Analyst's Toolkit is a weekly feature that assesses stocks, bonds and funds by using measures that can give different perspectives on valuation. Come back every Wednesday for fresh insights into analyzing securities.
To most people, Google (Stock Quote: GOOG) can do no wrong. Despite Microsoft's (Stock Quote: MSFT) best attempts and massive cash pile, the software company always seems to lag behind in areas outside operating systems.
But now Microsoft has released its Bing search engine, catching the attention of investors. It's a bold move aimed at Google.
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The love affair with Google is easily seen in its stock price. Google has risen 41% this year, almost triple that of Microsoft. Over three years, Google has climbed a total of 12%, compared with Microsoft's gain of 5.9%.
When evaluating those two companies and their merits, investors could consider a method of valuation know as the present value of growth opportunities, or PVGO, to gauge the expected growth priced into their shares. Technology stocks have a history of irrational growth estimates, so this technique can help bring investors down to Earth.
The theory behind the PVGO model is that the price of a stock comprises two components. The first is based on the value of the firm with no earnings growth. The second is the present value of growth opportunities.
The model can be written as follows:
Market price = (projected earnings/required return) + present value of growth opportunities.
Most of the variables are available on TheStreet.com at the stock quote page. Projected earnings can be found under the "Earnings Estimates" tab and the market price, of course, is listed on the main quote page as the current stock price.
The required return is a little more arduous. The number can be estimated by using the capital asset pricing model (CAPM). This calculation sounds far more difficult than it actually is.
The CAPM formula is as follows:
Required return = risk-free rate + stock beta X (return on the market - risk-free rate).
