There are times when the market behaves irrationally, driving down good stocks to absurdly cheap levels. Google Inc. is good, but is it absurdly cheap?
Investors have seen Google's stock – once one of the great wonders of the world – tumble 39 per cent since hitting a record high last November, enough to challenge the idea that it is a no-lose bet on the rise of online advertising.
Even over the past two years, Google's path looks troubling: The stock is up just over 16 per cent, which beats the performance of the S&P 500 but pales next to its meteoric rise from its initial public offering in 2004, when the stock rose more than eightfold in just three years.
Some investors believe that the recent setbacks are just a blip in an otherwise upward trajectory for Google, as the drift toward online advertising turns into a rush. But more likely the stock's recent heights are a painful reminder that good stocks can get ahead of themselves.
Google is indeed a good stock. It dominates the online search market with a 70 per cent market share and has been able to translate its tremendous reach into real profit, estimated to rise above $6-billion (U.S.) in 2008, on revenue of about $20-billion. It has also been innovating its approach to online advertising, fine-tuning the way it delivers advertising to Internet users and prices those ads. Last week, it launched the Chrome browser, a new platform for Web pages and applications that should help it compete against Microsoft Corp.'s Internet Explorer.
All of which is fine and good – except that online advertising, like mainstream advertising, is not immune to economic slowdowns. Already, JPMorgan Chase & Co. and Oppenheimer & Co. have trimmed their estimates for growth in online advertising, as advertisers are expected to grow more conservative in these uncertain times. Google, then, can be seen as a bellwether for a bad economy.
As well, Google has begun to suffer from the law of large numbers – that is, as its profits and revenues swell, it falls victim to a slower growth rate. Growth in earnings per share, year over year, has been falling over the past two years – from about 100 per cent in 2006 to 40 per cent in 2007 and to an expected 20 per cent in 2008 – and is expected to slow even more in the coming years.
When this happens, price-to-earnings ratios tend to fall. At their 2007 peak, Google shares had a trailing P/E of about 75, which was reminiscent of the dot-com years; it has since fallen to 29 and will fall even further if investors grow less confident about future earnings.
In its most recent quarterly results, released in July, Google missed analysts' expectations by 7 cents a share. While that is by no means a signal of doom and gloom ahead, it does show that expectations are too high. Down about $300 from its high, Google is cheaper. But it's not cheap.
