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The WSJ profiles Eugene Walton, one of the few Google (GOOG) bears on Wall Street. Walton just raised his price target on Google from $200 to $225, which is about 35% below where Google’s shares are now.

The difference between Walton and others on Wall Street is that he uses discounted cash flow to value Google. Wall Street prefers to use "relative valuations," meaning to compare Google’s valuation to similar stocks like Yahoo (YHOO).

The downside of relative valuation is that if the stocks you're comparing to are mispriced, you still won’t know the true value of the stock you're analyzing. All you’ll learn is that stock X is no more overpriced or underpriced than stock Y. Even though both may trade at ridiculous levels, there’s little comfort that they may do so equally.

Many of Mr. Walton's Wall Street peers expressed some reservations about Google's future growth rate but still upgraded the stock, saying they believe the company will outperform the competition. Uncertainty about Google's future warrants use of more conservative assumptions, says Mr. Walton. In his valuation, he assumes that Google's long-term, or "terminal" growth rate -- the rate at which cash flows are expected to grow, theoretically, in perpetuity -- is 2%. Another analyst who uses discounted cash flow, Philip Remek at Guzman & Co. in Coral Gables, Fla., used a 7% rate to come up with a price target of $260.

The relative-value proponents "want to play it both ways," says Mr. Walton. "They're being conservative about earnings beyond 2006, but they're also trying to justify the current share price. You can't do that."

Many academics contend that terminal growth rates should never be higher than the gross domestic product; otherwise, a company would eventually grow so fast that it would overtake the entire economy. Goldman Sachs estimates the GDP growth rate over time at between 3% and 3.5%.

Aswath Damodaran, a professor at New York University's Stern School of Business who specializes in valuation, says he isn't surprised that analysts using the relative-value method find Google to be fairly priced or undervalued. They feed into their long-term growth assumptions "whatever irrationality is driving the stock price today," he says.

Posted by edelfenbein at October 28, 2005 3:02 PM