Google decides to buy YouTube and everyone starts to ask me if it makes sense. At first I didn't know the answer but I gave it a night to ponder the thought. The answer seems simple. Google's stock price is around $400 and the acquisition is announced. The market reaction at first is tepid but reality finally sets in. My trainer is surrounded by a few clients when I give the logic for the deal. If Google is trading at a level of a 40 p/e (price to earnings ratio) and Google just paid $1.6 billion for YouTube, then what earnings does Google need to generate to justify this purchase? The answer is $40 million. $40 million times a 40 p/e equals $1.6 billion. One might respond that Google pays taxes so they need to earn more than $40 million. That is true but even if its tax bracket is 50%, then the advertising dollars needed to fill Google's coffers is still only $80 million.
If you are Google management and you want to buy the number one internet video brand, it seems like a good bet. Google generates about $6 billion of advertising revenues and now they need to figure out if they can find $80 million of advertising revenue for the fastest growing sector of the internet. It seems like an easy decision.
Internet advertising doesn't seem to be slowing down any time soon. Some might argue that Google is overvalued. I am in the Jim Cramer camp. If a company is growing at 35% a year and it has a 40 p/e, then it is cheap. If we are wrong and the stock is overvalued, then Google still made a good purchase of YouTube because it just bought the company with an over priced stock.
