I, The Absolute

Archive for September 15th, 2005

Google Valuation

Posted by itheabsolute on September 15, 2005

All knowledge/math begins with an assumption. I have tried to look at proofs to contest this belief of mine. I have been trying to see if numbers, regression, LP or any other financial / mathematical models could prove me wrong. None has, at least so far.

Yesterday and today, we had elaborate homework and classroom discussions on Google IPO valuations. The prices quoted by students for Google’s IPO ranged from USD 20 to USD 300. None was the right answer. Nor was any answer wrong. Google itself by pricing its IPO at USD 85 undervalued its own stock.

We had to calculate the discount rate for the company using capital asset pricing model. The following is the formula

Discount rate = Risk free return + Beta of stock (Market risk premium)

Risk free rate and market risk premium were easy to obtain and we were supplied these rates. Beta is the risk associate with a particular stock. How to calculate the Beta of Google when it was never listed on the bourses? The company closest to Google’s model was Yahoo; hence, we “assumed” yahoo’s Beta as Google’s. Discount rate was obtained. Now we had to calculate PV. To calculate the PV, we needed to “assume” the rate at which Google will grow. There is no way we could “know” it. And we also needed to “assume” the number of years for which Google’s cash flows had to be reckoned. We finally applied the formula for PV to arrive at the IPO price.

None of the students got the same price because the assumptions of each of us differed. Fun was, no one knows who of us could be right. Google itself did not know.

We have Nobel Prize winning CAPM and the NPV formulae to give us numbers which can at best be approximations of the possible real values. These models by themselves are helpless because they primarily depend on assumption and human judgment. People who estimated price of USD 20/ USD 300 had different views of Google’s growth.

I will hold to my belief that all knowledge/math begins with an assumption till someone proves me wrong.

PS: Google is at present trading above USD 300 levels.

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