• by Diane Mermigas , April 21, 2008

It's time to hose the Wall Street and Silicon Valley exuberance over Google's quarterly earnings and regained stock-price momentum. Soon, they will be gnashing their teeth over how to assign valuations to Google's ambitious cloud computing endeavors and its reinvention of media ad models. Google's cyberfollies have only just begun.

These two areas alone--cloud computing and advertising--will create billions of dollars of new wealth. They will transform the fundamentals and expectations of consumer-centric, ad-supported and increasingly social enterprise. And everyone is clueless about how to measure the results and to value the connections.

That is the heavy lifting awaiting media and commerce, which will look to Google's innovation and complex algorithms for answers. Still, the quintessential long-term, big-picture player is a publicly traded disruptor that has to indulge investors in short-term fixations. Google's advertising business--particularly in sensitive financial service and retail sectors--will begin to get soft in a protracted recession, although half of its revenues now come from overseas.

It will try to be a spoiler in Microsoft's unsolicited takeover of Yahoo, which has 18% of the online display advertising market. And Google will continue to refine search and measurement. Of course, the pace of domestic online growth is slowing, even as double-digit increases continue, leveling off as any new business would.

But understanding Google and its dramatic impact on overall business means looking at the next three years. Let's examine its international growth, morphing its paltry 1% share of the display advertising market, and developing precise social-networking metrics and general applications for nascent interactive platforms and devices.

More importantly, Google will use its recent DoubleClick acquisition to retool all of media advertising, including transactions and e-commerce. It will use its YouTube platform to revolutionize ad-supported online social-networked video. It will create ubiquitous search, share, and store across a sky-full of servers and integrate its innovative applications with Salesforce.com. It's the stuff of a near-term business revolution--and future Google mega profits that are sure to create stock price and valuation volatility to rival any we have seen from the company in recent months.

This underscores one of the most formidable and important challenges ahead: reconfiguring valuation of traditional businesses with declining legacy fundamentals, and gaining a grip on valuations of evolving business models that will take their place. But will there be necessary adjustment from a shortsighted stock market and jittery marketplace with no attention span or tolerance for seismic change?

This requires real-life, real-time examples that remain scarce. Amazon.com, which reports earnings this week, has a new cloud computing model at the heart of the infrastructure service for third parties that is not yet a line-item on its balance sheet. When Google introduced its auction-based, automated, front-end, self-service system of ad sales, and brought smaller advertisers into the fold with AdWords, it made a fundamental shift in the way advertising is generated, priced and measured. Operating Margins and revenues per employee were unprecedented, given the lack of a sales force and marketing event expenses. The changed formula and estimates are now baked into Google's revenue numbers.

The same will occur when Google brings front-end automation to display advertising across all media platforms--getting rid of the overwhelming inefficiencies and inconsistencies, especially in television and print. Bernstein Research estimates it will happen in less than five years, with Google at the helm. How else will it achieve its set goal of becoming a $100 billion revenue company?

None of that is reflected in Google's present valuation, which is rooted in familiar metrics that may not tell the entire story. RBC Capital Markets analyst Ross Sandler blends P/E, earnings and free cash-flow yield on 2009 estimates to devise a $143 billion market cap and $550 share target price (before Friday's surge). Google's first-quarter profits rose to $1.3 billion from $1 billion a year earlier on a 42% growth in revenues of $5.2 billion, while maintaining the same 30% margin as the fourth-quarter holiday period. Its $938 million in free cash flow is up 50% from 2007.

The more immediate lesson from Google's quarterly earnings report was the reliance on metrics. Google reported 20% global paid-click growth versus comScore's forecast 2% domestic growth, which sent investors and analysts into withdrawal before Google reported April 17. The road to developing more reliable metrics will remain bumpy. There must be some dependable third-party measurement to keep competitors accountable. If you think it's complicated now, wait until it's all about engagement, mapping, referrals, transaction assistance fees, and social capital.

Google's biggest one-day gain ever on Friday suggests that instant gratification for quarterly snapshots--the anticipation of which is heavily molded by conflicting third-party data--is not the best way to track the progress of companies or sectors. There was never a greater need for diligently tracking the amorphous big picture. This is no time for ignoring the greater forces at work.