Don’t Ignore These Red Flags For Google

Google (GOOG) had a nice run this year. At current levels, it is trading at a multiyear high since hitting $700 in 2007. It is currently up by 29% for the year. It’s obvious that the market is enthusiastic regarding Google’s prospects over the next few years.

I believe that the historical financial performance of the company has a lot to do with this. For the last five years revenues have grown by 23% a year. This translates to five-year average pretax margins of 31.5% for the same period. This is effectively higher than the previous years’ average of around 25% to 30% operating margins. If you look at closely at the company’s cash flows, free cash flows have also grown from $2.14 billion in 2004 to $34.10 billion in 2011. This is an increase of 298% a year for the seven-year period. This also translates to massive wealth creation for its shareholders. This equates to average return on investment of around 24%. While this is quite high for any U.S.-listed company, the downward trend of its returns is visible.

Competition Will Dampen Future Returns

The biggest driver of Google for the coming years will be its mobile revenues. It is currently in the process of creating an ecosystem that will match Apple (AAPL). Moving forward, I expect to see Google and Apple dominate the mobile industry. As of now, this ecosystem is already present with the Android platform. But Google’s main driver will be its advertising revenues rather than its hardware sales. I believe this is the reason for the market’s optimism in Google as it moves to increase its revenue per search. To continue reading, click here.