Powerful Earnings Raise Google's Mark

This column was originally published on RealMoney on May 1 at 3:36 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

If you own Google(GOOG Quote), congratulations. The Internet search and advertising company had a terrific 2005, and all signs point for continued growth.

In fact, the company's earnings exceed on every estimation. However, if you don't own the stock, now is not the time to chase it, because, remarkably, its valuation has run past its enormous earnings strength.

To make sure a company has high-quality profits, the first thing I do is run the financial statement through my earnings power model to create two alternate income statements, a defensive income statement (free cash flow) and an enterprising income statement (economic value added).

The defensive income statement fixes two of the GAAP ledger's four structural limitations, while the enterprising version fixes the other two. Strength in both is required for a company to possess authentic earnings power.

This dual income statement analysis was inspired by Benjamin Graham, the father of value investing.

My analysis begins with the quality of profits chart. Specifically, I look for three things:

1) Is the company profitable on a defensive and enterprising basis for the latest year?

2) Is there a tight fit between defensive, enterprising and GAAP profits?

3) What is the long-term trend?

Google gets high marks on all three counts, as we see below.

The company is profitable on a defensive and enterprising basis, there is a tight fit between all three income statements, and there is an upward trend in all three per-share earnings. So far, so good.

Next, I examine the relationship between defensive and enterprising profits. Using the earnings power chart, I want to know if the company is situated in the upper-right box of this four-box matrix: My research shows that companies situated there are good investments over time.

In Google's case, it has been in the upper-right box every year for the last four years. Even more impressive, the company is moving in an upper-right direction, forging what I call an earnings power staircase.

When a company forges an earnings power staircase, this distinctive chart pattern tells you that management is able to grow the business without tying up lots of money in working capital, fixed capital or elsewhere.

This is a positive, because studies show light-asset companies do better than heavy-asset companies. Google is a light-asset company, as the earnings power chart reveals.

For examples of other companies that forged earnings power staircases and generated substantial capital gains in the process, see my Web site.

And for you number crunchers, I exclude stock-based compensation from the defensive and enterprising income statements because it is a noncash charge. Instead, I use the Black-Scholes option pricing model to estimate the contingent liability of employee stock options, and then subtract that amount when estimating intrinsic value. In 2005, Google's stock-based compensation was $205 million, which management includes in its GAAP income statement.

Google is profitable in the broadest possible sense, and I expect continued strong results on the basis of my reading of its charts.

If you bought Google at a much lower price, then hold on. But I wouldn't add new money unless the stock falls to $250. In my next column, I'll provide a more detailed valuation analysis of Google that will spell out why I wouldn't buy this earnings powerhouse yet.

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