Google to $260

Google yesterday reported an 82 percent increase in profits for the most recent quarter, which disappointed investors and drove the stock lower in after-hours trading. Google shares opened below $400 this morning (and are off 8.94 percent at this writing). Is this the end of the party, as CNNMoney.com wrote today?

Oh, I think the party was over a while back, when Google started spending prodigouslyMy target for Google stock at the end of the year: $260. on its in-network inventories. The rush to create new services is driving costs higher. I recently heard that Google is offering freshly graduated programmers in its Kirkland, Washington, office starting salaries of $84,000, with signing bonuses on top of that for some—talent is expensive, but this kind of base salary is outlandish.

Tristan Louis is pointing to similarities to Netscape, another company that enjoyed an apparently insurmountable market share, yet failed. Not that any one thinks Google is poised to fail, though I think the idea that it's just Wall Street over-reacting and Silicon Valley will shrug it off, as Om Malik is writing, is off base.

My colleague, Tom Foremski, points to the hidden good news for Google, that it is growing Google-owned ad inventory: "Tuesday's Q4 GOOG report shows Google sites generated revenues of $1.098bn, an increase of 24 per cent from Q3. Network sites generated $799m, an increase of 18 per cent from Q3." Overall, revenues grew 21.6 percent in the fourth quarter compared to the third quarter of 2005.

That Google has more of its own inventory looks good, if you want Google to become a centralized service. Investors have benefitted from the decentralized advertising model Google invented. By bringing more inventory under the Google ownership umbrella, Google is embracing higher costs to keep this content interesting and engaging. It may also limit what it features in search results, because it needs to drive traffic to partners, like Time Warner, in order to earn revenue from those relationships; that will begin to defeat the perception Google is your access point to the world's information (unless you're in China, of course).

Let's look at how much it cost to add that in-network revenue. The cost of operations, if you subtract stock-based compensation and Google's contribution to the Google Foundation, grew 19.77 percent in the fourth quarter of 2005 compared the third quarter.

It's always good when a company spends more and makes more, but the 1.83 percent difference in spending increases and revenue growth is narrower than investors want to see for a company trading at 87 times trailing earnings. Any stumble—and we saw one in the disconnect between expectations and actual performance yesterday—is going to bring Google's stock down.

Google's stock appreciation has risen on the constant activity of new announcements—Print, Video, GMail, News (now out of Beta!), to name a few—all of which add to the companies fixed costs. But the returns on its investments don't seem to be maintaining the kind of magical margins that hold up a $400 price. The company is running a very narrow margin between new revenue and new spending. That makes Google stock riskier, so the era of slam-dunk returns is over.

My target for Google stock at the end of the year: $260, which should put the company at a trailing P/E of approximately 39.