Despite the strong market for paid search and its respected brand name, Google's ( GOOG) shares are fairly priced, Merrill Lynch said in a research note Wednesday.

The brokerage initiated the stock at neutral and said a 10-year discounted cash flow model yields fair value of $204 a share. The stock closed Tuesday at $194.50 and was recently down $1.55, or 0.8%, to $19.295 in premarket trading. Google more than doubled last year after going public at $85 in August.

Google has just one real peer in public markets, Yahoo! ( YHOO), even though it derives a far greater percentage of its revenue from search advertising, Merrill argued. Merrill said Google trades at a slight discount to Yahoo! on the bases of price-to-adjusted-earnings, price-to-earnings growth and enterprise value-to-earnings before interest, taxes, depreciation and amortization.

On a price-to-sales basis, Google is more expensive: about 17.4 times expected 2005 sales compared with Yahoo!'s 12 times. Merrill expects the company to earn 60 cents a share on revenue of $170 million in the fourth quarter.

"On an absolute basis, Google's valuations appear high on a P/E and PEG basis, but given the current fantastic growth rate of the industry coupled with the market's sense of the 'what's next' potential, the absolute valuations could end up looking really rational in retrospect," Merrill wrote.

The brokerage expects Google to post 50% EBITDA growth over the next year and 30% growth in the subsequent five years, rates that it said justify the high EV/EBITDA multiple.

"Although Google is a well-branded search engine, the shares are likely to be volatile, and trade on changing sentiment for the paid-search sector," Merrill said. "We expect some volatility in the early part of the year based on restricted shares being released and based on our estimates of the online paid-search market and Google's share of the market, we ultimately believe that Google's shares are fairly priced at this point."

Merrill Lynch has an investment banking relationship with Google.

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