Valuation models can be dangerous if used naively: An analyst can plug in any growth rate or required return estimate to get a desired valuation. Indeed, a valuation model can be a vehicle to build speculation into the valuation: Choose a speculative growth rate-or speculative near-term forecasts-and you will get a speculative valuation. Garbage in, garbage out. Remember the fundamentalist dictum: Beware of paying too much for growth. We would like to apply valuation models in a way that disciplines speculation about growth. Chapters 5 and 6 have shown that residual earnings and abnormal growth models protect us from paying too much for earnings growth from investment that does not add value. They also protect us from paying for earnings growth generated by accounting methods. But they cannot protect us from our own foolish speculation.

Benjamin Graham hit the nail on the head:

The concept of future prospects and particularly of continued growth in the future invites the application of formulas out of higher mathematics to establish the present value of the favored issue. But the combination of precise formulas with highly imprecise assumptions can be used to establish, or rather justify, practically any value one wishes, however high, for a really outstanding Issue. Reverse engineering gives us a way of handling valuation models differently: Rather than using a model to get a value, use a model to understand the forecasts implicit in the market price. This fits well with active investing. Investing is nota game against nature, but rather a game against other investors. For the active investor, there is no "true" intrinsic value to bed is covered. Rather, he or she is playing against others; active investors "win" if they find that others' expectations (embedded in the market price) are not justified by sound analysis. Thus, the right question is not whether a valuation model gives you the "right" value but rather whether the model can help you understand what expectations explain the market price. With this understanding, the investor then compares those expectations to his or her own. Rather than challenging the price with a "true" intrinsic value, the active investor challenges price by challenging others' expectations. Reverse engineering is the vehicle. At this point, you have not done the analysis to form confident expectations, but you can do the reverse engineering to understand others' expectations. This case asks you to do so with Google, Inc., a firm for which the market has had high expectations. After coming to the market at just under $100 per share in a much heralded IPO in August 2004, Google's shares soared to over $700 by the end of 2007. The firm, with revenues tied mostly to advertising on its Web search engine and Web application products, held out the promise of the technological frontier. It certainly delivered sales and earnings growth, increasing sales from $3.2 billion in 2004 to $16.6billion in 2007, with earnings per share increasing over the same years from $2.07 to $13.53. One might be concerned about buying such a hot stock. This case asks you to challenge the market price in mid 2008, but to do so 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 was 28 percent.

A. Apply abnormal earnings growth (AEG) valuation to value 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 current risk-free rate of 4 percent).

B. Analysts' intermediate-range forecasts (up to five years ahead) are notoriously optimistic, especially for a "hot stock" like Google. Anchoring on only the 2008 and 2009 forecasts, estimate the growth rate in abnormal earnings growth (AEG) that the market is forecasting for years after 2009. What does your answer tell you about analysts' five year growth rate?

C. Build a valuation building block diagram, like that in Figure 6.3in the text, and plot the

EPS growth rates for 2010 to 2012 that are forecasted by the market price.

D. How would you now go about challenging the market price of $520? Calculate Google's PEG ratio. Does this help you?

E. Suppose you conclude that the highest (AEG) growth rate that Google can maintain (in perpetuity) is 6 percent. What is the expected return to buying the stock at $520 with this growth rate? When might you prefer to reverse engineer to the expected return rather than the growth rate?