Google (Nasdaq: GOOG ) is one of the world's most innovative companies. It has given Web surfers a brilliant search engine and great services such as Google Maps and Gmail. But at 17 times sales and a P/E of 74, I think its stock is priced to perfection -- and then some.
Today, Wall Street's expectations for Google are sky-high. Even a small misstep has the potential to cause current stockholders considerable pain. Analysts currently estimate 30.5% annual revenue growth for the next five years, placing 2011 revenues at about $24.4 billion. That's larger than WPP Group, and Omnicom, two of the largest advertising agencies in the world today, combined. It's a precarious perch for a company facing a number of serious challenges.
The perils of click fraud
Google's ad network runs on a pay-per-click basis. Advertisers set an overall amount that they're willing to spend, and a maximum amount they're willing to pay Google for every time a Web user clicks on one of their ads. Once the ad goes up, each user click costs the advertiser money; when the advertiser's budget has been exhausted, their ad disappears. Owners of third-party sites displaying Google's ads also get a portion of the money Google earns for each click their sites generate.
In click fraud, mischief-makers or unscrupulous rivals repeatedly click on Google ads, either to exhaust rivals' ad budget on worthless clicks, or to generate more revenue for themselves. Google got off cheap when it recently settled a click-fraud lawsuit for $90 million, which should cover all claims since the company launched its pay-per-click ad system in 2002.
While the settlement limits Google's financial exposure, the issue still has not been resolved, and it has the potential to undermine trust in Google's ad network. This in turn could lower the amount that advertisers will be willing to pay for clicks. As advertisers demand better ways to measure ROI on the marketing funds they spend with Google, the effects of click fraud will be easier to measure, and the effect on Google possibly greater.
Canaries in the coal mine?
The rising cost of keywords is another dangerous trend for Google. Since ad prices are set by the market, with each advertiser determining what they're willing to pay to associate their advertisements with certain search keywords, Google has no pricing power and no real control over a potentially irrational marketplace. Companies like 1-800-Flowers.com, Blue Nile (Nasdaq: NILE ) , eBay (Nasdaq: EBAY ) , Priceline.com (Nasdaq: PCLN ) , and others are stating that the cost of doing business with Google is becoming unsustainable.
Blue Nile CEO Mark Vadon specifically stated that the cost of the company's top five keywords rose 80% year over year, driven by smaller, more aggressive players seemingly willing to bid irrationally. This is dangerous, because when prices begin to fall -- as they did for banner-ad leader Doubleclick after the Internet bubble -- Google's revenues and profits will shrink just as rapidly.
The menace of market pricing
While Blue Nile and others may be seeing unsustainable increases in ad rates, other companies may be seeing dirt-cheap rates. In addition, keep in mind that roughly 30% of advertisers switch mediums every year, seeking higher ROI elsewhere, which may be part of Blue Nile's reason for trimming its Google ad budget. Still, rational market players' complaints about higher click costs are a clear warning that the AdSense market is a bit frothy. In Google's defense, companies like Blue Nile and FTD probably have a limited amount of depth to their keywords ("diamond," "flowers," etc.) and are more vulnerable to a shock in ad prices. A more diversified retailer like Amazon.com (Nasdaq: AMZN ) would be able to emphasize cheaper keywords and drive visitors to different types of products.
The costs of content
Google aggregates content from all over the Web -- and many of the owners of that content now seek to charge Google for the privilege. It's not an unreasonable demand, given creators' right to control how their content is used. While the newly launched Google Finance may be a watershed moment for Web 2.0, it is also a watershed moment for Google's cost structure; for the first time, Google is paying to access content by shelling out for Reuters financial data. Other content providers, such as cell phone companies and newspapers, may see an opportunity to cut some deals, ultimately reducing Google's margins.
Don't be evil (most of the time)
As the company expands via massive investments in employees and infrastructure, Google's culture may be fraying at the edges. It must be difficult to preserve corporate values, especially given the 90% growth in Google's employee base in 2005 alone. Privacy issues associated with Gmail's launch went unforeseen by Google management, and were handled poorly. Google's much-criticized cooperation with the Chinese government's censorship of Web data also conflicts the company's "don't be evil" mantra. With violations like these so early in Google's life, will the company continue to act in its users' best interests going forward?
Expand first, make money later
Last but not least, Google seems committed to expanding into as many markets as possible, as quickly as possible, and working out how to monetize those markets later. The company may simply realize that Google search will not provide a sustainable competitive advantage in a market where the search crown seems to change every few years. (Remember AltaVista?) The constant stream of new services such as GoogleBase is great, but so far, none of them have become profitable. Google's sprawling expansion pits it against Microsoft (Nasdaq: MSFT ) and Yahoo! (Nasdaq: YHOO ) , among others, on multiple battlefronts in areas critical to each business's future profitability. It's hard enough for Google to defend against Yahoo! in paid search; to also simultaneously compete with Microsoft and eBay is audacious, to say the least.
The Foolish bottom line
Google is a fantastic company, and to some extent, its current high value is not surprising. The company would be more interesting to me in the low $100s, as competition kicks in and growth expectations drift toward a more realistic 20% or so. Google's current $300-something share price seems like a throwback to a few years ago, when companies were priced solely according to their vision and their audiences. Have we really forgotten the consequences of such blind optimism so quickly?