Don't go gaga over Google

(Fortune Magazine) -- With Google in its mid-toddler years as a public company - it turns three on Aug. 19 - it has achieved something truly historic: It has created more investor wealth in less time than any company in history. So investors, repeat after me: All hail, Google! But don't put it in the wealth-creation pantheon quite yet. And please don't buy it at today's price.

The company's Wall Street rise has been breathtaking, especially when you look at wealth creation in the most fundamental and revealing way: total dollars that investors could take out today (the market value of all equity and debt) minus total dollars that they put in (equity investments, loans and retained earnings).

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Google's figure is $149 billion and rising fast, pushing the company past most of America's biggest, most successful, most respected corporations. With Google (Charts, Fortune 500) at its recent record stock price of well over $500, only three companies have created more wealth: General Electric (Charts, Fortune 500), Exxon Mobil (Charts, Fortune 500) and Microsoft (Charts, Fortune 500).

That's an extremely fancy neighborhood, and what makes Google's arrival even more surprising is that the neighbors had to use way more capital to get there. Microsoft has used about $30 billion, GE more than $100 billion, and Exxon more than $200 billion. But Google has created all that staggering wealth using only $9 billion of capital. This is the info-based economy at its most dramatic and amazing.

Of course, any company's wealth creation rises and falls with its stock price, which raises a huge question in evaluating Google's achievement: Is today's price sustainable? I must report that there's just no way it is.

Every company's objective is to earn a return on capital that exceeds its cost of capital. Sounds obvious, but it's remarkable how many managers and even some investors lose sight of that fact. In performing this bedrock task, Google has been a superstar. Its cost of capital has consistently been around 13 percent, while its return on capital for the four quarters that ended March 31 was 52.5 percent. The resulting spread, almost 40 percent, is simply stunning and better than that for 99 percent of the companies in the Russell 3000, says the consulting firm EVA Dimensions.

So what's the problem? Just this: Google's tremendous past has sent investors into a delirium about its future. When you buy a stock, after all, what you're paying for is the future. Specifically, a stream of future profits, in particular what's called economic profit or economic value added (EVA), the dollar amount by which return on capital exceeds the cost of capital. With that in mind, I asked EVA Dimensions to calculate the EVA that Google would have to produce to justify today's stock price.

Here's what it found: To live up to the expectations embedded in its current share price, Google would have to increase its EVA, which was $2.4 billion for the past four quarters, by $2 billion annually this year, next year, and every year into the future - forever. So Google's EVA next year would have to be $4.4 billion; in five years it would have to be $12.4 billion, and so on.

That's what investors are counting on when they buy Google at today's price. Are they being realistic? No, they're not. To hit that EVA target, Google would have to invest $5.1 billion every year at its recent knockout return of 52.5 percent (assuming its capital cost doesn't vary much). But you can't invest $5.1 billion every year at 52.5 percent.

Indeed, the info-based economy just doesn't require that much capital, so investing mammoth sums almost always leads to lower, not higher, returns. Sure enough, Google's return on capital has been declining steadily as it has grown and invested more. Four years ago its return was 111 percent; the following year it was 82 percent. If the return continues to slide, which wouldn't be surprising, Google would find it even more difficult to hit the EVA target.

This analysis doesn't mean that Google stock will tank next week. Irrational valuations can last a long time, and sometimes they correct gently rather than violently. And it doesn't mean that Google is poorly run. On the contrary, it has been brilliantly run. It means that amid the breathless coverage that will doubtless attend Google's IPO anniversary, we need to remember that the ringing superlatives are based on a stock price that's nuts. Google is a terrific company that may one day deserve to sit beside GE, Exxon and Microsoft. But not yet.