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March 02, 2006

What Should Google Do About Its Stock Price?

Nothing!  Nada.  Ignore it.

[full disclosure: Neither Sergey Brin nor Larry Page have asked me for advice.  Haven’t even had a call from CEO Eric Schmidt who I know for his days at Sun and Novell.  But I have lived through a bubble as a CEO so I’ll give them all some advice anyway.]

It’s hard to face the fact that your stock is over-valued.  Google was over-valued at its peak of $475.11; it’s over-valued at yesterday’s close of $364.80.  It was probably over-valued at its 52 week low of $172.57.

At yesterday’s close, Google has a P/E ratio of 73.  It is even selling for 14 times sales!  Small companies get multiples like this or even better because they can grow sales at a very high compounded rate and can grow profitability at an even higher rate as growth makes it easier and easier to cover their fixed expenses.  This growth – if it happens – means they will grow into their stock price.  The market sets prices, almost anyone will tell you, on future expectations – not the past.

Huge companies can’t grow at as high a compounded rate because the universe isn’t big enough to accommodate them.  Google’s CFO George Reyes has been criticized for pointing out this mathematical fact.  Bullshit! He’s right; he’s telling the truth.  Nice of him to worry about investors too dumb to know this.

Moreover, there are diseconomies of scale.  You can’t scale a mouse to the size of an elephant; its legs would break because they’d be too thin to support its bulk.  Likewise, as a company grows past small, productivity per employee starts to go down.  You can’t find enough brilliant solo achievers; worse, you can’t get the best from many brilliant achievers within a large organization because they can’t get noticed without squandering some of that brilliance on internal politics.  You need proportionally more managers, accountants, lawyers and HR people in a large company – more overhead.

For all of 2005, Google had revenue of $1,411,163 and profits of $336,872 per employee.  But, by the fourth quarter, with both more employers and a lower profit margin, both numbers were down: $1,355,187 and $262,838 respectively.  New people are contributing less in profitability each than old people – significantly.

So Google isn’t going to grow quickly into an outsized valuation.

Obviously over-valued stocks can go up. If you’re a speculator, you might want to buy Google on a dip and sell when it recovers.  This is not investment advice; it’s management advice.

You can’t optimize for two things at once; it’s another of those inconvenient mathematical facts.  That means that if you spend executive time on stock price you don’t spend that time on creating a better company.  By staying private until they were very profitable, the Google founders gave themselves time to build an excellent company and excellent technology which now defines and dominates the search market.

As a public company, they can’t afford to get distracted from company building by worrying about the stock price – particularly when the stock is over-valued!

As a public company, they’ve been criticized for not giving “guidance” on expected revenues and profits.  Now that they have “disappointed” the Street, they’re probably glad they didn’t give guidance which might have been lawsuit fodder.  When I was a public company CEO, I did give guidance.  It was a mistake.  Generating the guidance numbers took too much management time.  Worse, the specter of missing the guidance we’d given motivated us to focus on quarterly results when we should have been spending all that time on building a better company for the long term.

Google got this one right.  I hope they stick to it.

Financial analysts are suggesting that Google announce some “strategic acquisitions” or “exciting new lines of business” in order to reignite the market for its stock.  It’s very hard not to listen these suggestions while your stock is sinking as inexorably as it once rose.  But Google doesn’t owe “investors” who bought over-priced stock in hope that’s it would become even more over-priced a short-term bounce so they can execute a quick exit or have a better looking portfolio at quarter end. 

Google owes it to its stockholders not to consider cosmetics at all in making acquisitions; it’s tough enough to choose the right acquisition candidates and to execute acquisitions well even when you focus on all the right things.  Google should only make announcements when it is strategically or tactically important to do so – to get new customers or to attract new partners, for example.  Making announcements with one eye on the stock ticker almost assures you’ll get the timing wrong.

Great companies are great in good times and bad.  A declining stock price isn’t even very “bad” compared to declining earnings or running out of cash – neither of which problems Google is anywhere near.  Declining stock price does mean it’s harder to use options to recruit employees and tends to raise salary costs.  A declining stock price is not as good a currency for acquisitions as an appreciating stock.

But, when a stock is too high, it will eventually come down.  The market will likely over-react on the downswing just as it did on the upswing.  As long as the company continues to execute and doesn’t get distracted by the anguished cries for relief from the Street, the decline sets the stage for future advances.

Last week 26.1% of visits to this blog came through Google US.  By comparison, 2.5% came from MSN search and 1.9% from Yahoo.  Google Canada accounted for 1.6% and Google UK 1.4%.  Google’s challenge is to continue to innovate around this extraordinary position.  These are the numbers Google executives need to remain fixated on along with employee productivity, ad rates, and all the things which really define their business.

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