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Markets

What Price Google?

The market isn't sure what shares of the leading search engine are worth. But by some measures, the stock still looks relatively cheap.

Nearly everyone agrees that Google is a great company. But at what price? The market clearly isn't sure. Shares have lurched from a high of $475 in January down to $337 in mid March, and back to $437 last week after an upbeat earnings report. Analysts aren't much help. Their target prices range from $310 to $600.

Google's 41% share of the U.S. search market leads the pack and is growing, and it collects $6 billion of the $500 billion spent worldwide each year on advertising. So it may seem a good bet that the company could grow more than enough to justify whatever price you pay today. But some Cisco investors may have felt the same way when they paid $80 for shares of the world's leading networking company in 2000 after five years of revenue growth averaging 57% annually. Cisco now trades for $21. That should give Google bulls pause.

All relative

If you missed buying shares at Google's March low point, the bad news is that's it is nowhere near the bargain it was a month ago. On the other hand, it's still relatively cheap by several measures. For example, Google trades at 47 times analysts' expected earnings of $9.32 per share for 2006 and 35 times next year's expected earnings of $12.44. That's cheap compared with Yahoo's price-earnings ratio of 63 for this year and 46 based on next year's earnings. Piper Jaffray analyst Safa Rashtchy says market-leading technology companies such as Google can justifiably trade at P/Es ranging from 50 to 60.

Another way to measure Google's value is with the PEG ratio, which compares the P/E to expected long-term profit growth. The faster the growth, the more justifiable a high P/E. In Google's case, the "G" -- the expected growth rate -- is 35%. So its PEG is 1.3, based on this year's earnings forecast, and 1.0 based on next year's. Generally, a PEG ratio close to one is considered cheap. Goldman Sachs analyst Anthony Noto says a leading growth company like Google should trade at a PEG of 1.5 to 2. By contrast, Yahoo's PEG is 2.4 on '06 profit estimates and 1.7 on next year's.

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If you want to take your analysis to a higher level of sophistication -- and complexity -- forget the P/E. Because various accounting maneuvers can distort reported earnings, many analysts rely on a purer measure of profitability that goes by the acronym Ebitda. It stands for earnings before interest, taxes, depreciation and amortization. Many analysts also believe that enterprise value -- a company's stock market capitalization, plus outstanding debt, minus cash holding -- is a better measure than stock-market value alone of how investors value a company.

Crunching the numbers

If you divide Google's enterprise value (think of it as its price) by its Ebitda (think of it as a proxy for profits) based on '06 estimates, you get 30. Yahoo's is 26, so based on this measure, Google is the more expensive stock. Is it a sign Google has become too expensive? Not necessarily, but it's certainly not the deal it was a month ago. Citibank analyst Mark Mahaney argues that because Google has the higher growth rate, its EV/Ebitda ratio should be higher than Yahoo's.

Why does Google trade so far below some analysts' target prices? Perhaps it's because much of its share price represents the promise of future earnings. And as a very young company, Google's ability to fulfill its promise is still largely untested.