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Google: Healthy and undervalued

Is Google financially healthy and worthy of your investment money? Don Reisinger explores the company's financial stability.

There's no debating that Google is a successful company. Aside from dominating the U.S. search market and the online advertising business, the tech giant has become a Wall Street darling, thanks to strong profits. Google's stock price that, at its height, rose above $700 per share--the company at that time had a market capitalization of approximately $250 billion.

But as the economy has slowed and the world sank deeper into a recession, Google has fallen with it. The company's stock price is now just $312 per share with a $98.42 billion market capitalization. Online ad spending will slow during 2009, and some investors believe Google could be impacted greatly.

Realizing that, I thought it would be a good time to look into Google's real value and decide if it's worth investing in, even as economic troubles continue to plague the world. Is Google a good bet for long-term gain?

Let's explore the company's financial health and find out. (Note that all the findings below are derived from Google's 2007 Annual Report and 2008 third-quarter data. The company plans to release 2008 fourth quarter data on January 22.)

Cash and income: Ideal and ideal
When evaluating the financial health of a company and determining whether or not you should invest your money in its stock, it's best to start with the easy stuff--income and cash. And in that department, Google is performing extremely well.

According to its latest quarterly filing data, Google's operations have grown at a healthy rate. Its last reported quarter, ending September 30, 2008, yielded the company more than $1.28 billion in profit, up more than $40 million over the previous quarter, and $200 million over the same quarter in 2007.

Google's cash reserves are equally healthy. The company's total cash-on-hand increased more than $3 billion year-over-year in 2007 and so far, after three quarters reported, the company has added more than $2 billion to its coffers in 2008. Expect that number to climb higher than $3 billion once again when the company's 2008 Annual Report is released.

Balance sheet health: Outstanding
When examining the value and growth potential of a company, its balance sheet can be a key indicator of whether or not you should invest money. Some companies have strong profit figures, but thanks to costly debt that's coming due, those profits may not adequately reflect the true financial health of the company. That said, you don't need to worry about anything of the sort with Google--it doesn't have any debt in its financial structure.

A quick check of Google's balance sheet reveals the online giant is in an enviable position. According to its latest quarterly filing, its assets--cash, investments, receivables, and property--are valued at more than $30 billion, while its liabilities are valued at just $3.3 billion. The balance can be found in the company's Stockholders' Equity section, which boasts more than $13 billion in retained earnings--the portion of the net income that is kept by Google--as well as Capital Surplus--capital received from investors who are paying more than the par value for each share acquired.

So what does all that mean? Google is extremely well-off. The company has no worry of long-term debt, which is a major drain on some, less-healthy companies, and with more cash each month, it's fully capable of acquiring other firms and paying its bills at the same time without borrowing funds from banks. That's a luxury only a select few companies can enjoy.

EPS and P/E: Yep, good here, too
More often than not, companies are valued based on their earnings. Because of that, key calculations like earnings per share (EPS) and the price-to-earnings (P/E) ratio are used by most analysts to offer opinions on whether you should invest money in a particular company or not.

Earnings per share measures the amount of profit attributed to shares owned by investors. The higher the EPS, the more valuable a stock actually is.

In Google's case, based on its latest quarterly data for the period ending September 30, 2008, the company's earnings per share was determined to be $4.06. According to its 2007 Annual Report, Google's EPS for the year ending December 31, 2007, was a whopping $13.29. Year-over-year, Google's earnings per share jumped by about 30 percent.

The price-to-earnings ratio is used by some analysts to determine the financial health of a stock. In essence, the P/E ratio determines if a stock is fairly priced. Some analysts believe the P/E ratio should match the growth percentage of EPS, which, for Google, is about 30 percent between 2006 and 2007.

Based on its financial data, Google's trailing P/E ratio is 19.67, which suggests, based on its EPS growth year-over-year, the stock is slightly undervalued at its current price. That said, using that comparison to determine value and financial health without considering market factors and key indicators like management effectiveness, can be dangerous.

Management effectiveness: Great

How well are Eric Schmidt and other top-level executives performing at Google? Much better than you would expect.

In order to determine management effectiveness, the investment community has developed two calculations: return on assets (ROA) and return on equity (ROE). In essence, ROA measures the company's profits attributed to assets, while ROE measures the company's profit attributed to its equity, or ownership interest. On both counts, Google fares well.

According to data produced from Google's financial statements, its current return-on-assets ratio is 14.35 percent, while its current return-on-equity ratio is 20.82 percent. That tells us that Google earns 14.35 percent profit on all the assets it owns, and it generates a 20 percent profit on every dollar invested by shareholders. Generally, and depending on the industry, a higher ROE means a company is more efficient. In Google's case, a 20 percent ROE should be heartening to potential investors.

Market factors and forward-thinking considerations
Is Google a financially healthy company? Absolutely. But that doesn't mean the online powerhouse will be able to stay that way forever. The business world, and especially the tech industry, are rife with companies that once dominated a market and now are trying desperately to make their way back. Some of that is due to mismanagement and sometimes those issues arise because macro-economic factors play havoc on a company's ability to compete.

Realizing that, it's tough to determine if Google will enjoy equal success over the long-term. Sure, the company's search engine market share is climbing each month in the U.S., and it's performing admirably all over the world, but its revenue comes from online advertising, which is expected to take a beating during 2009 as the economy continues its nosedive.

Meanwhile, there is little indication that Android, its open-source mobile operating system, will be able to compete on the same level with other mobile powerhouses, like Apple and RIM, and Google's acquisition of YouTube has led some analysts to wonder if it was a smart decision, since the revenue it's generating from the world's most popular video site is still immaterial to the company's financial statements.

But all that may not matter. Google is still the leader in online advertising, and with ventures like Google TV Ads, its executives are doing their best to expand their advertising empire into other realms. All the while, Google continues to enjoy strong profits and with no debt in its financial structure, there should be little worry of financial ruin anytime soon.

What is Google really worth?
Taking everything mentioned here into account, it becomes clear that Google is undervalued. Based on the health of its financial structure, its growth in the search business, and its domination of online advertising, the real value of Google's stock price, in my opinion, is substantially higher than its current share price.

When will it be fairly valued? It's tough to say. With a bearish market and shy investors, it could take at least a year. But I don't see any way this stock won't climb over the coming months; it's too attractive and too good of a buy not to.

Don Reisinger's financial expertise and ability to evaluate public companies comes from his work, prior to becoming a journalist, as a public company auditor. He holds no positions in Google.