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Google’s eye-popping stock price is still cheap

Wow, $3.2-billion (U.S.) is an awful lot to spend on a maker of beautiful thermostats. Unless, of course, you are Google Inc., the company that is becoming so large, with such grand ambitions, that it may justify being named for the number 10 to the hundredth power.

Google's latest acquisition, the maker of those beautiful thermostats, is called Nest Labs. To be fair, the devices are said to be quite a marvel: They learn your home routine, program themselves, and can be controlled via smartphone. (In the market for a thermostat myself, I recently passed on the $250 Nest for a $25 programmable Honeywell.)

The deal seems like folly until you realize that Google now has a market capitalization of $384-billion and $55-billion in cash on hand. That valuation, and that cash pile, is not because of Google Glass eyewear, or the driverless car, or the robots, thermostats, or whatnot. It's because Google's one great, original idea – the world's best Internet search engine – has given it the luxury of dabbling in all sorts of futuristic ideas that can seem like nonsense.

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Or, more importantly for investors, that one great idea is practically on autopilot, racking up sales gains of 20 per cent quarter after quarter. Despite the eye-popping sticker price on Google's shares – $1,148.62 at Wednesday's close – you can buy one of the world's great businesses for a perfectly reasonable amount and get all that weird stuff practically for free.

About that $1,000-plus price tag: Google's perverse refusal to split its shares makes its stock seem expensive to even relatively sophisticated investors, even though it is not. Since analysts expect Google to post earnings per share over the next 12 months of about $50, according to Standard & Poor's Capital IQ, its forward price-to-earnings ratio is just above 20.

For that, you get the business that continues to benefit most as advertising shifts away from traditional outlets like newspapers and television, and migrates online. In a recent Reuters Breakingviews article, Rob Cox and Richard Beales noted that had the U.S. newspaper industry grown from the year 2000 on at past rates, it would have had around $80-billion in ad sales today.

Instead, it had $18.9-billion in 2012; that $60-billion in "missing" revenue is roughly akin to what online search generates today – and Google has about $44-billion of it, from virtually nothing in 2000. In its third quarter, Google reported 22 per cent sales growth on the websites it owns; they contribute nearly two-thirds of the company's revenue. "Partner sites" provide another 20 per cent, or so. "Paid clicks" on ads on Google and partner sites grew 26 per cent, year-over-year, in the quarter.

Shawn Milne of Janney Capital Markets, who has a "buy" rating and a fair-value estimate of $1,220 per share, estimates the global Internet advertising market is $120-billion and growing at a rate of 15 per cent to 20 per cent per year. Google has the "dominant position in search" and will provide even more advertising solutions, including for mobile phones.

The rest of it, to use jargon, is what they call "optionality." In a September note about Google Glass, analyst Robert Peck of SunTrust Robinson Humphrey said investors "are paying for and focusing on the core, getting [Glass's] upside potential 'for free.'"

Mr. Peck thinks Google Glass could be worth $3-billion to the company by 2017. He also said this week that he believes Nest could add $3-billion in sales and $1.3-billion in gross profits by 2017, assuming 5 per cent of the homes in the United States buy the $250 Nest thermostat and two of the company's new $140 smoke alarms.

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With all due respect to Mr. Peck, I don't think either of those things will come true, actually. But at Google's current valuation, it doesn't cost much of anything for Google, or investors, for that matter, to take a flyer on any of these ideas.

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