Even at $500 Google's Stock Is a Screaming Buy

But investors should take heart. Google's dominant position in a rapidly expanding industry is stronger than ever, and even more important, its shares are — wait for it — cheap. That's right: As improbable as it may sound, this $500 stock actually looks like a bargain.

After the markets closed on July 19 the Mountain View, Calif., company reported second-quarter profits that fell short of analysts' average estimate by three cents a share. Never mind that Google doesn't give guidance, increasing the likelihood that the Street's models will be off. Google is a momentum stock.

"That means that it's not enough to meet the Street's estimate, you have to beat it," says Denise Garcia, an analyst with A.G. Edwards, who rates shares at Buy. "And you can't just beat it by a little; you have to beat it by a lot."

Higher costs were to blame, with expenses rising in every category, most conspicuously for new employees. Indeed, with more than 1,500 people added to the payroll during the quarter, Google hired workers like a Depression-era labor program.

Investors, spooked by the earnings miss, knocked 7% off the shares over the next four trading days. Add in Thursday's drop along with the rest of the market and Google shed more than $40 a share in the last week to $508 as of Thursday's close. The stock's all-time high, hit on July 16, was $558 and change. Shares have given back 9% since then.

There's no doubt it's been ugly and painful. But step back and take a look at the fundamentals and the valuation, and what emerges is a buying opportunity. "The overall thesis on Google remains intact," says Oppenheimer analyst Sandeep Aggarwal, who has shares at Buy. "It's still a growth story with very high profit margins."

Lost amid the hand-wringing over the earnings miss was that Google's revenue rose 58% for the quarter, its seasonally weakest, beating analysts' average forecast. International revenue, adjusted for foreign exchange, expanded 68% and now accounts for almost half of the top line. Meanwhile, Google's market share stands at anywhere from 52% to more than 60%, depending on who's doing the scoring. By comparison, No. 2 Yahoo's (YHOO) share is estimated at roughly 20% to 25%.

Now put that in the context of explosive Internet advertising growth. The nation's top 100 advertisers direct just 5.5% of their total ad spending to the web, according to industry trade publication Advertising Age. Meanwhile, Internet advertising is expected to hit 9% of total ad spending by 2011, according to Jupiter Research, an industry research firm.

Paid search advertising, which is Google's bread and butter, accounts for 40% of total ad spending on the Net and is the fastest growing category, helped by the fact that it's both cost effective and highly scalable.

"Even at 40%, search has just barely scratched the surface," Aggarwal says. "We think advertisers on a long-term basis are going to embrace search. Google, with the largest market share, is the biggest beneficiary of that growth."

That helps explains why 35 out of 38 analysts polled by Thomson Financial rate shares a Buy. The remaining three have it at Hold. Then there's the valuation. With a forward price/earnings multiple of 26, Google trades at roughly a 35% discount to peers, according to Thomson. (Using a narrower peer group, A.G. Edwards puts the discount at closer to 7%.) Yahoo alone trades at more than 42 times forward earnings, or at a 62% premium to Google. Even on a historical basis, Google's forward P/E offers a 40% discount to it own three-year average. (Yes, forward P/E stems from analysts' projections, which were just proved wrong. However, prior to the second-quarter miss, Google beat the Street — by a wide margin — for five consecutive quarters, according to Thomson.)

At the same time analysts' average long-term growth forecast stands at more than 33%. That puts the forward price/earnings-to-growth, or PEG, ratio, at 0.8. That's not only almost incomprehensibly low for a growth stock, but represents discounts of 50% and 35% to peers and the broader market, respectively. (PEG measures how expensive a stock is relative to its growth prospects.) Meanwhile, analysts' average price target of $604 implies an upside of 19% in the next 12 months or so.

So what gives with the week-long selloff? Partly it's just the busted momentum hangover. But there's also lingering concern that Google's turning into a spend-a-holic.

Rick Summer, an analyst at Morningstar, has a rare Sell on the stock. (Morningstar doesn't figure in Thomson data.) "It makes me a very unpopular person," he says, but his thesis cuts to the core of investors' cost concerns. Summer's belief is that Google's investments in marketing and new products will grow more rapidly than sales, and that the company's most recent results are an early symptom of that trend.

"We're not suggesting that they should stop investing for the future," Summer says. "What we're saying is that given their rational investment in the businesses that they are pursuing, it's intellectually honest to assume that operating margins are going to decline over time."

Google gets grief for failing to monetize lots of brand-building investments, from Google Maps to Google Mobile to Google News. Maybe those projects will never contribute to results, or maybe they'll act like call options and offer some pleasant upside surprise. Either way it's too soon to let them obscure what is an otherwise extraordinary business. "We agree that Google is something of a 'one-trick-pony' in its current form, with online advertising accounting for about 99% of total company revenue," wrote Cantor Fitzgerald analyst Derek Brown last week. "But what an absolutely extraordinary trick it has proven to be."

As long as Google maintains its market share in the robust Internet ad market, its outsized growth rate looks secure. It doesn't take a Google search to find that in this case the price is right.