Problem
Challenge Google's market price in mid-2008 by challenging the forecasts implicit in the market price. Tease out those forecasts using the abnormal earnings growth valuation model.
In mid-2008, Google traded at $520. Analysts at the time were forecasting EPS of $19.61 for 2008 and $24.01 for 2009, yielding a forward P/E of 26.5. Analysts' consensus five-year EPS growth rate (this is the EPS growth rate in 2010, 2011, 2012) was 28 percent. Google will pay no dividend.
I. Apply abnormal earnings growth (AEG) valuation to value a share of Google based on these forecasts. Beta shops report a typical beta for Google of about 2.0, so use a high required return of 12 percent (against the risk-free rate of 4 percent). Assume that AEG after 2012 grows at 4% per year, which is the long-term average GDP growth rate.
II. Analysts' intermediate-range forecasts (up to five years ahead) are notoriously optimistic, especially for a "hot stock" like Google. Therefore, now use only the 2008 and 2009 EPS forecasts by analysts, and estimate the growth rate in abnormal earnings growth (AEG) that the market is forecasting (i.e. is implicit in the stock price in mid-2008) for years after 2009. Now assume that AEG after 2009 grows at a constant rate that need not equal the long-term average GDP growth rate. Also, compute EPS each year until 2014 implied by the growth rate in AEG that the market is forecasting. What does your answer tell you about analysts' five-year growth rate of 28 percent (EPS growth rate in 2010, 2011, 2012) mentioned above?
III. Assume the same information as in the Assignment. Again use only the 2008 and 2009 EPS forecasts by analysts, and now suppose that Google's constant AEG growth rate after 2009 is 6 percent per year. What is the expected return to buying Google stock at $520 with this growth rate?