Google: How Much Is Too Much?


By Ben Elgin Back in August, as Google raced toward its initial public offering, many would-be investors felt its executives were a bit too cocksure. After the search-engine giant first predicted it would fetch between $108 and $135 per share, Wall Street dismissed the offering as far too expensive, forcing Google (GOOG) to drop its asking price to $85.

Today investors who passed on the stock at $85, or even $135, are no doubt kicking themselves. Less than three months after its IPO, Google's stock has rocketed to $187 per share -- 120% above its asking price and 52% above the midpoint of its first, seemingly inane prediction. But if Google's stock was arguably overpriced in the low $100s, it must be beyond the realm of sanity today, right? The answer isn't quite so simple.

CHECK THE NUMBERS. For starters, the landscape surrounding Google has changed dramatically since its offering. Its closest competitor, Yahoo! (YHOO), has seen its stock surge 32%, to $38, since late August, meaning a similar rise could be expected for Google. At the same time, Google obliterated third-quarter expectations on Oct. 21. Its $503 million in revenues topped analyst estimates by 11%, while adjusted net income of $125 million - factoring out one-time items, such as a legal settlement with Yahoo - beat estimates by nearly 30%.

The blow-out quarter inspired analysts to dramatically boost future projections, thus resetting the equations that had deemed Google's stock overvalued. Based on these recast 2005 profit projections, Google trades at a seemingly reasonable 55 times next year's earnings. Yahoo, by contrast, trades at 76 times its 2005 earnings, while eBay (EBAY) boasts a multiple of 63. That Google should be valued 15% to 25% below its seasoned Internet brethren makes sense to many stock pickers, given the search giant's less-experienced management team and homogeneous revenue stream.

What's encouraging is that Google appears to have gained significant market share over the past several months, in spite of massive competitive efforts launched by Yahoo and Microsoft (MSFT). According to analytics firm WebSideStory, Google has gone from handling 41% of U.S. searches in March to 49% in October.

SINGLE-BARREL BUSINESS. Revenue figures seem to back this up. Google's paid-search sales grew 19% sequentially, vs. 8% to 10% quarter-over-quarter growth for Yahoo's search advertising. "It's unclear whether this was caused by publicity from Google's IPO or by the company innovating," says Mark S. Mahaney, analyst at American Technology Research.

Although Google is picking up steam and may not be exorbitantly expensive compared to competitors, by other metrics it's probably a little overpriced. Take free cash flow. Janco Partners estimates that Google is trading at 48 times its 2005 free cash flow, a 14% premium above Yahoo's multiple of 42. Because Janco analyst Martin Pyykkonen believes Google should have a trading multiple 20% below that of Yahoo, due to its unproven track record and concentrated revenues, he has pegged Google's target price at $125 to $140.

Moreover, Google's early successes haven't dissipated its long-term challenges. The company remains a single-barrel business, with nearly all of its sales coming from ads next to search results. "Yahoo certainly has more arrows in their quiver," says Pyykkonen, pointing out that the portal generates roughly 40% of sales from search ads, 40% from so-called "display" ads scattered across its online properties, and 20% from subscriptions services, including online personals and fantasy sports.

WHERE'S THE MONEY? With search ads a booming business, Google's lack of revenue diversity hasn't been a problem. But many industry analysts believe this market could significantly decelerate in the next year or two. Researcher eMarketer predicts growth of such search ads in the U.S. could slow from 55% this year to 19% in 2005. Although overseas growth will continue at a faster clip, the looming domestic slowdown shines a spotlight on Google's lack of other businesses.

Such concerns certainly aren't lost on Google. The search giant has been rolling out a number of new products, from its ad-supported e-mail offering dubbed Gmail to new software that searches users' computer hard drives. While these are interesting technology bets, they have yet to show serious money-making potential.

No question, Google has far exceeded expectations thus far as a public company. Its stellar performance has muted many of its skeptics. But while Google has made a case for a stock price in the $125 to $150 range, investors who dare to buy near $200 are probably taking a mammoth gamble. Elgin is a correspondent in BusinessWeek's Silicon Valley bureau


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