When Yahoo's stock cratered after posting results that matched analyst estimates to the penny, I remarked that I wished for the same fate for Google.  If Google would just put up in-line results this quarter, and if the market would give them a 10% haircut, I'd be a buyer.  They got a haircut, but not as much as I'd hoped, and for reasons I don't quite understand.

First the facts:

1.) Analyst estimates for Yahoo pro forma earnings per share averaged $0.13.  Yahoo delivered exactly $0.13, and the stock tanked 11%.

2.) Analyst estimates for Google pro forma earnings per share averaged $1.21.  Google blew that away by delivering $1.36.  And the stock was still hammered 6% in after-hours trading.

There seems to be quite a lot of confusion about what what terms like "pro forma earnings per share" and "GAAP earnings per share" really mean.  The simple answer is that GAAP EPS is the number required by the auditors, while pro forma is the number that analysts prefer.  Analysts back out things like extraordinary items (like the gains Yahoo made by holding Google stock this quarter), and they reverse stock-based compensation ($47 million for Google this quarter).

But unlike Yahoo, Google doesn't publish a pro forma number.  And they make it really hard for analysts to quickly compute it.  So it's easy to falsely compare Google's GAAP results ($1.19 per share) with the pro forma estimate ($1.21 per share) and wind up with an invalid comparison -- you'd think Google missed their numbers.  If you really want to look at GAAP, the average analyst estimate was $1.09, and Google still trounced that estimate at $1.19.  Confused yet?  For more on this, see Marketwatch's write-up.

Another factor to consider is that Eric Schmidt, as he does every quarter, tried to get analysts to cool their jets a bit.  While (unlike Yahoo), Google does not provide guidance to analysts on sales or earnings, he did say that the third quarter this year will be difficult for Google.  Q2 and Q3 are seasonally weak for search anyway.  And with Google doing more business in Europe which has a much more pronounced summer drop-off than the U.S., and with a very strong Q3 last year, comparisons will be difficult this year.

But after listening to the call and running my own calcs on the Q2 numbers, all I can say is, "Wow!"  This was another incredible quarter.  By all accounts, Google's rate of growth should be starting to slow and its margins should be starting to shrink.  Last quarter I gushed about Google's dazzling results -- growth was accelerating, margins were expanding, and the business was printing money.  This quarter it's not only more of the same, but it looks to me like Google outdid Q1.  And Q2 is supposed to be seasonally depressed!

Here are the numbers I look at:

1.) Net revenue growth.  This isn't the gross revenue number that Google is forced to report by the accountants.  I first deduct traffic acquisition cost (TAC) from gross revenue.  (TAC is the amount Google pays partner sites for generating traffic to Google ads.)  Just like Ebay reports only their commissions as sales and not the gross value of the merchandise that their marketplace moves, I think the relevant revenue number for Google is the net amount they actually keep after passing through 80% of partner ad revenue to partner sites.

2.) Operating cash flow.  This represents the portion of each dollar of revenue that Google keeps after it pays salaries, utilities, rent, and other normal operating expenses.  I want to see this number growing faster than net revenue, and when expressed as a percentage of net revenue, I want to see that increase as well.

3.) Free cash flow.  This is operating cash flow less capital expenditures.  It's relatively easy for a capital-intensive business like Google (or airlines or cable companies) to throw off lots of cash from operations, but if they plow that and more back into more computers (or airplanes or cable plants), then the net result could be a wash.

So when I look at Google's second quarter using these measures, I'm very impressed.  First, Google is still growing at a blistering pace.  Net revenue is up 110% over last year, which is statistically equivalent to last quarter's 112% growth rate.  No hint of a slow-down here, and Google hasn't even started to monetize new services like Gmail, Local, Maps, Earth or Video.

And Google is achieving this growth not by discounting, but while actually increasing margins -- Google is keeping more of every dollar of ad revenue after they pay operating costs and invest in the business.  Operating cash flow as a percentage of net sales was 38.4% this time last year, then increased spectacularly to 66.6% last quarter, and increased again to 70.2% this quarter.  After investing $157 million in new data centers and offices this quarter (up 163% from last year), Google's free cash flow as a percentage of net sales was an astounding 52.1%, up from 48.7% last quarter, and up from 15.6% last year.

I'm sorry if I'm gushing here, but I've never seen a business perform this well, this consistently.  Google not only provides products with worldwide appeal, but has built a business that performs at levels far greater than its most successful peers.  Microsoft generates tremendous piles of cash each quarter, but they have nowhere near Google's growth rate or profit margins.  Yahoo can't touch 'em, Oracle can't touch 'em, Time Warner can't touch 'em.

So if Q2 was supposed to be a difficult quarter and Google still delivered these sparkling results, how will they do in Q4 when business really picks up?  What's not to like here?

Google and Yahoo were closely corrleated at the beginning of this year.  Then in mid-April Google sprinted up while Yahoo stagnated.  And after Yahoo's earnings release on Tuesday, Google took another step up while Yahoo dropped a sickening 11%.  See my earlier divergence post about why this is more than just missed expectations -- the market is concluding that Google's business is structurally more profitable and faster growing than Yahoo's.

