-Asian Tiger period has never quite seemed like a coincidence to me.)

Second, saying we had a Golden Age without mentioning what happened afterward — that is, descent into stagflation, collapsing productivity, etc. — seems sketchy at best. It seems unlikely that what happened post-1973 had nothing to do with what was going on pre-1973. Yet your entire argument assumes that had we just continued on with the “mixed economy,” we could have come up with better solutions to those problems, without acknowledging that the mixed economy was what created them.

Finally, I’m not even sure how sharp the break you imagine has been, at least in Europe. Are European governments really out of the business of managing their country’s labor markets and allocation of capital?

There’s no doubt that capital markets are given over to bouts of irrationality — though why you think this isn’t true of government planners is a little perplexing. And the stock market is especially speculative, and, I think, especially erratic in its judgment. But a good deal of this speculativeness is built into the problem we’re asking capital markets (or planners) to solve. To value Google today, you have to predict what the company, its rivals, the Internet, the government, etc. are going to do for the next two decades or so. That’s a remarkably — let’s say, insanely — hard thing to do. It is, by its nature, a speculative task. And I have yet to see any evidence — empirical, experimental, or theoretical — demonstrating that a small group of government experts, subject to political pressures, is likely to do a better job of it than the market.


Jack 04.30.04 at 1:40 pm

I would find this argument more convincing if I could see how a mixed economy would better:
a) provide negative feedback for irrational market pricing
b) mobilise enough capital to build all of the internet tools the market has provided.
I certainly wouldn’t wish to claim thatthe market has been doing a particularly great job recently but I think hte interesting questions are what speciic measures would fix what specific flaws in th current functioning of the market.


Mat 04.30.04 at 2:55 pm

The exact value of the planned share offering is US$2,718,281,828, which coincidentally also corresponds to the mathematical constant e.

This is all very serious…
(from the BBC.)


blair berbert 04.30.04 at 3:32 pm

It may be worth considering how efficient free markets are in allocating capital to industrial versus post-industrial (non-productive service) economies. In order to rationally distribute capital (no matter who, the state or private investor are in control over where the capital goes), the capital provider must have an accurate metric to determine which firms (or even nations, in a post-modern context) will maximize the ROI.

Measuring industrial ventures has historically been a somewhat straightforward task, in that you can measure output (goods sold) as a function of inputs (raw material, labor, etc.), as a way of getting at value added, and weigh that against the capital involved to come up with a sort of production/capital efficiency ratio. For service firms, however, valuation becomes vastly more difficult as labor and intangibles such as IP and technology rise greatly in respect to other material inputs. Furthermore, while the sale of services can still be reduced to a monetary value, the forecast of demand for said services is almost certainly an exercise in futility when its market is still in its infancy.


Tom 04.30.04 at 6:52 pm

“In addition, I wanted to talk a bit about the option, suggested by one of the commenters on Kevin Drum’s blog of arbitraging by short-selling overpriced dotcoms and buying those with more reasonable valuations. …
Looking at this NYT report, that doesn’t seem likely to be an option.”

I was the commenter who suggested this; I wasn’t suggesting shorting against other dot-coms (though Ebay might be an option, as EBay does have a solid revenue model that isn’t volatile, and has non-technical barriers to entry in its market). I was suggesting shorting against other firms that are dependent on advertising for much of their revenue – e.g. other media such as glossy lifestyle magazine groups or network TV, in an attempt to hedge out some of the risk you’re taking on by shorting. As Google takes 95% of its revenue from advertising, if there’s a boom in advertising then you’d also expect a boost in earnings for the competing firms you’ve went long in.

Recalling the Palm IPO (when Palm was briefly worth more than 3Com *which owned Palm*) the problem with shorting might be the thin float; folks who tried to short >100 shares got their trades refused as the market was just too illiquid for Palm shares.


wcw 05.01.04 at 4:28 am

in re: hedging, you definitely want to hedge a lot more than just advertising revenues. Ebay or Yahoo would seem to be ideal to hedge some of the more obvious market risks of continued overvaluation of the sector. even if you’re right eventually, as Keynes didn’t quite say, eventually we are all dead. until then, you want to beware the market’s getting even more irrational. if it turns out to be March 2000 all over again, you’re happy anyway. what you want to hedge against is March 1998.


Ian Whitchurch 05.02.04 at 10:35 am


We can talk in general, or we can talk in specifics. In general – maybe. In specific – I believe Google can quadruple it’s revenue in the short term, and maybe it can keep it going for 20 years.

Lord Lever once said “Half the money I spend on advertising. My only problem is I dont know which half”. Google can tell you that. If you sell records, Google can tell you – right now – which of your stable of artists are hotter than they were last week. That is worth, literally, billions to most of the world economy. And thats why Google is worth a punt.

I cant speak for anyone else, but for me, Google is the internet. I use them more than half a dozen times each day, and I use them for my job (I work in the capital markets).

The Internet Bubble was like the South Sea Bubble, in that the promotors of the South Sea Bubble were right when they said international trade would revolutionise the business of Britain, and great fortunes would be made. But that doesnt mean the South Sea Company would make profits.

But I think Google will make profits, and enough to justify the valuation of their IPO.

Comments on this entry are closed.