Google's Momentum Is Tied To Innovations In Advertising

We typically see many comparisons of Apple (AAPL) to Google (GOOG) where people place the iPhone against the Android or make similar hardware comparisons that mistakenly become company comparisons. People who do this intend to compare apples to apples when they are really comparing apples to oranges. However, Google's business is much different than Apple's business. Google derives 90% of its revenue from advertising, while Apple derives 90% of its revenue from sales of hardware.

On the display side of Google's advertising, innovations are driving growth. Ad Exchange is a real-time marketplace that helps ad networks, agency holding companies, and emerging third party providers to maximize return on investment across millions of sites. With Ad Exchange, audiences are defined enabling advertisers to buy what they want when they want it. Google reported in Q4 2011 that Double Click Ad Exchange increased 130% year over year.

Google has also made the use of Adwords easier for advertisers. Businesses with large catalogs of products no longer have to select keywords for each product. With the new Dynamic Search Ads, the ads are automatically generated based on the content on the customer's website. This allows businesses to advertise an increased amount of products and automatically advertise only those products that are in stock via a monitoring system. Traffic to consumer sites from product listing ads increased 600% year over year for Q4 2011.

Google's Trueview in-stream ads now allow users to skip the ads. Therefore the users who do view the ads are more interested in the advertised products. The company explained that those who do view the ads are highly engaged. View rates for these ads are between 15% to 45%. The company is currently running Trueview ads on the Google Display Network and on YouTube Mobile. Over 60% of Google's in-stream ads are now skippable.

We'll take a look at where the company is right now and where it is going. Google currently looks fairly valued on the low end of the fair valuation scale. It has a trailing PE ratio of 21.55, a forward PE of 12.78, a PEG of 0.84, and a price to book ratio of 3.62.

Google is extremely profitable with a profit margin of 25.69% and an operating margin of 32.3%. It has an operating cash flow of $14.56 billion and free cash flow of $8.29 billion.

Google is another company that has the ability to pay dividends from a portion of its free cash flow but chooses not to. I think that it would be a good idea for Google to pay a modest dividend. This would increase the pool of Google investors originating from dividend oriented mutual funds. Apple's recent declaration of a dividend should benefit the company as more mutual funds invest in the stock. I think that it would be wise for Google to do the same.

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Google has two upward earnings revisions for 2012 and one upward revision for 2013. It is expected to grow earnings annually at 17.91% for the next five years. This solid growth should allow the current stock price of $641 to rise to about $1400 in five years.

The stock has risen from $500 in the autumn of 2011 to its current price of $641 for a 28% gain. Since the stock is still on the low end of fair valuation, I think that the $1400 price target is realistic by 2017. However this stock may not be for everyone, since it can have 15% to 20% price swings in just a few months. Despite the price swings, I think that the long-term outlook remains intact.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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