Searching for true value of Google stock

Imagine a company the size of Coca-Cola or networking giant Cisco Systems, but one that is growing at more than 85 per cent year-over-year. How much would you pay for shares in a company like that?

That's not a theoretical question. It's one that investors have to confront when buying shares in Google, and one that existing shareholders have to think about when deciding whether or not to sell those they own. Over the past few weeks, more than a few of the latter have decided to bail out of the search-engine company's stock, which has dropped by more than 20 per cent since January.

Why the sharp decline? After all, Google's business is growing faster than just about any technology company you could name, and certainly a lot faster than most of the other firms out there with a market value of US$110 billion ($162 billion). In the most recent quarter, the search giant's revenue rose by 86 per cent to just shy of US$2 billion, and its profit also climbed by more than 80 per cent over the previous year, to US$372 million. For the full year, sales almost doubled to US$6 billion and its earnings per share rose 267 per cent.

There was a flaw in this otherwise rosy picture, however: despite the incredible growth, Google's profit per share of US$5.50 (excluding certain one-time costs such as stock options) came in well below the US$5.90 per share expected by most of the Wall St analysts who cover the company. And whose fault was that? Some felt that overly ambitious estimates were responsible for the stock's decline, while others blamed Google's refusal to provide profit and revenue guides expected by brokerage analysts.

Unfortunately for investors, there's a little more to it than just some overly bullish analysts or Google's tight-lipped management. That's because almost all of the "miss" in the company's results was caused by a much higher tax rate - and the tax rate was one of the few areas where Google did provide some guidance to analysts. In a nutshell, the company said it expected to have a tax rate of about 30 per cent, but it ended up being more than 40 per cent. For some, that raised a red flag. Why such a big discrepancy?

Google said the higher rate was a function of the breakdown of its revenue between US-based and international sales. In effect, the company didn't make as much money in Europe as it had expected to, and therefore its taxes were higher than forecast. For many analysts, that suggested the company might not have as good a handle on how its business is doing outside of the US as they figured it did - which raises the fear that Google might get it wrong again in the future. When your stock is selling for 25 times sales (as it was at its peak), that's not the kind of uncertainty investors want to hear.

Some analysts were willing to give the company a pass on the profit shortfall. Anthony Noto of Goldman Sachs said the issue was a result of estimating the tax rate on a full-year basis and then having to apportion it to different quarters as the year went on. The analyst kept his "outperform" rating and US$500 target for the stock, and said it still represented good value.

Others weren't quite so sanguine, however - and they have turned out to be right, at least in the short term, as the shares have fallen from US$475 to US$362.

Scott Devitt, of Stifel Nicolaus, for example, is one of the few analysts with an outright "sell" rating on the stock - something Wall St tends to avoid - and he says the "bloom is off" the superstar search company.

"Search is still a high-growth business long term, and Google is the leader, in our view," he wrote in a report. "But Google shares will likely face a period of consolidation as unrealistic expectations are tempered."

Standard & Poor's analyst Scott Kessler also has a "sell" rating on the stock, and said in a report after the company's earnings release that Google still faced "considerable risks".

One of the central risks for Google is that more than 90 per cent of its revenue comes from search-related advertising. That's an incredible concentration of business for a company Google's size, and it means that any slowdown in the search-ad market will hit the company hard, since it has no other business to fall back on. At the moment, search advertising is growing at double-digit rates because so many advertisers are moving their spending online, but there is no way of knowing for sure how long that is going to continue - or how competition from Microsoft and Yahoo will affect sales.

So is Google undervalued at US$362? It's certainly more reasonably valued than it was when it was trading at US$475. Whether that makes it a buy or not is a little harder to answer.