Yesterday I said that Google and Yahoo were diverging. Today investors appear to be continuing the rotation out of Yahoo and into Google.  Even Ebay's good news isn't cheering Yahoo investors.

Two roads diverge in a wood, and I took the one less traveled by, and that has made all the difference. – Robert Frost

Today’s market action after Yahoo’s second-quarter results may look like the garden-variety estimates game, but I detect a more profound shift. I think expectations of Google and Yahoo are diverging, as investors realize that Google has the better growth and profitability story.

After a nice spurt in regular trading today, both Google and Yahoo got hit in after-hours trading when Yahoo released their second-quarter results (listen to a podcast of the analyst call courtesy earningscast). But Yahoo suffered deeper wounds while Google was largely spared. Yahoo was off 10% after hours and down over 7% on the day, while Google was off 2% after hours but still up marginally on the day.

Given that Yahoo’s results were generally in-line with published analyst estimates, what gives? And since Yahoo was seen as a harbinger for Google, why didn’t Google get punished as well?

The easy answer (and the one you’ll see in the mass media) is that investors were expecting Yahoo to beat expectations. In other words, the published analyst estimates didn’t really reflect their genuine expectations. Yahoo’s 13 cents per share, which matched published estimates, failed to meet the “whisper number” (free reg req’d) of 15 cents per share.

The real reason that Yahoo was hit harder than Google may be that investors are seeing what I’ve been stressing for some time now – that Google is a breed apart from the internet crowd and is diverging to the upside from Yahoo and the others.

No question, Yahoo has a great business (I own shares in both Yahoo and Google). But next to Google, Yahoo looks like they’re standing still. Sure, Yahoo’s putting up growth and cash flow numbers that are the envy of most corporations. Yes, Yahoo is still innovating like crazy, they have a massive user base, and their revenues are much more diversified and predictable than Google. But they’ve become a stable, predictable, cash machine (not that there’s anything wrong with that). On the other hand, Google is still a wild growth company that repeatedly blows past even the most optimistic forecasts.

Google has managed to do the impossible – a billion-dollar enterprise with margins that are huge and getting wider, while growing at a torrid pace that is accelerating. Usually, large organizations (like Microsoft and increasingly Yahoo) can milk the cash cow and throw off lots of cash, but at the expense of growth. And usually, margins tend to shrink – not expand – as volume grows.

Let’s look at a few indicators. Yahoo is growing net revenue at the to-die-for rate of 44% year-over-year. That’s awesome until you look at Google’s 108% growth rate. Yahoo generates 46 cents in cash flow from operations for every one dollar in net revenue, which is an incredible margin – until you consider that Google is doing 67 cents per net-revenue dollar. Yahoo generates $417,000 in annualized net revenue per employee – which most CEOs would kill for – until you consider that Google’s employees are more than twice as productive at $912,000.

This is on top of an already-divergent market cap, with Google at about $86 billion and Yahoo at about $48 billion. If you recall, a year ago during Google’s IPO, Google priced at a significant discount to Yahoo. So the divergence has been in the works for some time now, but I’m betting that the gap will widen from here, favoring Google.

So what’s this all mean for Google’s valuation? If Yahoo is fairly valued at a forward P/E of 55, then Google should trade at about $330 just to match Yahoo’s valuation. And if you consider that Google’s much higher growth rate coupled with much higher margins should translate into a much higher multiple, then what’s Google really worth? Of course, maybe Yahoo is overvalued at these levels, but you can see that there’s room for a lot more divergence from here.

For my money, I’m hoping that Google delivers an in-line quarter on Thursday like Yahoo did today, and also suffers a 10% hit. If this happens, I’ll pick up more shares at ~270 because I believe that Google has taken the road less traveled and truly is a different breed.

A big part of Google's consumer appeal and brand strength comes from their Don't Be Evil ethic. Certainly the strength of their engineering and the quality of their products is primary. But Google's competitors like Microsoft and Yahoo also have superb engineering teams.

Google has recognized that to achieve their mission to organize the world's information, they've got to have more than great engineers. They also need the trust of users. Google's competitors can't match the trust that people place in Google.

John Battelle was interviewed on The Podcast Network's Gadget Show, and says that Google's Don't Be Evil ethic can't grow with the company. Download the MP3 here. The discussion of the sustainability of Google's Don't Be Evil ethic starts at 15:25.

Q: Are they really not evil? There are a lot of people saying that they don’t believe it.

Battelle: That’s a tough motto to keep up with, I think. It’s inherently well intentioned, but also inherently subjective.

So the more people that attempt to hold you to that standard, the more subjective standards there are. So what’s evil in China versus what’s evil in the United States is one big example. What’s evil to owners of copyright, intellectual property, versus what’s evil to teenagers who have no money but want to share part of culture? It’s very, very subjective.

So it’s hard to hold that up as a model for your company. I think it doesn’t scale. Which is probably one of the few things about Google that doesn’t scale.

(Crossposted to Don't Be Evil site.)