Google (NASDAQ:GOOG) (NASDAQ:GOOGL) has delivered uninspiring returns for investors lately. Shares of the online search giant are down by nearly 2% over the last 12 months, even while the Nasdaq index rose by 18%.
Most of this weakness seems to derive from declining cost-per-click numbers, meaning Google's ad prices, over the last several quarters. That included a 7% year-over-year dip in the first quarter of 2015. This is creating some concern among investors.
Google is also investing large amounts of money in growth, which is affecting its profit margin. Meanwhile, social media players such as Facebook and Twitter are delivering rapid growth in online advertising, albeit from a much smaller revenue base than Google, and many investors seem worried about the rising competitive threat from new industry participants.
A fundamentally healthy business
From a fundamental point of view, Google is a remarkably solid business with plenty of room for growth. The company is the undisputed king in search, and it owns a massive ecosystem of services and applications that should secure Google's competitive position in online advertising for years to come.
In spite of declining ad prices, Google's overall financial performance is quite strong. Constant currency sales grew 17% year over year last quarter, and Google has a healthy operating profit margin in the neighborhood of 25% of revenue. The business also produces tons of cash flow on a consistent basis, and it has a pristine balance sheet with more cash and liquid investments than debt.
According to PricewaterhouseCoopers, the U.S. online advertising market produced $49.45 billion in revenue during 2014. The figure is expected to grow to $83.89 billion in 2019, and Google will most likely be a major beneficiary from this growth. Even better, international markets are still relatively underpenetrated, and they should be powerful growth drivers for decades to come.
The future looks good
The decline in ad prices is mostly due to expanding participation from mobile and YouTube ads in the overall revenue mix. While ads in these channels sell for lower prices than traditional desktop search ads, they also offer enormous potential for growth.
Both mobile and YouTube are relatively young opportunities, and Google has plenty of room to improve these segments and drive better results for advertisers (and thus more pricing power for itself). For example, Google is experimenting with a "buy" button on its mobile product search pages to produce more transactions and create additional value for advertisers.
Also, the company is investing in several disruptive technologies with enormous long-term potential but little visibility in the short term. These include initiatives such as self-driving cars and glucose-sensing contact lenses for diabetes treatment, among countless others.
Many of these projects will probably have little commercial viability, but some could succeed, and they could open the door to unimaginable economic and technological possibilities. At the very least, it's good to know that Google remains bold and aggressive when it comes to research and innovation.
In the words of Executive Chairman Eric Schmidt:
Most companies ultimately fail because they do one thing very well but they don't think of the next thing, they don't broaden their mission, they don't challenge themselves, and they don't continually build on that platform in one way or another. They become incrementalists. And Google is very committed to not doing that. We understand that technological change is essentially revolutionary, not evolutionary.
Google is undervalued
Google stock trades at a forward P/E ratio in the neighborhood of 17 times projected earnings for 2016. This is in line with the average valuation for companies in the S&P 500 index, and it seems like an attractive entry point for one of the most powerful growth companies in the world.
Even if growth slows in coming years, Google will probably do much better than the average company in the index. It can comfortably justify an above-average valuation on the back of its leadership position in the highly profitable online advertising business.
In a more optimistic scenario, perhaps Google could sustain higher than expected growth for longer than most investors anticipate. This could be because of sustained growth in online advertising, new growth opportunities in different areas, or a combination of both. If this happens, Google stock could deliver outstanding returns for investors over years to come.