Google a Strong Earner, but a Weak Buy

In my earlier column on Google (GOOG - commentary - Cramer's Take), I used the Earnings Power Chart to gauge the quality of its reported, or GAAP, profits. In case you missed it, Google boasts profitability that can appease a pessimistic commercial banker and an optimistic venture capitalist. This type of strength in both is required for a company to possess authentic earnings power.

Even better, Google is forging an Earnings Power Staircase. When a company forges a staircase, it is growing fast without tying up lots of money in working capital, fixed capital and other assets that reduce free cash flow and dampen net returns on capital. Google's powerful trajectory should persist, based on my reading of its Earnings Power Chart.

So, do we buy the stock?

To answer this question, we need to value the business. After all, even a great company can be a bad stock if we overpay. Wal-Mart (WMT - commentary - Cramer's Take) is a case in point. Although earnings at the world's largest retailer are up 123% since 1999, the stock is down 33%, to $47 from a high of $70.

Why? Because investors today are paying a lower multiple of earnings than in the past. Six years ago, Wal-Mart sold for 58 times trailing earnings. Today, however, it sells for just 18 times.

There are many ways to appraise a business. Because each method has its strengths and weaknesses, savvy investors use multiple approaches. I will analyze Google using my "65-15" Test, which answers two questions:
1.) What is my price-intrinsic value (PIV) ratio?
2.) What is my expected return based on the current stock price?

The test's name stems from my desire to see a PIV of 65% or less and an expected return that is north of 15%. As strong an earner as Google is, the company fails this test on both counts.

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Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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