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What's Holding Google Back?

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The stock's recent slip could be a sign of the company's plateauing growth.

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Holding strong as the Internet's top dog with revenue expanding at a 25% annual clip and earnings even faster, you'd think Google (GOOG) would enjoy a market price premium. But judging by its saggy stock -- having slipped well below the $600 point -- it seems the market prefers to price Google as if it were an industry also-ran. Something's holding the stock back.

At $583 per share, Google trades at about 18 times 2010 earnings, and 16 times 2011 earnings. It also trades at price/revenue multiples of six and five for 2010 and 2011, respectively. Longtime technology market watchers recall that these multiples are on the low side when it comes to pricing market-leading companies that deliver impressive growth.

Consider the multiples awarded to Microsoft (MSFT) and Cisco (CSCO) back when they were at the top of their tech industries. In exchange for market domination and fast growth, investors rewarded both of them with forward price-to-earnings in excess of 30 times and price-to-revenue multiples approaching 10 times.

With those kinds of memories at hand, a lot of Google shareholders are frustrated to find the stock lumbered with a multiple half that size. So, what seems to be hindering the stock?
Alas, just like Microsoft and Cisco before it, Google, ultimately, has the law of large numbers to contend with. The bigger its Web search and online advertising market share gets, the tougher it gets to grow. According to online market researcher Hitwise, Google already has more than 72% of the US search market wrapped up, versus Yahoo's (YHOO) 13% and Microsoft Bing's 10%. It's not entirely clear how the company can push market share much higher, at least without incurring the wrath of antitrust agencies.

Moreover, given the astounding efficiency of its search optimization engine, it's not entirely clear how the company can squeeze much more revenue from its huge current customer base. Unlike Microsoft, which used its Windows OS platform to drive huge desktop software sales, Google has no equivalent of the MS Office suite to juice revenues. There's no straightforward way of increasing each search customer's spending by, say, 40% -- the kind of growth that Google will need to warrant a higher share value.

Google might follow that age-old strategy of buying its way to growth. This helps explain why Google agreed to pony up $700 million for ITA Software, an online travel agency technology provider, along with 40 other companies so far this year. The trouble is that we've seen this approach before, and it hasn't turned out too well. Despite spending hundreds of billions on acquisitions over the past decade, Microsoft and Cisco shares have done next to nothing for their holders.

The good news is that Google stock doesn't look expensive. On the other hand, it's hard to find compelling reasons to think the stock will gain much ground any time soon.

Steve Smith's OptionSmith portfolio is +40% in 2010. Take a FREE 14 day trial to get exclusive access to the portfolio and trade alerts emailed to you before every trade. Learn more.


No positions in stocks mentioned.
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