Financial management principles and practices

Google/Microsoft

Business Model

Google is, at its heart, an advertising company. The vast majority of the company's income -- 96.3% according to the 2011 Form 10-K -- derives from advertising. Of this, 71.5% comes from Google websites and the remainder comes from Google Network Member sites. Other revenue streams are so small that they are not broken down by unit. These "other" revenues include those associated with the Android mobile operating system and the Chrome browser. Google's search is the market leader, and Google is listed as the number one website in the world according to Alexa (2012). Google's largest competitor in search is Yahoo, with Baidu holding down the third spot in the industry globally. There are another six Google national sites that rank ahead of Microsoft's Bing search engine. Google ties its advertising to its search function. The company provides a wide range of branded websites such as Maps, Scholar and Translate that provide additional knowledge searches.

For its part, Microsoft has a very different business model than does Google. Bing is the company's search website, but this is not a major part of its business model. Most of Microsoft's revenues come from Windows, Servers and its Office suite of products. The entire online business, of which Bing is just one component, contributed just $2.5 billion of the company's $69.9 billion in total revenue. Microsoft does partner with Yahoo, however, and this gives Bing a much greater reach because Yahoo has a much larger market share than does the Bing site. That said, unlike Google, online advertising is just a small portion of Microsoft's business, and overall Microsoft has a more diversified income stream as the result of its multiple strong businesses.

Management Style

The management style at Google is oriented towards innovation and openness. The company for a time put principles ahead of profit in its dispute with China over Internet censorship (BBC, 2010). Google has historically emphasized innovation as a means of doing business, and seeks to make information online more accessible. As a consequence, Google has initiated a large number of spinoff sites to the basic Google site, focused on a number of different sub-categories of search. The company is able to provide searches and information for free because the robustness of its searches makes its results valuable to advertisers. Through different advertising programs, Google is able to match advertisers with web surfers with a high degree of accuracy, and as a result Google is now the dominant online advertising company.

Google sees itself as a growth company. There are a few reasons for this conclusion. This first is that Google does not pay a dividend, a behavior characteristic of a company that wants to reinvest its money in new businesses or in growing existing businesses. Google's management still has a strong innovation orientation, and because the company has tremendous financial resources it expects to enter into new businesses when good opportunities arise. The Android mobile operating system is one such opportunity and to this point Google has yet to significantly monetize this product's industry-leading market share.

By contrast, Microsoft is managed much more like a mature business. The company's dividend payout ratio is very high, and this shows that management sees many of its businesses as cash cows. There is little room for growth through internal investment, so the company returns a large amount of its earnings to the shareholders. Microsoft still has some drive to enter new businesses, using the company's obscene financial wealth. However, products like the Windows Mobile operating system, Bing and the Xbox illustrate that perhaps there is a lack of true innovation at Microsoft these days. The contrast in culture and management style is also reflected in the way that the market views these two firms, giving Google a higher P/E ratio despite the company having a stock price over $600.

Between the two companies, Google is better able to withstand a recession, but there is a caveat to that statement in that both companies are basically recession-proof. Google has $44 billion in cash and a current ratio of 5.9. The company's low debt, high margins and a cash reserve larger than half the world's countries makes it very much able to withstand a recession. Indeed, Google's business just continued to improve through the last recession as though the recession did not exist. Microsoft has even more money than Google, with $52.7 billion on its balance sheet, and a healthy current ratio of 2.6. As with Google, Microsoft did not have too many problems with the last recession, although revenue dropped by $2 billion in fiscal 2009. The main point of difference between these two companies as pertains to their ability to withstand a recession is that Google has almost no debt. The lower the debt ratio, the better a company is able to withstand a blow to its cash flows. That said, Google did not see a reduction in revenue during the last recession. Likewise, it needs to be said that while Microsoft has significantly more debt than does Google, this will not compromise it during a recession, because the company has enough cash to pay off every penny of liabilities that it has -- reduced cash inflows won't hurt Microsoft if the company pays off all of its debt. Thus, while Google is in theory better able to withstand a recession, in practice both companies are equally able to withstand one.

The profitability ratios can provide some insight for investors trying to consider which of these companies to invest in. The return on assets measures how well the company converts its assets into net income. This is a good measure for a tech firm because companies like this do not have many assets, and should avoid acquiring too many assets as that is likely to reduce the return on assets. Microsoft has the better return on assets in part because the company has fewer assets and higher revenues.

The return on equity is another useful measure. It explains how well the company can convert its equity into net income. The value of this measure for investors is that investors are the ones who receive this return. The value of their equity grows as the company earns strong returns. What this means is that companies can increase their return on equity without making more money simply by decreasing the amount of equity in their capital structure. Google has very little debt, while Microsoft has just under 50%. As a result of this, all other factors being equal, it would be expected that Microsoft would have the better return on equity. Indeed, that is the case, and Microsoft's ROE is vastly superior to that of Google.

There are a number of key financial guidelines that investors use to help them choose between two companies. The first of these is the price/earnings ratio. The P/E ratio is important because the value of a stock to an investor is comprised of two parts -- the company's intrinsic value and the expected growth in value. The intrinsic value is the book value, but the expected growth rate is simply the market's expectations of future performance. These expectations are based in part on past performance but also on careful analysis of the company's future business. In the case of these two companies, Google has the higher P/E ratio. This is probably because Google remains focused on growth and innovation while Microsoft seems more focused on earning money with its existing businesses. The key to using the P/E ratio is to understand that under the efficient market hypothesis, the stock price of the company's equity takes into account all known factors. Therefore, stock prices are considered to be fair value. The purchase of one stock over another is little more than a gamble on the change in expectations or performance for the companies concerned. Given Google's current growth and innovation track, there is a good likelihood that the company will emerge with another innovation that will spur a sharper growth rate. Microsoft is less likely to have such a change in direction, and is more likely to face intense competition from more innovative companies. The result is that market expectations are better for Google and they are probably right.

Another key financial guideline for investors, however, is the dividend payout ratio. For these companies, clearly Microsoft has the better one since Google does not pay a dividend. Microsoft's payout ratio is actually very high. This measure is important because dividends rarely decline. As a result, the payout ratio represents a known cash flow, whereas for a company like Google the entire return is based on capital gains. Given EMH, investing in Google is nothing more than a gamble on those capital gains. At least with Microsoft the investor knows that there will be money earned every quarter in the form of dividends.

A third key financial guideline for investors is the debt ratio. There is a good reason for this. The first is that companies with higher debt, while riskier investments, will return better returns to their shareholders, as explained earlier in the discussion about ROE. Additionally, the risk factor is something to take into consideration. Firms that have very high debt ratios are not only closer to insolvency, but because they are riskier will also have higher borrowing costs. There is little to choose form in terms of solvency between these companies, but the higher debt ratio at Microsoft will ultimately be better for investors because more of their money is returned in the form of profits.